The Kroger Co. Form 10-Q Summary
Reporting period: The filing covers the 12- and 28-week periods ended August 17, 2013, compared with August 11, 2012. The request metadata identifies “2012 Q2,” but the filing is for the second quarter of fiscal 2013.
Business Context and Reporting Period
Kroger is a large supermarket operator with fuel centers, convenience stores, pharmacies, manufacturing operations, jewelry stores, and in-store health clinics. Identical supermarket sales excluding fuel increased 3.3% in both the second quarter and first two quarters of 2013. Management reported positive identical supermarket sales for 39 consecutive quarters.
Key Financial Metrics
| Metric | Second Quarter 2013 | Second Quarter 2012 | First Two Quarters 2013 | First Two Quarters 2012 |
|---|---|---|---|---|
| Sales | $22.722 billion | $21.726 billion | $52.765 billion | $50.791 billion |
| Operating profit | $595 million | $535 million | $1.474 billion | $1.348 billion |
| Operating margin | 2.62% | 2.46% | 2.79% | 2.65% |
| Net earnings attributable to Kroger | $317 million | $279 million | $798 million | $718 million |
| Diluted earnings per share | $0.60 | $0.51 | $1.52 | $1.29 |
| Net cash from operating activities | Not separately provided | Not separately provided | $2.613 billion | $2.031 billion |
- Second-quarter sales increased 4.6%; sales for the first two quarters increased 3.9%.
- Second-quarter net earnings increased 13.6%, while first-half net earnings increased 11.1%.
- Diluted EPS increased 17.6% in the quarter and 17.8% year to date, benefiting from higher earnings and share repurchases.
- Gross margin was 20.40% in the quarter versus 20.47% in the prior-year quarter; first-half gross margin was 20.51%, unchanged year over year.
- FIFO operating profit, a non-GAAP measure, was $608 million, or 2.67% of sales, in the quarter and $1.504 billion, or 2.85% of sales, for the first two quarters.
- The LIFO charge declined to $13 million from $35 million in the quarter and to $30 million from $81 million for the first two quarters.
- Cash used for investing activities was $1.137 billion year to date, including $1.110 billion for property and equipment. Cash used for financing activities was $1.274 billion.
- Cash and temporary cash investments were $440 million at August 17, 2013, compared with $238 million at February 2, 2013.
Debt, Liquidity, and Capital Resources
- Total debt, including capital leases and financing obligations, was approximately $7.9 billion at quarter-end, down from approximately $8.9 billion at year-end 2012 and $8.1 billion at the end of the prior-year quarter.
- Debt reduction primarily reflected a $1.595 billion decrease in commercial paper borrowings and repayment of $400 million of senior notes, partly offset by issuance of $1.0 billion of senior notes in July 2013.
- Kroger had no borrowings under its $2.0 billion unsecured revolving credit facility or $75 million of uncommitted money market lines. Commercial paper outstanding was $50 million, and letters of credit reducing revolver availability totaled $14 million.
- Management estimated next-twelve-month liquidity needs of approximately $2.9 billion, excluding the potential Harris Teeter transaction, and expected operating cash flow and available borrowing capacity to be sufficient.
- Capital investments excluding acquisitions and purchases of leased facilities totaled $1.1 billion in the first two quarters, compared with $983 million in the prior-year period.
Material Changes Versus the Prior Comparable Period
- Sales growth reflected higher identical supermarket sales, increased fuel gallons, higher average retail fuel prices in the quarter, and product cost inflation.
- Operating margin improved because of cost controls, productivity improvements, and lower rent and depreciation rates, partially offset by higher shrink and advertising costs, investments in lower prices, and increased fuel sales.
- Interest expense declined to $99 million from $106 million in the quarter and to $228 million from $247 million year to date, primarily because of lower debt and lower weighted-average interest rates.
- The effective tax rate increased to 35.5% from 34.5%, partly offsetting operating improvement.
- Share repurchases were reduced in preparation for the proposed Harris Teeter acquisition. Kroger repurchased $236 million of shares during the first two quarters, compared with $871 million in the prior-year period.
- Shareowners’ equity increased to $4.848 billion at August 17, 2013 from $4.214 billion at February 2, 2013.
Guidance, Outlook, Risks, and Unusual Items
- Management maintained fiscal 2013 diluted EPS guidance of $2.73 to $2.80 and identical supermarket sales growth excluding fuel guidance of 3.0% to 3.5%.
- Expected 2013 FIFO non-fuel operating margin was to expand slightly, excluding specified prior-year items. Management expected an annual LIFO charge of approximately $55 million, interest expense of approximately $430 million, and capital investments of $2.1 billion to $2.4 billion excluding acquisitions and leased facilities.
- Kroger entered into an agreement to acquire Harris Teeter Supermarkets for approximately $2.5 billion in cash. Closing was expected in the fourth quarter of calendar 2013, subject to customary conditions.
- A bridge loan facility permits borrowings of up to $850 million, subject to conditions including consummation of the merger. The facility includes leverage and fixed-charge coverage covenants.
- Key risks include competitive pricing, labor negotiations, economic conditions, fuel and commodity costs, consumer spending, supply and operating disruptions, refinancing and commercial paper market access, tax changes, potential goodwill or long-lived asset impairments, and litigation.
- Long-lived assets with a carrying amount of $35 million were written down to $10 million in the first two quarters, resulting in a $25 million impairment charge.
- Various antitrust, wage-and-hour, civil rights, product liability, and other lawsuits were pending. Management believed the aggregate exposure was not material, but acknowledged that outcomes could differ materially from estimates.
- On September 20, 2013, the company announced that President and Chief Operating Officer W. Rodney McMullen would become Chief Executive Officer effective January 1, 2014.
Investor Verification Points
- Verify that the intended period is fiscal 2013 second quarter, not 2012 second quarter, because the filing period ended August 17, 2013.
- Assess whether continued 3.0% to 3.5% identical sales growth and modest non-fuel margin expansion are achievable amid competitive pricing and lower-price investments.
- Review financing requirements, covenant compliance, refinancing plans, and the incremental leverage and funding needs associated with the Harris Teeter acquisition.
- Reconcile reported GAAP margins and earnings with management’s non-GAAP FIFO operating profit and FIFO margin measures.
- Monitor fuel mix, shrink, advertising costs, product inflation, LIFO charges, and the effective tax rate because each materially affects reported profitability.
- Evaluate litigation contingencies, the $25 million impairment charge, and the potential effects of tax regulations and future asset impairment testing.