The change in our total sales was primarily the result of identical store sales increases and increased fuel gallons, as well as inflation in fuel and other commodities. Identical store sales growth for the second quarter of 2006 was 7.9% including supermarket fuel operations and 6.0% excluding supermarket fuel operations. Increased customer count and average transaction size in the second quarter of 2006 were both responsible for our increases in identical supermarket sales, excluding fuel.
We define a supermarket as identical when it has been in operation without expansion or relocation for five full quarters.Differences between total supermarket sales and identical supermarket sales primarily relate to changes in supermarket square footage. Our identical supermarket sales results are summarized in the table below. The identical supermarket dollar figures presented were used to calculate second quarter 2006 percent changes.
We define a supermarket as comparable when it has been in operation for five full quarters, including expansions and relocations. Our comparable supermarket sales results are summarized in the table below. The comparable supermarket dollar figures presented were used to calculate the second quarter 2006 percent changes.
We calculate First-In, First-Out (“FIFO”) Gross Margin as follows: Sales minus merchandise costs plus Last-In, First-Out (“LIFO”) charge. Merchandise costs include advertising, warehousing and transportation, but exclude depreciation expenses and rent expense. FIFO gross margin is an important measure used by management to evaluate merchandising and operational effectiveness.
Our FIFO gross margin rate declined 112 basis points to 23.47% for the second quarter of 2006 from 24.59% for the second quarter of 2005. Excluding the effect of retail fuel operations, our FIFO gross margin rate decreased 65 basis points for the second quarter of 2006 compared to the second quarter of 2005. The growth in our retail fuel sales lowers our FIFO gross margin rate due to
the very low FIFO gross margin on retail fuel sales as compared to non-fuel sales. Improvements in shrink, advertising and warehousing costs helped offset slightly higher energy costs and our investments in targeted retail price reductions for our customers, including some targeted investments in select markets to take advantage of market share opportunities. We estimate higher energy costs decreased our second quarter FIFO gross margin rate 4 basis points.
Our FIFO gross margin rate declined 83 basis points to 24.08% for the first two quarters of 2006 from 24.91% for the first two quarters of 2005. Of this decline, the effect of fuel sales accounted for a 49 basis point reduction in our FIFO gross margin rate.
Operating, General and Administrative Expenses
Operating, general and administrative (“OG&A”) expenses consist primarily of employee-related costs such as wages, health care benefit costs and retirement plan costs. Among other items, rent expense, depreciation and amortization expense, and interest expense are not included in OG&A. OG&A expenses, as a percent of sales, decreased 73 basis points to 17.50% for the second quarter of 2006 from 18.23% for the second quarter of 2005. The effect of retail fuel operations accounted for a 38 basis point reduction in our OG&A rate. The growth in our retail fuel sales lowers our OG&A rate due to the very low OG&A rate on retail fuel sales as compared to non-fuel sales. Excluding the effect of retail fuel operations and stock option expense, OG&A declined 47 basis points. Strong identical supermarket sales, along with good cost controls in areas such as energy usage and labor productivity helped us overcome some of the significant increases in fuel and energy-related costs that many companies are facing.
OG&A expenses, as a percent of sales, decreased 43 basis points to 17.88% for the first two quarters of 2006 from 18.31% for the first two quarters of 2005. Of this decline, fuel sales accounted for a 40 basis point reduction in our OG&A rate. Similar to second quarter trends, year-to-date declining rates on non-fuel sales reflected strong identical supermarket sales and good cost control.
Rent Expense
Rent expense was $153 million, or 1.01% of sales, for the second quarter of 2006, compared to $145 million, or 1.04% of sales, for the second quarter of 2005. For the year-to-date period, rent expense was $349 million, or 1.01% of total sales in 2006, compared to $348 million, or 1.09% of sales, in 2005. The increase in rent expense in the second quarter of 2006, compared to the second quarter of 2005, was primarily due to higher closed-store future rent liabilities.
Depreciation Expense
Depreciation expense was $290 million, or 1.92% of total sales, for the second quarter of 2006 compared to $294 million, or 2.12% of total sales, for the second quarter of 2005. Depreciation expense was $678 million, or 1.96% of total sales, for the first two quarters of 2006 compared to $682 million, or 2.15% of total sales, for the first two quarters of 2005. The decrease in depreciation expense, in total dollars, was the result of lower capital expenditures in the previous fiscal year. The decrease in depreciation expense, as a percent of sales, was the result of leverage obtained from strong identical sales growth and improved efficiency in capital investment.
Interest Expense
Net interest expense was $110 million, or 0.73% of total sales, and $121 million, or 0.87% of total sales, in the second quarter of 2006 and 2005, respectively. For the year-to-date period, interest expense was $265 million, or 0.77% of total sales, in 2006 and $280 million, or 0.88% of total sales, in 2005. The reduction in net interest expense for both the quarter and year-to-date periods of 2006, when compared to the same periods of 2005, resulted from a $263 million reduction in total debt and an increase in temporary cash investments totaling $416 million at August 12, 2006 compared to August 13, 2005.
Income Taxes
Our effective income tax rate was 38.2% for the second quarter of 2006 and 37.4% for the second quarter of 2005. For the year-to-date period, our effective income tax rate was 37.8% in 2006 and 36.5% in 2005. The 2006 effective income tax rated differed from the federal statutory rate due to the effect of state taxes. The 2005 effective income tax rate differed from the federal statutory rate due to the effect of state taxes and a reduction in previously recorded tax contingency allowances.
LIQUIDITY ANDCAPITALRESOURCES
Cash Flow Information
Net cash provided by operating activities
We generated $1.8 billion of cash from operating activities during the first two quarters of 2006, compared to $1.8 billion in 2005. The increase in cash payments to our Company-sponsored pension plan and higher accounts receivable balances were offset by higher net earnings, higher accounts payable balances, decreased prepaid assets and non-cash charges to record stock option expense and increased legal reserves. The decrease in our prepaid assets is primarily related to the use of prefunded employee benefits during the first two quarters of 2006. We contributed $150 million to company sponsored pension plans during the first two quarters of 2006 compared to $107 million during the first two quarters of 2005.
Net cash used by investing activities
Investing activities used $702 million of cash during the first two quarters of 2006 compared to $646 million during the first two quarters of 2005. The amount of cash used by investing activities increased in 2006 versus 2005 due to higher capital spending, partially offset by increased cash proceeds from asset sales. See “Capital Expenditures” for further discussion of our capital spending activities.
Net cash used by financing activities
Financing activities used $551 million of cash in the first two quarters of 2006 compared to $911 million in the first two quarters of 2005. We continue our efforts to reduce outstanding debt balances and to repurchase shares of our stock, which are the uses of cash for financing activities. The decrease in the amount of cash used by financing activities was the result of decreased debt reduction, partially offset by increased treasury stock purchases and an increase in the amount of cash proceeds from the issuance of capital stock. See “Debt Management” and “Common Stock Repurchase Program” sections for further details on these programs.
Debt Management
As of August 12, 2006, we maintained a $1.8 billion, five-year revolving credit facility that terminates in 2010 and a $700 million five-year credit facility that terminates in 2007. Outstanding borrowings under the credit agreements and commercial paper borrowings, and some outstanding letters of credit, reduce funds available under the credit agreements. In addition to the credit agreements, we maintain a $50 million money market line, borrowings under which also reduce the amount of funds available under our credit agreements. The money market line borrowings allow us to borrow from banks at mutually agreed upon rates, usually at rates below the rates offered under the credit agreements. As of August 12, 2006, we had no outstanding commercial paper borrowings under our credit agreement and had no borrowings under the money market line. The outstanding letters of credit that reduced the funds available under our credit agreements totaled $330 million as of August 12, 2006.
Our bank credit facilities and the indentures underlying our publicly issued debt contain various restrictive covenants. As of August 12, 2006, we were in compliance with these financial covenants. Furthermore, management believes it is not reasonably likely that Kroger will fail to comply with these financial covenants in the foreseeable future.
Total debt, including both the current and long-term portions of capital leases and lease-financing obligations, decreased $263 million to $7.0 billion as of the end of the second quarter of 2006, from $7.2 billion as of the end of the second quarter of 2005. Total debt decreased $275 million as of the end of the second quarter of 2006 from $7.2 billion as of year-end 2005. The decreases in 2006 resulted from the use of cash flow from operations to reduce outstanding debt and lower mark-to-market adjustments. We expect to fund current year debt maturities with cash on-hand.
Common Stock Repurchase Program
During the second quarter of 2006, we invested $162 million to repurchase 7.6 million shares of Kroger stock at an average price of $21.40 per share. For the first two quarters of 2006, we invested $295 million to repurchase 14.3 million shares of Kroger stock at an average price of $20.70 per share. These shares were reacquired under three separate stock repurchase programs. The first is a $500 million stock repurchase program that was authorized by Kroger’s Board of Directors on September 16, 2004. The second is a $500 million repurchase program that was authorized by Kroger’s Board of Directors on May 4, 2006, which replaced the prior $500 million authorization. The third is a program that uses the cash proceeds from the exercises of stock options by participants in Kroger’s stock option and long-term incentive plans as well as the associated tax benefits. During the first two quarters of 2006, we purchased approximately 10.7 million shares, totaling $217 million, under our $500 million stock repurchase programs and we purchased an additional 3.6 million shares, totaling $77.7 million, under our program to repurchase common stock funded by the proceeds and tax benefits from stock option exercises. As of August 12, 2006, we had approximately $389 million remaining under the May 2006 repurchase program.
CAPITAL EXPENDITURES
Capital expenditures totaled $361 million for the second quarter of 2006 compared to $272 million for the second quarter of 2005. Year-to-date, capital expenditures, excluding acquisitions, totaled $811 million in 2006 and $672 million in 2005. During the second quarter of 2006, we opened, acquired, expanded or relocated 11 food stores and also completed 34 within-the-wall remodels. In total, we operated 2,477 supermarkets and multi-department stores at the end of the second quarter of 2006 compared to 2,515 at the end of the second quarter of 2005. Total food store square footage decreased 0.2% from the second quarter of 2005. Excluding acquisitions and operational closings, total food store square footage increased 1.4% over the second quarter of 2005.
CRITICAL ACCOUNTING POLICIES
We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a consistent manner. Except as noted below, our critical accounting policies are summarized in our 2005 Annual Report on Form 10-K filed with the SEC on April 7, 2006.
The preparation of financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. We base our estimates on historical experience and other factors we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could vary from those estimates.
Stock-Based Compensation Expense
Effective January 29, 2006, we adopted the fair value recognition provisions of SFAS No. 123(R), using the modified prospective transition method, and therefore have not restated results for prior periods. Under this method, we recognize compensation expense for all share-based payments granted after January 29, 2006, as well as all share-based payments granted prior to, but not yet vested, as of January 29, 2006, in accordance with SFAS No. 123(R). Under the fair value recognition provisions of SFAS No. 123(R), we recognize share-based compensation expense, net of an estimated forfeiture rate, over the requisite service period of the award. Prior to the adoption of SFAS No. 123(R), we accounted for share-based payments under Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees” and the disclosure provisions of SFAS No. 123. We recognized compensation expense for all share-based awards described above using the straight-line attribution method applied to the fair value of each option grant, over the requisite service period associated with each award. The requisite service period is typically consistent with the vesting period, except as noted below. Because awards typically vest evenly over the requisite service period, compensation cost recognized through August 12, 2006 is at least equal to the grant-date fair value of the vested portion of all outstanding options.
The weighted-average fair value of stock options granted during the first two quarters ended August 12, 2006 and August 13, 2005, was $6.90 and $7.70, respectively. The fair value of each stock option grant was estimated on the date of grant using the Black-Scholes option-pricing model, based on the assumptions shown in the table below. The Black-Scholes model utilizes extensive accounting judgment and financial estimates, including the term employees are expected to retain their stock options before exercising them, the volatility of our stock price over that expected term, the dividend yield over the term, and the number of awards expected to be forfeited before they vest. Using alternative assumptions in the calculation of fair value would produce fair values for stock option grants that could be different than those used to record stock-based compensation expense in the Consolidated Statements of Operations.
The following table reflects the weighted average assumptions used for grants awarded to option holders:
| | | 2006 | | 2005 |
| Risk-free interest rate | | 5.07 | % | | 4.11 | % |
| Expected dividend yield | | 1.50 | % | | N/A |
| Expected volatility | | 27.60 | % | | 30.83 | % |
| Expected term | | 7.50 Years | | 8.70 Years |
The weighted average risk-free interest rate was based on the yield of a treasury note as of the grant date, continuously compounded, which matures at a date that approximates the expected term of the options. Prior to 2006, we did not pay a dividend, so an expected dividend rate was not included in the determination of fair value for options granted during fiscal year 2005. Using a dividend yield of 1.50% to value options issued in 2005 would have decreased the fair value of each option by approximately $1.60. We determined expected volatility based upon historical stock volatilities. We also considered implied volatility. We determined expected term based upon a combination of historical exercise and cancellation experience as well as estimates of expected future exercise and cancellation experience.
Total stock compensation recognized in the two quarters ended August 12, 2006 was $39 million, pre-tax. This included $30 million related to stock options and $9 million related to restricted shares. A total of $7 million of the restricted stock expense was attributable to the wider distribution of restricted shares in the first quarter 2006 grant of share-based awards, and the remaining $2 million of restricted stock expense related to previously issued restricted stock. As a result, the incremental compensation expense
attributable to the adoption of SFAS No. 123(R) in the first two quarters of 2006 was $37 million, pre-tax, or $23 million and $0.03 per basic and diluted share, after tax. Stock compensation expense recognized in the two quarters ended August 13, 2005, related entirely to restricted stock grants, was $3 million. These costs were recognized as operating, general and administrative costs in our Consolidated Statements of Operations for the two quarters ended August 12, 2006 and August 13, 2005. The cumulative effect of applying a forfeiture rate to unvested restricted shares at January 29, 2006 was not material. The pro forma earnings effect of stock options in the prior year, in accordance with SFAS No. 123, is described below.
If compensation cost for our stock option plans for the quarter ended August 13, 2005, and the two quarters then ended, had been determined based upon the fair value at the grant date for awards under these plans consistent with the methodology prescribed under SFAS No. 123, our net earnings and diluted earnings per common share would have been reduced to the pro forma amounts below:
| | | 2005 |
| (In millions, except per share amounts) | | Second | | | Year-To- |
| | | Quarter | | | Date |
| Net earnings, as reported | | $ | 196 | | | $ | 490 | |
| Add: Stock-based compensation expense included in net earnings, net of income tax benefits | | | 1 | | | | 3 | |
| Subtract: Total stock-based compensation expense determined under fair value method for all awards, net | | | | | | | | |
| of income tax benefits | | | (10 | ) | | | (18 | ) |
| |
| Pro forma net earnings | | $ | 187 | | | $ | 475 | |
| |
| Net earnings per basic common share, as reported | | $ | 0.27 | | | $ | 0.68 | |
| Pro forma earnings per basic common share | | $ | 0.26 | | | $ | 0.66 | |
| |
| Net earnings per diluted common share, as reported | | $ | 0.27 | | | $ | 0.67 | |
| Pro forma earnings per diluted common share | | $ | 0.26 | | | $ | 0.65 | |
As of August 12, 2006, there was $117 million of total unrecognized compensation cost related to non-vested stock-based compensation arrangements granted under our stock option plans. We expect this cost to be recognized over a weighted-average period of approximately 2 years. The total fair value of options that vested was $34 million for the two quarters ended August 12, 2006 and August 13, 2005.
Our stock option grants generally contain retirement-eligibility provisions that cause the options to vest on the earlier of the stated vesting date or retirement. For share-based awards granted prior to the adoption of SFAS No. 123(R), compensation expense was calculated over the stated vesting periods, regardless of whether certain employees became retirement-eligible during the respective vesting periods. Upon the adoption of SFAS No. 123(R), we continued this method of recognizing compensation expense for those awards granted prior to the adoption of SFAS No. 123(R). However, for awards granted on or after January 29, 2006, we will recognize expense for stock option grants containing retirement-eligibility provisions over the shorter of the vesting period or the period until employees become retirement-eligible. As a result of retirement-eligibility provisions in stock option awards granted in 2006, approximately $6 million of compensation cost was recognized prior to the completion of stated vesting periods.
Shares issued as a result of stock option exercises may be newly issued shares or reissued treasury shares. We expect to fund these exercises with treasury shares.
RECENTLYISSUEDACCOUNTINGSTANDARDS
In November 2004, the FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43 Chapter 4, which clarifies that inventory costs that are “abnormal” are required to be charged to expense as incurred as opposed to being capitalized into inventory as a product cost. SFAS No. 151 provides examples of “abnormal” costs to include costs of idle facilities, excess freight and handling costs and spoilage. SFAS No. 151 became effective for our fiscal year beginning January 29, 2006. The adoption of SFAS No. 151 did not have a material effect on our Consolidated Financial Statements.
In February 2006, the FASB issued Staff Position (“FSP”) No. 123(R)-4, “Classification of Options and Similar Instruments Issued as Employee Compensation that Allow for Cash Settlement upon the Occurrence of a Contingent Event.” FSP No. 123(R)-4 addresses the classification of options and similar instruments issued as employee compensation that allow for cash settlement upon the occurrence of a contingent event. FSP No. 123(R)-4 provides that cash settlement features that can be exercised only upon the occurrence of a contingent event that is outside the employee’s control does not require classifying the option or similar instrument as a liability until it becomes probable that the event will occur. We adopted the provisions of FSP No. 123(R)-4 during the first quarter of 2006. The adoption did not have a material effect on our Consolidated Financial Statements.
In June 2006, the FASB issued Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109.” FIN No. 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 is effective
for fiscal years beginning after December 15, 2006. We are reviewing the effect the implementation of FIN No. 48 will have on our Consolidated Financial Statements.
In June 2006, the FASB ratified the consensus of Emerging Issues Task Force (“EITF”) Issue No. 06-03, “How TaxesCollected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement(That Is, Gross versus Net Presentation)”. EITF No. 06-03 indicates that the income statement presentation oftaxes within the scope of the Issue on either a gross basis or a net basis is an accounting policy decision thatshould be disclosed pursuant to Opinion 22. EITF No. 06-03 becomes effective for our fiscal year beginningFebruary 4, 2007, although earlier adoption is permitted. We do not expect the adoption of EITF No. 06-03 to havea material effect on our Consolidated Financial Statements.
OUTLOOK
This discussion and analysis contains certain forward-looking statements about Kroger’s future performance. These statements are based on management’s assumptions and beliefs in light of the information currently available. Such statements relate to, among other things: projected change in net earnings; identical sales growth; expected pension plan contributions; our ability to generate operating cash flow; projected capital expenditures; square footage growth; opportunities to reduce costs; cash flow requirements; and our operating plan for the future; and are indicated by words such as “comfortable,” “committed,” “will,” “expect,” “goal,” “should,” “intend,” “target,” “believe,” “anticipate,” “plan,” and similar words or phrases. These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially.
Statements elsewhere in this report and below regarding our expectations, projections, beliefs, intentions or strategies are forward-looking statements within the meaning of Section 21 E of the Securities Exchange Act of 1934. While we believe that the statements are accurate, uncertainties about the general economy, our labor relations, our ability to execute our plans on a timely basis and other uncertainties described below could cause actual results to differ materially.
- We expect earnings per share growth of approximately 6%-8% in 2006, including the effect of the increased legal reserves recorded in the first quarter which reduced earnings per diluted share $0.03. This estimate includes the effect of a 53rd week in fiscal 2006, which we anticipate will be approximately $0.05 per diluted share. We expect the expensing of stock options will reduce net earnings $0.06 per diluted share in 2006.
- We expect identical food store sales growth, excluding fuel sales, to exceed 4.0% for the balance of the year and to exceed 4.9% for all of 2006.
- In fiscal 2006, we will continue to focus on sales growth and balancing investments in gross margin and improved customer service with operating cost reductions to provide a better shopping experience for our customers. We expect operating margins in California to improve slightly due to the continued recovery in that market, although we expect improvement in 2006 will be less than in 2005.
- We plan to use, over the long-term, one-third of cash flow for debt reduction and two-thirds for stock repurchase and payment of cash dividends.
- We expect to obtain sales growth from new square footage, as well as from increased productivity from existing locations.
- Capital expenditures reflect our strategy of growth through expansion and acquisition, as well as focusing on productivity increase from our existing store base through remodels. In addition, we will continue our emphasis on self-development and ownership of real estate, logistics, and technology improvements. The continued capital spending in technology is focused on improving store operations, logistics, manufacturing procurement, category management, merchandising, and buying practices, and should reduce merchandising costs. We intend to continue using cash flow from operations to finance capital expenditure requirements. We expect capital investment for 2006 to be in the range of $1.7-$1.9 billion, excluding acquisitions. We expect total food store square footage to grow 1.5%-2% before acquisitions and operational closings. Including operational closings and excluding acquisitions, we expect total food store square footage to remain consistent with 2005.
- Based on current operating trends, we believe that cash flow from operations and other sources of liquidity, including borrowings under our commercial paper program and bank credit facilities, will be adequate to meet anticipated requirements for working capital, capital expenditures, interest payments, and scheduled principal payments for the foreseeable future. We also believe we have adequate coverage of our debt covenants to continue to respond effectively to competitive conditions.
- We expect that our OG&A results will be affected by increased costs, such as higher energy costs, pension costs and credit card fees, as well as any future labor disputes, offset by improved productivity from process changes, cost savings negotiated in recently completed labor agreements, and sales increases.
- We expect our effective tax rate for 2006 will be approximately 37.8%.
- We expect to fund current year debt maturities with cash on-hand.
- We will continue to evaluate under-performing stores. We anticipate operational closings will continue at an above-historical rate.
- We expect rent expense, as a percent of total sales and excluding closed-store activity, will decrease due to the emphasis our current strategy places on ownership of real estate and leverage gained through sales increases.
- We believe that in 2006 there will be opportunities to reduce our operating costs in such areas as administration, labor, shrink, warehousing and transportation. These savings will be invested in our core business to drive profitable sales growth and offer improved value and shopping experiences for our customers.
- Although we are not required to make cash contributions during fiscal 2006, we made a $150 million cash contribution to our qualified pension plans on March 27, 2006. Additional contributions may be made if our cash flows from operations exceed our expectations. We expect any elective contributions made during 2006 will reduce our contributions in future years. Among other things, investment performance of plan assets, the interest rates required to be used to calculate pension obligations and future changes in legislation will determine the amounts of any additional contributions.
- We expect our contributions to multi-employer pension plans to increase at 5% per year over the $196 million we contributed during fiscal 2005.
Various uncertainties and other factors could cause us to fail to achieve our goals. These include:
- We have various labor agreements expiring in 2006, covering smaller groups of associates than those contracts negotiated in 2005. In all of these contracts, rising health care and pension costs will continue to be an important issue in negotiations. A prolonged work stoppage at a substantial number of stores could have a material effect on our results.
- Our ability to achieve sales and earnings goals may be affected by: labor disputes; industry consolidation; pricing and promotional activities of existing and new competitors, including non-traditional competitors; our response to these actions; the state of the economy, including the inflationary and deflationary trends in certain commodities; stock repurchases; and the success of our future growth plans.
- In addition to the factors identified above, our identical store sales growth could be affected by increases in Kroger private label sales, the effect of our “sister stores” (new stores opened in close proximity to an existing store) and reductions in retail pricing.
- Our operating margins could fail to improve if our operations in California do not improve as expected, if we are unsuccessful at containing our operating costs, or if we need to invest incremental dollars in response to competitive activity.
- We have estimated our exposure to the claims and litigation arising in the normal course of business, as well as in material litigation facing the Company, and believe we have made adequate provisions for them where it is reasonably possible to estimate and where we believe an adverse outcome is probable. Unexpected outcomes in these matters, including the ultimate resolution of the legal proceedings arising from the hiring practices at our Ralphs subsidiary during the labor dispute, could have an adverse effect on our results.
- The proportion of cash flow used to reduce outstanding debt, repurchase common stock or pay a cash dividend may be affected by the amount of outstanding debt available for pre-payments, changes in borrowing rates and the market price of Kroger common stock.
- Consolidation in the food industry is likely to continue and the effects on our business, either favorable or unfavorable, cannot be foreseen.
- Rent expense, which includes subtenant rental income, could be adversely affected by the state of the economy, increased store closure activity and future consolidation.
- Depreciation expense, which includes the amortization of assets recorded under capital leases, is computed principally using the straight-line method over the estimated useful lives of individual assets, or the remaining terms of leases. Use of the straight-line method of depreciation creates a risk that future asset write-offs or potential impairment charges related to store closings would be larger than if an accelerated method of depreciation was followed.
- Our effective tax rate may differ from the expected rate due to changes in laws, the status of pending items with various taxing authorities and the deductibility of certain expenses. Our expected tax rate assumes that the work opportunity tax credit will be retroactively reinstated by year-end.
- We believe the multi-employer pension funds to which we contribute are substantially underfunded, and we believe the effect of that underfunding will be the increased contributions we have projected over the next several years. Should asset values in these funds deteriorate, or if employers withdraw from these funds without providing for their share of the liability, or should our estimates prove to be understated, our contributions could increase more rapidly than we have anticipated.
- The grocery retail industry continues to experience competition from other traditional food retailers, supercenters, mass merchandisers, club or warehouse stores, drug stores and restaurants. Our continued success is dependent upon our ability to compete in this industry and to reduce operating expenses, including managing health care and pension costs contained in our collective bargaining agreements. The competitive environment may cause us to reduce our prices in order to gain or maintain share of sales, thus reducing margins. While we believe our opportunities for sustained profitable growth are considerable, unanticipated actions of competitors could adversely affect our sales.
- Changes in laws or regulations, including changes in accounting standards, taxation requirements and environmental laws may have a material effect on our financial statements.
- Changes in the general business and economic conditions in our operating regions, including the rate of inflation, population growth and employment and job growth in the markets in which we operate, may affect our ability to hire and train qualified employees to operate our stores. This would negatively affect earnings and sales growth. General economic changes may also affect the shopping habits of our customers, which could affect sales and earnings.
- Changes in our product mix may negatively affect certain financial indicators. For example, we continue to add supermarket fuel centers to our store base. Since gasoline generates low profit margins, including generating decreased margins as the market price increases, we expect to see our FIFO gross profit margins decline as gasoline sales increase. Although this negatively affects our FIFO gross margin, gasoline sales provide a positive effect on operating, general and administrative expenses as a percent of sales.
- Our ability to integrate any companies we acquire or have acquired, and achieve operating improvements at those companies, will affect our operations.
- Our capital expenditures could differ from our estimate if we are unsuccessful in acquiring suitable sites for new stores, if development costs vary from those budgeted or if our logistics and technology projects are not completed in the time frame expected or on budget.
- Our expected square footage growth and the number of store projects completed during the year are dependent upon our ability to acquire desirable sites for construction of new facilities as well as the timing and completion of projects.
- Interest expense could be adversely affected by the interest rate environment, changes in the Company’s credit ratings, fluctuations in the amount of outstanding debt, decisions to incur prepayment penalties on the early redemption of debt and any factor that adversely affects our operations that results in an increase in debt.
- The amount we contribute to Company-sponsored pension plans could vary if the amount of cash flow that we generate differs from that expected.
- Adverse weather conditions could increase the cost our suppliers charge for their products, or may decrease the customer demand for certain products. Additionally, increases in the cost of inputs, such as utility costs or raw material costs, could negatively affect financial ratios and earnings.
- Although we presently operate only in the United States, civil unrest in foreign countries in which our suppliers do business may affect the prices we are charged for imported goods. If we are unable to pass on these increases to our customers, our FIFO gross margin and net earnings will suffer.
We cannot fully foresee the effects of changes in economic conditions on Kroger’s business. We have assumed economic and competitive situations will not change significantly for 2006.
Other factors and assumptions not identified above could also cause actual results to differ materially from those set forth in forward-looking statements. Accordingly, actual events and results may vary significantly from those included in, contemplated or implied by forward-looking statements made by us or our representatives.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
There have been no significant changes in our exposure to market risk from the information provided in Item 7A. Quantitative and Qualitative Disclosures About Market Risk on our Form 10-K filed with the SEC on April 7, 2006.
Item 4. Controls and Procedures.
The Chief Executive Officer and the Chief Financial Officer, together with a disclosure review committee appointed by the Chief Executive Officer, evaluated Kroger’s disclosure controls and procedures as of the quarter ended August 12, 2006. Based on that evaluation, Kroger’s Chief Executive Officer and Chief Financial Officer concluded that Kroger’s disclosure controls and procedures were effective as of the end of the period covered by this report.
In connection with the evaluation described above, there was no change in Kroger’s internal control over financial reporting during the quarter ended August 12, 2006, that has materially affected, or is reasonably likely to materially affect, Kroger’s internal control over financial reporting.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings.
Litigation — In December, 2005, the United States Attorney’s Office for the Central District of California notified the Company that a federal grand jury had returned an indictment against Ralphs Grocery Company (“Ralphs”), a wholly-owned subsidiary of The Kroger Co., with regard to Ralphs’ hiring practices during the labor dispute from October 2003 through February 2004 (United States of America v. Ralphs Grocery Company, United States District Court for the Central District of California, CR No. 05-1210 PA). The indictment alleges a criminal conspiracy and other criminal activity resulting in some locked-out employees being allowed or encouraged to work under false identities or false Social Security numbers, despite Company policy forbidding such conduct. In addition, these alleged hiring practices are the subject of claims that Ralphs’ conduct of the lockout was unlawful, and that Ralphs is liable under the National Labor Relations Act (“NLRA”). The Los Angeles Regional Office of the National Labor Relations Board (“NLRB”) has notified the charging parties that all charges alleging that Ralphs’ lockout violated the NLRA have been dismissed. That decision is being appealed by the charging parties to the General Counsel of the NLRB.
On June 30, 2006, Ralphs entered into an agreement that included a plea of guilty to some of the charges in the indictment and will, if approved by the Court, resolve both the criminal litigation with Ralphs and the NLRB proceedings.If the plea agreement isapproved, Ralphs will pay a fine of $20 million and establish a restitution fund of $50 million, amounts for which the Company hasestablished reserves.The Company can provide no assurance that the agreement will be approved by the court.
Various claims and lawsuits arising in the normal course of business, including suits charging violations of certain antitrust and civil rights laws, are pending against the Company. Some of these purport or have been determined to be class actions and/or seek substantial damages. Any damages that may be awarded in an antitrust case will be automatically trebled. Although it is not possible at this time to evaluate the merits of all these claims and lawsuits, nor their likelihood of success, the Company is of the belief that any resulting liability will not have a material adverse effect on the Company’s financial position.
The Company continually evaluates its exposure to loss contingencies arising from pending or threatened litigation and believes it has made adequate provisions therefor. Nonetheless, assessing and predicting the outcomes of these matters involves substantial uncertainties. It remains possible that despite management’s current belief, material differences in actual outcomes or changes in management’s evaluation or predictions could arise that could have a material adverse effect on the Company’s financial condition or results of operation.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
| (a) | | On May 22, 2006, the Company issued 1,242,468 shares of common stock to NE Supermarket Associates. These shares were issued upon conversion of warrants that were issued in a private placement transaction not involving a public offering pursuant to Section 4(2) of the Securities Act of 1933, as amended. The conversion of the warrants into common stock was an exempt exchange under Section 3(a)(9) of the Securities Act. The shares were issued pursuant to a “cashless” exercise of warrants and the Company received no proceeds. |
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| (c) | | |
| ISSUER PURCHASES OF EQUITY SECURITIES |
| | | | | | | Total Number | | Maximum |
| | | | | | | of Shares | | Dollar Value of |
| | | | | | | Purchased as | | Shares that May |
| | | | | | | Part of | | Yet Be |
| | | | | | | Publicly | | Purchased |
| | Total Number | | Average | | Announced | | Under the Plans |
| | of Shares | | Price Paid | | Plans or | | or Programs(3) |
| Period(1) | Purchased | | Per Share | | Programs(2) | | (in millions) |
| First four weeks | | | | | | | | | |
| May 21, 2006 to June 17, 2006 | 1,675,000 | | $ | 19.98 | | 1,675,000 | | $ | 453 |
| Second four weeks | | | | | | | | | |
| June 18, 2006 to July 15, 2006 | 2,825,956 | | $ | 21.14 | | 2,805,000 | | $ | 412 |
| Third four weeks | | | | | | | | | |
| July 16, 2006 to August 12, 2006 | 3,169,285 | | $ | 22.36 | | 3,074,000 | | $ | 389 |
| Total | 7,670,241 | | $ | 21.39 | | 7,554,000 | | $ | 389 |
| (1) | | The reported periods conform to the Company’s fiscal calendar composed of thirteen 28-day periods. The second quarter of 2006 contained three 28-day periods. |
| (2) | | Shares were repurchased under (i) a $500 million stock repurchase program, authorized by the Board of Directors on May 4, 2006, and (ii) a program announced on December 6, 1999, to repurchase common stock to reduce dilution resulting from our employee stock option plans which program is limited to proceeds received from exercises of stock options and the tax benefits associated therewith. The programs have no expiration date but may be terminated by the Board of Directors at any time. No shares were purchased other than through publicly announced programs during the periods shown. |
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| (3) | | Amounts shown in this column reflect amounts remaining under the $500 million stock repurchase program referenced in clause (i) of Note 2 above. Amounts to be invested under the program utilizing option exercise proceeds are dependent upon option exercise activity. |
Item 4. Submission of Matters to a Vote of Security Holders.
| (a) | | June 22, 2006 – Annual Meeting |
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| (c) | | The shareholders elected five directors to serve until the annual meeting in 2007, or until their successors have been elected and qualified, and ratified the selection of PricewaterhouseCoopers LLP as the Company’s independent registered public accounting firm for 2006. The shareholders approved resolutions to: implement the annual election of directors; eliminate cumulative voting for directors; eliminate the 75% supermajority requirement for some transactions; and opt out of the Ohio Control Share Acquisition Statute. The shareholders defeated a resolution to adopt rules of conduct in connection with shareholder meetings and to permit shareholder meetings to be held outside of Cincinnati, Ohio. The shareholders also defeated shareholder proposals requesting that: the Board of Directors issue interim reports detailing progress made toward requiring the Company’s chicken suppliers to use controlled-atmosphere killing; and the Board of Directors prepare a sustainability report. |
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| To serve until 2007 | | | | | For | | Withheld |
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| Reuben V. Anderson | | | | | 589,058,781 | | 41,974,775 |
| Don W. McGeorge | | | | | 611,518,239 | | 19,515,317 |
| W. Rodney McMullen | | | | | 611,489,007 | | 19,544,549 |
| Clyde R. Moore | | | | | 598,548,315 | | 32,485,241 |
| Steven R. Rogel | | | | | 599,009,011 | | 32,024,545 |
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| | | | For | | Against | | Withheld |
| PricewaterhouseCoopers LLP | | | 600,468,265 | | 25,921,314 | | 4,643,977 |
| Elimination of 75% Supermajority Requirement for Some Transactions | | 614,575,107 | | 10,825,597 | | 5,632,852 |
| Rules of Conduct for Shareholder Meetings; MeetingsOutside of | | | | | | |
| Cincinnati | | | 259,462,261 | | 357,829,980 | | 13,741.315 |
| Opt out of Ohio Control Share Acquisition Statute | | | 615,089,919 | | 8,644,298 | | 7,299,339 |
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| | | | | | | | Broker Non- |
| | For | | Against | | Withheld | | Votes |
| Annual Election of Directors | 574,909,753 | | 9,460,836 | | 4,947,616 | | 41,715,351 |
| Elimination of Cumulative Voting for Directors | 552,154,309 | | 31,810,430 | | 5,353,466 | | 41,715,351 |
| Shareholder proposal (interim reports on chicken | | | | | | | |
| supplier requirements) | 39,545,911 | | 474,888,901 | | 74,883,393 | | 41,715,351 |
| Shareholder proposal (sustainability report) | 50,726,208 | | 475,600,155 | | 62,991,842 | | 41,715,351 |
| Item 6. Exhibits. | | | |
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| EXHIBIT 3.1 | | - | Amended Articles of Incorporation are hereby incorporated by reference to Exhibit 3.1 of the Company’sQuarterly Report on Form 10-Q for the quarter ended May 20, 2006, filed with the SEC on June 29, 2006. |
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| EXHIBIT 3.2 | | - | Regulations are hereby incorporated by reference to Exhibit 3.2 of the Company’s Quarterly Report on Form 10-Q for the quarter ended May 20, 2006, filed with the SEC on June 29, 2006. |
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| EXHIBIT 4.1 | | - | Instruments defining the rights of holders of long-term debt of the Company and its subsidiaries are not filed as Exhibits because the amount of debt under each instrument is less than 10% of the consolidated assets of the Company. The Company undertakes to file these instruments with the Commission upon request. |
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| EXHIBIT 31.1 | | - | Rule 13a–14(a) / 15d–14(a) Certifications – Chief Executive Officer. |
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| EXHIBIT 31.2 | | - | Rule 13a–14(a) / 15d–14(a) Certifications – Chief Financial Officer. |
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| EXHIBIT 32.1 | | - | Section 1350 Certifications. |
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| EXHIBIT 99.1 | | - | Additional Exhibits - Statement of Computation of Ratio of Earnings to Fixed Charges. |
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| THE KROGER CO. |
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| Dated: September21, 2006 | By: | | /s/ David B. Dillon |
| | | | | David B. Dillon |
| | | | | Chairman of the Board and Chief Executive Officer |
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| Dated: September21, 2006 | By: | | /s/ J. Michael Schlotman |
| | | | | J. Michael Schlotman |
| | | | | Senior Vice President and Chief Financial Officer |
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| Exhibit 3.1 - | | Amended Articles of Incorporation are hereby incorporated by reference to Exhibit 3.1 of the Company’s Quarterly Report on Form 10-Q for the quarter ended May 20, 2006, filed with the SEC on June 29, 2006. |
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| Exhibit 3.2 - | | Regulations are hereby incorporated by reference to Exhibit 3.2 of the Company’s Quarterly Report on Form 10-Q for the quarter ended May 20, 2006, filed with the SEC on June 29, 2006. |
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| Exhibit 4.1 - | | Instruments defining the rights of holders of long-term debt of the Company and its subsidiaries are not filed as Exhibits because the amount of debt under each instrument is less than 10% of the consolidated assets of the Company. The Company undertakes to file these instruments with the Commission upon request. |
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| Exhibit 31.1 - | | Rule 13a–14(a) / 15d–14(a) Certifications – Chief Executive Officer. |
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| Exhibit 31.2 - | | Rule 13a–14(a) / 15d–14(a) Certifications – Chief Financial Officer. |
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| Exhibit 32.1 - | | Section 1350 Certifications. |
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| Exhibit 99.1 - | | Additional Exhibits - Statement of Computation of Ratio of Earnings to Fixed Charges. |
