KROGER CO quarterly report, Q2 FY2012

Kroger Co. Form 10-Q Summary

Reporting period: The filing covers the 12-week second quarter and 28 weeks ended August 11, 2012, compared with August 13, 2011. The request metadata identifies “2011 Q2,” but the filing is for 2012 Q2.

Business context and key results

Kroger operates U.S. supermarkets, fuel centers, pharmacies, convenience stores, manufacturing operations and related businesses. Management attributed sales growth to positive identical-supermarket sales, higher fuel gallons sold, increased transaction counts and pharmacy performance. Identical supermarket sales excluding fuel increased 3.6% in the quarter and 3.9% year to date, extending positive growth to 35 consecutive quarters.

Metric	Q2 2012	Q2 2011	First two quarters 2012	First two quarters 2011
Sales	$21,726 million	$20,913 million	$50,791 million	$48,374 million
Operating profit	$535 million	$488 million	$1,348 million	$1,299 million
Net earnings attributable to Kroger	$279 million	$281 million	$718 million	$713 million
Diluted earnings per share	$0.51	$0.46	$1.29	$1.17
Net cash from operating activities	Not separately provided	Not separately provided	$2,033 million	$2,193 million

Margins, cash flow, debt and liquidity

GAAP gross margin was 20.47% in Q2 2012 versus 20.84% in Q2 2011, and 20.51% year to date versus 21.08%. The decline reflected fuel mix, investments in lower prices, shrink and warehouse costs.
FIFO gross margin was 20.63% in Q2 and 20.67% year to date, compared with 21.00% and 21.24%, respectively, in the prior-year periods.
Operating margin improved to 2.46% from 2.33% in Q2, but declined to 2.65% from 2.69% year to date.
Operating cash flow was $2.033 billion, down from $2.193 billion. Investing cash use was $991 million, including $985 million of capital-expenditure payments. Financing cash use was $992 million, including $871 million of treasury-stock purchases.
Cash and temporary cash investments were $238 million at August 11, 2012, versus $188 million at January 28, 2012. Total assets were $23.547 billion and total equity was $3.793 billion.
Total debt, including current and long-term capital-lease and financing obligations, was approximately $8.1 billion at quarter-end, down $38 million from year-end but up $779 million from the prior-year quarter-end. Reported long-term debt excluding capital leases was $6.404 billion.
Kroger had $360 million of commercial paper outstanding, no borrowings under its $2 billion revolving credit facility or $75 million of money-market lines, and $14 million of letters of credit reducing revolver availability. Management stated that debt covenants were satisfied.
Estimated liquidity needs for the next 12 months were approximately $3.6 billion, including approximately $1.3 billion of debt maturities. Management expected operating cash flow and available borrowing sources to be adequate.

Material changes versus the prior comparable period

Second-quarter sales increased 3.9%, while year-to-date sales increased 5.0%. Fuel sales rose 4.2% in Q2 and 8.7% year to date, primarily from higher gallons sold despite lower average retail fuel prices.
Second-quarter net earnings decreased 0.7%, but diluted EPS increased 10.9% because of share repurchases. Year-to-date net earnings increased 0.7% and diluted EPS increased 10.3%.
Interest expense increased to $106 million from $97 million in Q2 and to $247 million from $235 million year to date, reflecting higher debt and reduced interest-rate-swap benefits.
The Q2 effective tax rate increased to 34.5% from 27.6%, primarily because the prior-year period benefited from favorable tax issue resolutions. The year-to-date rate increased to 34.5% from 33.8%.
Kroger repurchased 23.7 million shares for $525 million in Q2 and 38.4 million shares for $871 million year to date. The average Q2 repurchase price was $22.15 per share.
Capital expenditures, excluding acquisitions and leased-facility purchases, were $984 million year to date. Kroger opened, acquired, expanded or relocated 17 food stores and completed 53 within-the-wall remodels.
The company issued $850 million of senior notes in the first quarter and repaid $346 million of senior notes in the second quarter. It expects to refinance approximately $1.5 billion of debt maturing in 2013 and 2014.
The Board declared a subsequent quarterly dividend of $0.15 per share, approximately 30% above the prior $0.115 dividend.

Guidance, outlook and management commentary

Fiscal 2012 diluted EPS guidance was increased to $2.35–$2.42, with management expecting to achieve the upper end. The outlook includes the 53rd week, lower expected LIFO expense, share repurchases and benefits from UFCW pension-plan consolidation.
Identical supermarket sales excluding fuel were expected to increase 3.0%–3.5%. Management noted that generic substitution following branded prescription-drug patent expirations would pressure pharmacy sales.
Expected 2012 LIFO expense was approximately $140 million–$190 million, interest expense approximately $460 million, and capital investments $1.9 billion–$2.2 billion excluding acquisitions and leased-facility purchases.
Management expected FIFO non-fuel operating margins to expand slightly, excluding the 2011 UFCW consolidated pension-plan charge, while continuing to invest in prices and customer experience.
Expected 2012 contributions included approximately $75 million to company-sponsored defined-benefit pension plans and approximately $240 million to multi-employer pension plans. Management expected meaningful increases in multi-employer pension expense over the next several years.

Risks, contingencies and unusual items

The IRS tax dispute involving Ralphs remained on appeal. An adverse outcome could require a cash payment of up to approximately $567 million, including interest, with accounting effects charged through operations.
Kroger reported various antitrust, wage-and-hour, civil-rights and product-liability claims. Management believed aggregate exposure was not material, but acknowledged that outcomes could differ materially from estimates.
Multi-employer pension plans were generally underfunded, and Kroger could face higher contribution requirements or substantial withdrawal liabilities if it exits markets or ceases contributions.
Labor agreements in several markets and a distribution facility were scheduled for renegotiation. Prolonged work stoppages could materially affect results.
Key operating risks include food and fuel cost inflation, competitive pricing, consumer caution, pharmacy patent expirations, labor costs, pension performance, interest rates, debt refinancing, weather disruptions, impairment charges and access to commercial-paper or credit markets.
Long-lived assets with a $12 million carrying value were written down to $3 million, resulting in a $9 million impairment charge during the first two quarters of 2012.

Facts investors should verify

Confirm that the intended period is 2012 Q2, rather than 2011 Q2, based on the filing’s August 11, 2012 period end.
Track execution against the $2.35–$2.42 fiscal-year diluted EPS guidance and 3.0%–3.5% identical-sales outlook.
Evaluate margin effects from price investments, fuel mix, shrink, warehouse costs and pharmacy generic substitution.
Monitor refinancing of approximately $1.3 billion of debt due within 12 months and the planned refinancing of $1.5 billion due in 2013–2014.
Assess the potential cash and earnings impact of the Ralphs tax appeal, multi-employer pension obligations and labor negotiations.
Compare future operating cash flow with capital spending, dividends, share repurchases and debt repayments to assess liquidity sustainability.