The Kroger Co. Analyst Day - Final.(Broadcast transcript)

CARIN FIKE, DIRECTOR, IR, KROGER CO: Good afternoon, everyone, I assume you can hear me. We've got the webcast on? Great. Thank you for joining us for Kroger's 2008 Investor Conference. That's right Don. We're starting. I think most of you already know me, I'm Carin Fike, Kroger's Director of Investor Relations. But for those of you that I'm meeting for the first time, you may only know me through our audio webcasts. So, yes it's true, I really am this tiny. As they say in the business, I think the audio webcast adds about 10 pounds. I didn't know if that joke was going to work.

This afternoon and this evening, and really into tomorrow morning, you're going to hear a lot about what Kroger is doing to improve our connection with customers. Well, we're also trying to improve our connection with investors as well.

Earlier this year we asked several of you to participate in a survey about our investor relations program and there were a few pretty clear themes that came out of your feedback, one of which was your desire for greater transparency about our business and our quarterly financial results.

With that objective in mind, we began strengthening and amplifying the disclosures in our quarterly earnings releases, our conference call scripts and our SEC filings. And that's also really what caused us to hold today's event.

So, we hope that you gain a greater understanding of our business and our strategy through your participation in our investor conference today, not only through the presentations that you're going to hear this afternoon and this evening, but also through the interactions that you have with my Kroger colleagues who are participating in this event today and tomorrow. So, thank you for your feedback, keep it coming, we do appreciate it, we do listen, and we try to respond.

We have a full program on tap for this afternoon so let's get started. But first I need to satisfy my attorney friends in the audience and get the Safe Harbor language out of the way. As you can all read the PowerPoint slide, I want to remind everyone that today's discussion will include forward-looking statements.

I must caution you that such statements are predictions and actual evens or results can differ materially. A detailed discussion of the many factors that we believe may have a material affect on our business on an ongoing basis is contained in our SEC filings. But Kroger assumes no obligation to update that information.

And with that task completed, I will turn the podium over to David Dillon, Kroger's Chairman and Chief Executive Officer. Dave, my job's done, it's all yours.

DAVID DILLON, CHAIRMAN OF THE BOARD AND CEO, KROGER CO: Well, thank you Carin, and it's one of the few people I can move the microphone actually up when I need to use it. So, thank you all for being here. I suppose Carin, based on what you said, we could say that the way in which we're listening to our investors is an example of the same kind of model we're trying to use as we listen to our customers. But I get ahead of myself with that, more on that later.

Thank you all for joining us here in Cincinnati, Ohio and via the webcast, if you're not physically here with us to participate in Kroger's 2008 Investor Conference. 2008 is a momentous year for Kroger. Our company was founded 125 years ago right here in Cincinnati, not far from this very spot by a man named Barney Kroger.

Kroger's 125 year history is a testament to the longevity of our organization, which is the result of our ability to innovate, adapt and change with customers and, as it would seem too, with our investors. After dinner this evening I'll be speaking with you about how Kroger has listened and responded to customers, not only through our 125 year history but, more importantly, it's a critical practice we continue today.

This afternoon you'll be hearing from some members of Kroger's leadership team about our more recent history, specifically our Customer 1st strategy. Rodney McMullen, Kroger's Vice Chairman, will talk about our strategy, how far it's come and where it is today. Don McGeorge, Kroger's President and Chief Operating Officer, will describe how we're executing our strategy with a primary focus on the investments we're making in the customer shopping experience and how we are funding those investments.

We'll probably be ready for a break about then, after Don's finished, and after the break Don Becker, who is Kroger's Executive Vice President and Head of Merchandising, will expand on some of the merchandising strategies in our plan, particularly those geared towards helping shoppers stretch their grocery budget in today's challenging environment.

We'll also talk to you about the great story you're going to see tomorrow. Then Mike Schlotman, Senior Vice President and Chief Financial Officer, will focus on the financial aspects of our plan. After Mike's presentation we'll take a break during which we'll wine and dine you and, as you saw at lunch today, most of which, maybe all of which, are our products.

Following dinner I'll recap some of the themes that you'll hear this afternoon and share some of my thoughts on where we're headed. For those of you listening in via the webcast, I want to mention that my remarks this evening after dinner will be webcast and they'll be scheduled to begin at 8.00 Eastern Time tonight. And then, tomorrow morning, our local Cincinnati division will be hosting you for a tour of one of our great local stores. So, we've got a full program lined up for you in the next 24 hours, so let's get started.

I'm pleased to introduce to you Kroger's Vice Chairman, Rodney McMullen. Now Rodney has a short title, but I need to describe his job a little bit better. Rodney is responsible for many of the aspects of Kroger's operations, including strategic initiatives, business planning, capital planning, real estate, acquisitions, facility engineering, internal audit, Kroger Personal Finance -- I worked that in Kathy, Kroger Personal Finance, I wanted to make sure you heard that -- information systems, logistics, consumer research, our jewelry stores, convenience stores, Supermarket Petroleum, Turkey Hill Dairy and, oh yes, I left out finance.

Well, we're not certain when Rodney has time to sleep but we are certain he has some interesting things to say. So, Rodney, I'll turn it over to you, welcome.

RODNEY MCMULLEN, VICE CHAIRMAN OF THE BOARD, KROGER CO: Thanks, Dave. And Carin, now that I know it adds 10 pounds I feel really bad. I'll think about that on every call from now on, Carin. Thanks, Dave, again, and good afternoon everyone. Thanks for taking time out of your busy schedule to come and spend time with us in Cincinnati and we hope you find it well worthwhile.

As Dave mentioned, I plan to kick off today's program with a discussion about Kroger's Customer 1st strategy and the progress we're making. But first, I wanted to touch on the 8-K that Kroger filed today. In that filing, and you should have got a copy of it when you checked in with Julie, in that filing we confirmed Kroger's identical sales and earnings guidance for fiscal 2008.

We continue to anticipate full year identical sales growth, excluding fuel, in the range of 4.5% to 5.5%. On this basis, in the first half of the year our identical sales growth was 5.3%. And through eight weeks of our current third quarter our, identical sales, excluding fuel, continued to trend above 5%. So, you can see that our business continues to be strong, despite the current economic headwinds.

For fiscal 2008 earnings, Kroger continues to expect earnings per share of $1.85 to $1.90 per diluted share. As you know, this represents a 9% to 12% increase over the 2007 earnings of $1.69 per diluted share. This is a very solid result in a challenging economic environment where the customer is clearly under pressure from a variety of angles. And, as we always like to remind you, don't forget the Kroger dividend adds another little over 1% to your return each year.

So, we are eight weeks into the third quarter. We continue to anticipate what we've been telling investors all along during the year. That is Kroger's lowest year-over-year earnings per share growth rate will occur in the third quarter. Recall that our third quarter results last year included a $40 million tax benefit. We used some of that tax benefit to offset lower fuel margins last year and to accelerate some strategic investments that we had scheduled in our business plan later in the year.

A portion of the tax benefits also increased Kroger's bottom line. The net affect on our third quarter results last year was income of approximately $0.02 to $0.03 per diluted share. This is largely why we expect Kroger's third quarter earnings per share growth this year will range from slightly below to slightly above prior year results.

After adjusting for the prior year net benefits, this year's expected third quarter earnings per share results would represent an increase over last year's third quarter results and we continue to expect very solid results from our grocery operations.

As we've also shared with you previously, we continue to expect Kroger's fourth quarter earnings per share growth rate to be higher than the overall yearly number and that also will be driven by solid grocery store operations and the timing of the LIFO expense last year versus this year. And Mike will cover additional details for those a little later today.

Mike will also touch on liquidity information that was contained in our 8-K filing. Given the recent disruptions in the credit markets, Carin's been getting several questions from different people on the status of the market. And we thought it would be helpful just to share a little bit of insight in terms of where we are. But one of the things that you'll find on that is that we have plenty of liquidity and Mike will also cover that detail.

I think that our 8-K filing today is very important because it demonstrates the message that we've been communicating to investors for the last several years. The strength of our Customer 1st strategy positions Kroger to deliver a solid shareholder return in both good times and bad. We believe that our Customer 1st plan is the right approach because it's enough flexibility to handle a wide range of economic environments, including the current one.

And it's also not easy to replicate. A competitor may adopt certain pieces of our strategy, but it's Kroger's ability to tie all of the elements of our strategy together that creates a true competitive advantage.

We view Kroger's Customer 1st plan as a long-term sustainable business strategy. It is a journey that we embarked upon several years ago and it will take several years to fully implement. In fact, in our minds the journey never ends. Our strategy continues to evolve as the customer changes, which is truly the power of Customer 1st.

But just because the journey has no end does not mean we don't know where we're going. We have very clear objectives and targets defined for our organization. We regularly benchmark ourselves against those measures to make sure that we're still on track with our plan and responding to our customers' ever-changing needs.

And while our focus is clearly on customers, we have not for one second forgotten our commitment to shareholders. In fact, we view these two stakeholder groups as totally intertwined. We firmly believe that if Kroger provides the right shopping experience for our customers, our business model will be profitable and our shareholders will be rewarded.

Kroger's annual financial guidance represents our commitment to shareholders. We plan to deliver on our commitments by keeping our focus firmly on the customer with the following objectives in mind -- improve the customer's experience in our stores, create associate engagement, provide customers with good value for their money, develop non-food retail services --.

Examples of this would be the Kroger Personal Finance talked about and that Don Becker will include a few comments in his presentation. The Gift Card Mall that you've heard us talk about, i-Wireless, which is a prepaid cell business, that we are partners in. Some of those are just examples of some of the non-retail services we're developing to give good value for our customers and make it easy for our customers to go one stop.

And then obviously deliver near-term financial results that are very solid, while continuing to invest in the company's future growth. That last objective is one of the most critical ones for you as an investor to understand. It shapes how our business model supports our Customer 1st plan. After spending time with us today I hope you will have a clear vision of that objective.

As I look out in the audience, I see several familiar faces. And that is reassuring because you've been following Kroger for a long period of time and you know the story well. But others among you are relatively new and I just want to spend a few moments giving you a little bit of recap in terms of the background on why we adopted the Customer 1st strategy and what it means to Kroger.

At the early part of this century, that's one of those comments that always feels weird to say because for a long time the early part of the century was like 100 years ago and now it's just a few years ago, we at Kroger saw some sobering signs that our business model and strategy at that time was not sustainable. Our company was at crucial crossroads, continue down the path and lose our ability to create value for shareholders or acknowledge the change in our industry and our customers and adapt to that.

By now you know the path we've chosen. That journey began in December of 2001 when Kroger announced a radical change in its business model. No longer would we grow earnings by increasing our gross margins to cover expanding OG&A rates. That practice had left us non-competitive in an industry that had become dominated by discounters.

From that point on we would grow earnings by growing sells and increasing the productivity of our stores. To do so we knew we had to invest in our business. We also knew that we had to generate cost savings to afford those investments.

Today our business model is driven by strong identical sales growth, as you can see from our performance so far this quarter and over the last several quarters or year, as a matter of fact. We use sales leverage and operating cost savings to fund sustainable investments and our customer shopping experience. And in a few minutes Don's going to share several of those examples with you. These investments improve our connection with customers and support ongoing strong sales growth, which obviously creates earnings growth also.

We call our business strategy Customer 1st because it describes exactly where our focus lies, squarely on customers. Our plan begins with satisfying our customers' needs and building a strong relationship with them. The foundation of this strategy is listening to customers and responding to what they tell us, and sometimes that's easier said than done.

We all go through these experiences. Sometimes when you get feedback, that feedback is not always what you want to hear. So, the first thing you have to do is make sure that you're really listening and not emotional. And it's fun watching the organization mature to where you hear more and more people say, what is it the customer wants, why does the customer want that versus, well, I always thought that was right. And it's one of the things where it's not as easy said as done.

Our customers tell us there are really four key elements in determining where they shop. And you've heard these several times before but, as you know, we define these as Our People Are Great, I get the products I want plus a little, the shopping experience makes me want to return and our prices are good. So, our response to what customers tell us has included investments focused in these four key areas, people, products, shopping experience and price.

Our first investments were in lower retail prices. We knew we had to improve our pricing position before customers would give us credit for improving the other aspects of the shopping experience. We knew there was a certain level where we had to be for -- basically, the ticket to the dance.

Note that our strategy's objective is good prices not great prices. That is a deliberate choice. Many factors go into the customer's purchasing decision. Price is certainly an important factor, but customers also consider service, product selection and the overall store experience.

With regard to pricing, our objective is to neutralize price as a decision in the customer's mind. To do so, we don't need to match or beat our discount competition on price. Our customer research and experience tells us that if our prices are within a certain range of our lowest competitor, customers will shop with us because of the non-price attributes that our stores provide.

And once we started to meaningfully change customers' perception of Kroger's relative pricing position, a change by the way that doesn't happen over night, we were positioned to focus on the non-price elements of our plan. And one of the things, as you know, we measure this on a regular basis and I thought I'd share some of that measure and progress that we've made on our strategy with you.

Most of you probably evaluate our progress based on the financial measures that we report to you each quarter, identical sales growth, excluding fuel, non-fuel operating margins, and EPS growth. That's the right thing to do and we use those guide posts to gauge our progress on Customer 1st too. But internally, we also use some other mechanisms to measure how we are doing on our plan and I'm going to share a couple of those mechanisms with you today. And we call those Associate First Tracker and Customer 1st Tracker.

Earlier I mentioned associate engagement among our strategic objectives. The Associate Tracker captures measurements that we use to gauge our progress in this area. Associate surveys are the basis for this measurement. We survey all Kroger associates twice each year. And every associate is asked and encouraged to participate and give us feedback, because one of the things, obviously, without feedback we can't change and we can't improve.

The Associate Tracker focuses on two primary areas, Our People Are Great and Knowledge of Values. If you think about Our People Are Great, there's actually 12 questions primarily behind that measurement. They would include such things as do you feel like you're contributing to the company's success? When you give feedback do you think people listen to that? Are you getting feedback in order to grow in your job? Those types of things.

On Knowledge of Values, that would include our values, such things as diversity, inclusion, safety, respect and a few more. But it really does measure those two attributes in terms of how they view that we are acting as a company.

Since the baseline measurement was established in 2005, our scores on Our People Are Great measurement has improved 26%. They have improved 20% on Knowledge of Values. This measurement is obviously a critical component of our people key. It is used by Kroger's leadership teams to identify the areas of opportunity.

It also gets a lot of attention because we recognize Our People Are Great as the most important link to our customers. And obviously we're very pleased with the results that we've achieved over the last three years.

While the Associate Tracker really focuses on the people key of our Customer 1st strategy, the Customer 1st Tracker Report incorporates all four keys, people, products, shopping experience and price, and has separate measures in this report. The Customer 1st Tracker Report is very important because it represents the customer's view of how we are doing. It's our report card. It's not a subjective measure of Kroger people by Kroger people, but it's a subjective measure of our customers, how they view that we're doing.

Every quarter we survey over 26,000 households and ask for feedback on both Kroger and our competitors. Ratings in the Customer 1st Tracker are based on this valuable feedback, which we use to determine whether our initiatives continue to deliver increasing value to our customers.

And really, if you think about a program in your head versus the one that we're actually doing, it's really the method that we're finding out -- what are we really delivering in the store versus what we think we're delivering in the store. And it obviously also helps us to assess how well our competitors are doing and how well they're performing for customers.

We establish baseline scores for the Customer 1st Tracker for each of the four keys using customer responses from the second half of 2004. We also established a target for each key. The target was benchmarked to retailers that we believed were best-in-class on a particular attribute that we were seeking to achieve.

I first introduced this report to you at the investor conference two years ago, so this slide may look familiar to those of you that were at that event. It also shows our most recent progress on the four keys of our Customer 1st plan. As you can see, customers continue to give us the most credit for improving our prices, 11% over our baseline measure in 2004.

Two years ago we reported a 13% improvement. So, this more recent result could be viewed as a slight step backwards. But one of the things that we all need to remember is part of the change in customers' perception on price would be tied to the overall higher food costs that they are paying these days.

You know if you think about inflation, when a customer comes in and buys a gallon of milk and the gallon of milk costs $1 more today than it did a month ago because of inflation, all they're going to say is that is not as good a price. They're not going to understand that that's because raw materials went up that much is what I mean by that. And gas would be the same thing and any other area. But I want you to be completely assured that we look at these measures very closely.

Turning to the measures for non-price elements of our strategy, we're pleased to report that our entire organization has made additional progress, showing an approximately 7% improvement for people, products and shopping experience. This is important to us because our strategy is obviously not one dimensional.

We believe we need to win on all four keys of our Customer 1st plan in order to deserve our customers' loyalty for life. And this belief is tied into Kroger's long-term incentive plan which requires improvements in all four keys to pay off. Improvements in four keys with a decline in one key would result in a pay off of zero.

So, if you think about the long-term incentive plan, we could have a 20% improvement in three of the four keys, if we had a 1% decline in one we would earn zero for that component of our long-term incentive plan. So, that shows you how strong our Board believes that we really need to improve on all four keys, not just one key or parts of keys.

Both tracker reports indicate that we've made solid progress in the organization, but there's still a lot of work to do. Now for me the exciting part is look at the progress that we've made from a financial perspective and from an identical sales and everything else perspective, versus the improvement we've made on tracker. That's exciting.

But the thing that's even more exciting is, if you look at the opportunity in front of us, we believe the opportunity improve even from where we are today, is bigger than what we've actually achieved. So, we think the exciting part is the performance opportunity in front of us is even bigger than what we've achieved in the past.

Don McGeorge will share with you what we're doing to improve our customers' connections on all four keys relative to the Customer 1st plan. He'll also describe what we're doing to fund those investments, because obviously you have to pay for it.

Now before I hand over the podium to Don, I would like to discuss another subject that we thought might be of interest to you and that's Kroger's multi-format strategy. There's quite a bit of talk these days about small-format grocery stores. So, we want to remind investors that Kroger has the most diverse portfolio of formats in the United States grocery industry.

Our multiple formats are a competitive advantage for Kroger. In today's retail environment, no two customers have the same needs and expectations. There are no one size fits all and our multiple formats help us serve our company's diverse customer base. Our multiple supermarket formats include the traditional combo food and drug stores, multi-department stores, marketplace stores and price impact warehouse stores.

We also operate convenience stores and yes, even jewelry stores that came to us as part of the successful merger with Fred Meyer in 1999. The jewelry stores complement our Customer 1st strategy by providing good value and additional selection for our customers. And tomorrow you'll have the opportunity to visit one of our jewelry stores and speak with the President of the Fred Meyer Jewelry division, Pete Engel.

The execution of Kroger's multi-format strategy progresses along a continual learning curve. Our approach is pretty consistent. Initial developments are small in scale, until we get comfortable with our understanding of the customer wants and needs and our ability to deliver against those wants and needs.

The development of our marketplace format is a great illustration of this approach. We've expanded the marketplace format from one MSA in 1999 to eight MSAs currently, including our most recent marketplace opening in Knoxville, Tennessee markets about a week ago.

We also have marketplace stores currently under construction in several additional markets, with plans to further expand the format. In all of these markets we also continue to operate traditional combination stores. So, as part of our learning process includes learning how to operate multiple formats to serve the same customer different shopping trips needs. We continue to view the marketplace format as one of several growth vehicles for our company.

We also use our multi-format strategy to develop the knowledge and benefit of one format to help another. A great example of this is our Convenience Store division. It was their fuel procurement and operating expertise that had been developed over several years of selling gasoline through their fuel pumps that will well outpace our peers in rolling out supermarket fuel centers. Approximately 30% of our supermarkets sell gasoline and we continue to roll out additional fuel centers because we are thrilled by the way our customers have been responding to our offering.

So, that obviously was a slight detour from our earlier focus comments on the development of our Customer 1st strategy and measuring the four keys. We just thought it was a subject that you would be interested in.

Plus, investor conferences are obviously a time for us to share Kroger's vision for the future and we continue to see huge opportunities from our multi-format strategy. And it continues to be an important part of our overall Customer 1st plan. And we think we're just getting started and we're just getting started on tying all our formats together.

In closing, I think you will see today how excited we are about the progress we have made, yet we know there is still much work to be done. We know that there's plenty of opportunity for Kroger to strengthen our connection with customers. As we move forward, we believe we have the right business strategy.

Our performance over the last several years demonstrates the underlying strength and sustainability of Kroger's Customer 1st plan. The real value of our strategy is the flexibility that it gives Kroger to successfully change with customers and navigate the many challenges we will face in a highly competitive industry under a wide variety of economic conditions. It allows us to remain focused on our plan.

As a result, we are not focused to make short-term decisions that may negatively affect our long-term connection with customers. We believe our Customer 1st strategy benefits shareholder both in the short and long term through solid near-term financial results and investments to grow Kroger's business for the future.

With that, thank you for your attention and I would be happy to answer any questions that you might have. Yes, Meredith?

MEREDITH ADLER, ANALYST, BARCLAYS: There's obviously been a lot of talk in the marketplace about small format foodery stores. Any comment about whether you've looked at that, what you think the economics are, is there a place for it? I know you have Fresh Fare, is that really the same thing?

RODNEY MCMULLEN: Yes from our perspective it wouldn't be the same thing. The Fresh Fare store obviously serves more of an upscale neighborhood where food is purely the focus. A lot of times it's a building where we can't expand to a larger store anyway, so it's just really focused on service and food.

If you look at small formats, we do believe there's an economic model for a smaller format. And if you look at our convenience stores,…