1 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended November 6, 1999 or [ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 COMMISSION FILE NUMBER 1-303 THE KROGER CO. An Ohio Corporation I.R.S. Employer Identification No. 31-0345740 1014 Vine Street, Cincinnati, OH 45202 - ---------------------------------------- ---------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (513) 762-4000 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No . ----- ----- There were 834,337,245 shares of Common Stock ($1 par value) outstanding as of December 6, 1999. 2 PART I - FINANCIAL INFORMATION Item 1. Financial Statements The unaudited information included in the consolidated financial statements for the third quarter and three quarters ended November 6, 1999 include the results of operations of the Company for the 12 week quarter and 40 week period ended November 6, 1999. The information for the quarter ended October 3, 1998 includes the results of operations of The Kroger Co. for the 16 week quarter ended October 3, 1998, its wholly-owned subsidiary Dillon Companies, Inc. ("Dillon") for the 13 week quarter ended September 26, 1998, and its wholly-owned subsidiary Fred Meyer, Inc. ("Fred Meyer") for the 12 week quarter ended November 7, 1998. The information for the three quarters ended October 3, 1998 includes the results of operations of The Kroger Co. for the 40 week period ended October 3, 1998, Dillon for the 39 week period ended September 26, 1998, and Fred Meyer for the 40 week period ended November 7, 1998. It was not practicable to recast the 1998 quarterly amounts for The Kroger Co. or Dillon to conform to the quarterly reporting periods of The Kroger Co.'s newly adopted fiscal year. Because of these differing periods, 1999 results cannot be directly compared to 1998 results. In the opinion of management, the information reflects all adjustments (consisting only of normal recurring adjustments) which are necessary for a fair presentation of results of operations for such periods but should not be considered as indicative of results for a full year. CONSOLIDATED STATEMENT OF OPERATIONS (in millions, except per share amounts) (unaudited) 3rd Quarter Ended 3 Quarters Ended November 6, October 3, November 6, October 3, ---------------------- ----------------------- 1999 1998 1999 1998 ----------- ---------- ----------- ---------- Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,329 $11,501 $34,111 $ 31,877 Merchandise costs, including warehousing and transportation . 7,606 8,552 25,158 23,785 -------- ------- ------- -------- Gross profit. . . . . . . . . . . . . . . . . . . . . . . . 2,723 2,949 8,953 8,092 Operating, general and administrative . . . . . . . . . . . . 1,889 2,105 6,240 5,819 Rent. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156 165 498 467 Depreciation and amortization . . . . . . . . . . . . . . . . 221 223 723 646 Merger related costs. . . . . . . . . . . . . . . . . . . . . 69 31 304 238 -------- ------- ------- -------- Operating profit. . . . . . . . . . . . . . . . . . . . . . 388 425 1,188 922 Interest expense. . . . . . . . . . . . . . . . . . . . . . . 148 170 495 489 -------- ------- ------- -------- Earnings before income tax expense and extraordinary loss . 240 255 693 433 Tax expense . . . . . . . . . . . . . . . . . . . . . . . . . 111 104 301 202 -------- ------- ------- -------- Earnings before extraordinary loss. . . . . . . . . . . . . 129 151 392 231 Extraordinary loss, net of income tax benefit . . . . . . . . - (7) (10) (228) -------- ------- ------- -------- Net earnings. . . . . . . . . . . . . . . . . . . . . . . . $ 129 $ 144 $ 382 $ 3 ======== ======= ======= ======== Basic earnings per common share: Earnings before extraordinary loss. . . . . . . . . . . . . $ 0.16 $ 0.18 $ 0.47 $ 0.28 Extraordinary loss. . . . . . . . . . . . . . . . . . . . . - (0.01) (0.01) (0.28) ------ ------ ------- -------- Net earnings . . . . . . . . . . . . . . . . . . . . . . $ 0.16 $ 0.17 $ 0.46 $ - ====== ====== ======= ======== Average number of common shares used in basic calculation . . 832 821 829 813 Diluted earnings per common share: Earnings before extraordinary loss. . . . . . . . . . . . . $ 0.15 $ 0.18 $ 0.46 $ 0.27 Extraordinary loss. . . . . . . . . . . . . . . . . . . . . - (0.01) (0.01) (0.27) ------ ------ ------- -------- Net earnings . . . . . . . . . . . . . . . . . . . . . . $ 0.15 $ 0.17 $ 0.45 $ - ====== ====== ======= ======== Average number of common shares used in diluted calculation . 857 855 860 848 The accompanying notes are an integral part of the consolidated financial statements. 2 3 CONSOLIDATED BALANCE SHEET (in millions, except per share amounts) (unaudited) November 6, January 2, 1999 1999 ----------- ---------- ASSETS Current assets Cash. . . . . . . . . . . . . . . . . . . . . . . . . . $ 283 $ 299 Receivables . . . . . . . . . . . . . . . . . . . . . . 620 587 Inventories . . . . . . . . . . . . . . . . . . . . . . 4,276 3,493 Prepaid and other current assets. . . . . . . . . . . . 418 692 ------- ------- Total current assets. . . . . . . . . . . . . . . . 5,597 5,071 Property, plant and equipment, net. . . . . . . . . . . . 8,058 7,220 Goodwill, net . . . . . . . . . . . . . . . . . . . . . . 3,800 3,847 Other assets. . . . . . . . . . . . . . . . . . . . . . . 483 503 ------- ------- Total Assets. . . . . . . . . . . . . . . . . . . . $17,938 $16,641 ======= ======= LIABILITIES Current liabilities Current portion of long-term debt . . . . . . . . . . . $ 530 $ 311 Accounts payable. . . . . . . . . . . . . . . . . . . . 3,292 2,926 Salaries and wages. . . . . . . . . . . . . . . . . . . 673 639 Other current liabilities . . . . . . . . . . . . . . . 1,804 1,574 ------- ------- Total current liabilities . . . . . . . . . . . . . 6,299 5,450 Long-term debt. . . . . . . . . . . . . . . . . . . . . . 7,863 7,848 Other long-term liabilities . . . . . . . . . . . . . . . 1,368 1,426 ------- ------- Total Liabilities . . . . . . . . . . . . . . . . . 15,530 14,724 ------- ------- SHAREOWNERS' EQUITY Preferred stock, $100 par, 5 million shares authorized and unissued . . . . . . . . . . . . . . . . - - Common stock, $1 par, 1 billion shares authorized: 884 million shares issued in 1999 and 876 million shares issued in 1998 . . . . . . . . . . . 884 876 Additional paid-in capital. . . . . . . . . . . . . . . . 1,986 1,913 Accumulated deficit . . . . . . . . . . . . . . . . . . . (12) (421) Common stock in treasury, at cost; 50 million shares. . . (450) (451) ------- ------- Total Shareowners' Equity 2,408 1,917 ------- ------- Total Liabilities and Shareowners' Equity . . . . . . $17,938 $16,641 ======= ======= The accompanying notes are an integral part of the consolidated financial statements. 3 4 CONSOLIDATED STATEMENT OF CASH FLOWS (in millions) (unaudited) 3 Quarters Ended ---------------------------- November 6, October 3, 1999 1998 ---------- --------- Cash Flows From Operating Activities: Net earnings. . . . . . . . . . . . . . . . . . . . . . . . . . $ 382 $ 3 Adjustments to reconcile net earnings to net cash provided by operating activities: Extraordinary loss . . . . . . . . . . . . . . . . . . . . . 10 229 Depreciation . . . . . . . . . . . . . . . . . . . . . . . . 647 580 Goodwill amortization. . . . . . . . . . . . . . . . . . . . 76 66 Deferred income taxes. . . . . . . . . . . . . . . . . . . . 106 (13) Other. . . . . . . . . . . . . . . . . . . . . . . . . . . . (8) 93 Changes in operating assets and liabilities net of effects from acquisitions of businesses: Inventories. . . . . . . . . . . . . . . . . . . . . . . (665) (38) Receivables. . . . . . . . . . . . . . . . . . . . . . . (75) 14 Accounts payable . . . . . . . . . . . . . . . . . . . . 471 219 Other. . . . . . . . . . . . . . . . . . . . . . . . . . 367 312 ------- ------ Net cash provided by operating activities. . . . . . . 1,311 1,465 ------- ------ Cash Flows From Investing Activities: Capital expenditures. . . . . . . . . . . . . . . . . . . . . . (1,470) (1,164) Proceeds from sale of assets. . . . . . . . . . . . . . . . . . 101 64 Payments for acquisitions, net of cash acquired . . . . . . . . - (107) Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (33) (106) ------- ------ Net cash used by investing activities. . . . . . . . . (1,402) (1,313) ------- ------ Cash Flows From Financing Activities: Proceeds from issuance of long-term debt. . . . . . . . . . . . 1,718 5,140 Reductions in long-term debt. . . . . . . . . . . . . . . . . . (1,600) (4,663) Debt prepayment costs . . . . . . . . . . . . . . . . . . . . . (2) (312) Financing charges incurred. . . . . . . . . . . . . . . . . . . (10) (99) Decrease in book overdrafts . . . . . . . . . . . . . . . . . . (58) (118) Proceeds from issuance of capital stock . . . . . . . . . . . . 63 102 Treasury stock purchases. . . . . . . . . . . . . . . . . . . . - (122) Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . - (2) ------- ------ Net cash provided (used) by financing activities . . . 111 (74) ------- ------ Net increase in cash and temporary cash investments . . . . . . . 20 78 Cash and temporary cash investments: Beginning of year . . . . . . . . . . . . . . . . . . . . . . 263 183 ------- ------ End of year . . . . . . . . . . . . . . . . . . . . . . . . . $ 283 $ 261 ======= ====== Supplemental disclosure of cash flow information: Cash paid during the year for interest. . . . . . . . . . . . $ 425 $ 497 Cash paid during the year for income taxes. . . . . . . . . . 75 149 Non-cash changes related to purchase acquisitions: Fair value of assets acquired . . . . . . . . . . . . . . . - 2,166 Goodwill recorded . . . . . . . . . . . . . . . . . . . . . - 2,397 Value of stock issued . . . . . . . . . . . . . . . . . . . - (653) Liabilities assumed . . . . . . . . . . . . . . . . . . . . - (3,737) The accompanying notes are an integral part of the consolidated financial statements. 4 5 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ------------------------------------------ 1. BASIS OF PRESENTATION AND PRINCIPLES OF CONSOLIDATION ----------------------------------------------------- The year-end condensed balance sheet data was derived from audited financial statements, and, due to its summary nature, does not include all disclosures required by generally accepted accounting principles. The accompanying financial statements include the consolidated accounts of The Kroger Co. and its subsidiaries ("Kroger"), including Fred Meyer, Inc. and its subsidiaries ("Fred Meyer") which were merged with Kroger on May 27, 1999 (see note 2). The year-end condensed balance sheet includes Kroger's January 2, 1999 balance sheet combined with Fred Meyer's January 30, 1999 balance sheet. Amounts included in the consolidated financial statements for the third quarter and three quarters ended November 6, 1999 include the results of operations of the Company for the 12 week quarter and 40 week period ended November 6, 1999. The information for the quarter ended October 3, 1998 includes the results of operations of The Kroger Co. for the 16 week quarter ended October 3, 1998, its wholly-owned subsidiary Dillon Companies, Inc. ("Dillon") for the 13 week quarter ended September 26, 1998, and its wholly-owned subsidiary Fred Meyer for the 12 week quarter ended November 7, 1998. The information for the three quarters ended October 3, 1998 includes the results of operations of The Kroger Co. for the 40 week period ended October 3, 1998, Dillon for the 39 week period ended September 26, 1998, and Fred Meyer for the 40 week period ended November 7, 1998. It was not practicable to recast the 1998 quarterly amounts for The Kroger Co. or Dillon to conform to the quarterly reporting periods of The Kroger Co.'s newly adopted fiscal year. Because of these differing periods, 1999 results cannot be directly compared to 1998 results. Significant intercompany transactions and balances have been eliminated. References to the "Company" in these consolidated financial statements mean the consolidated company. 2. BUSINESS COMBINATIONS --------------------- On May 27, 1999, Kroger issued 312 million shares of Kroger common stock in connection with a merger, for all of the outstanding common stock of Fred Meyer, Inc., which operates stores primarily in the Western region of the United States. The merger was accounted for as a pooling of interests, and the accompanying financial statements have been restated to give effect to the consolidated results of Kroger and Fred Meyer for all periods presented. In conjunction with purchase acquisitions, the Company accrued certain costs associated with closing and divesting of certain acquired facilities and severance payments to terminate employees of the acquired companies. The following table presents the activity in the Company's accrued purchase liabilities: Facility Closure Employee (in millions) Costs Severance Total ----------------------------- -------- --------- ------- Balance at December 27, 1997 $ 19 $ 8 $ 27 Additions 122 22 144 Payments (13) (2) (15) Adjustments to severance accrual - (3) (3) ----- ----- ----- Balance at January 2, 1999 128 25 153 Payments (3) (7) (10) ----- ----- ----- Balance at November 6, 1999 $ 125 $ 18 $ 143 ===== ===== ===== 5 6 FACILITY CLOSURE COSTS ---------------------- The Company acquired certain idle facilities in its purchase acquisitions including 63 closed stores, four closed warehouses and one vacant parcel all of which are leased. The Company also acquired 16 stores that the California Attorney General required to be divested and 17 stores that were duplicate facilities. Divestitures of 15 stores have been completed and 10 of the duplicate facilities have been closed. The remaining 7 duplicate stores are expected to close by the end of 1999. Facility closure costs accrued include obligations for future contractual lease payments, net of sublease income, and closure costs. EMPLOYEE SEVERANCE ------------------ Employee severance relates to 46 employees that have been terminated and 51 employees that will be terminated in the future. Under severance agreements, the severance will be paid over a period not to exceed three years following the date of termination. 3. MERGER RELATED COSTS -------------------- The Company is in the process of implementing its integration plan relating to recent mergers. The integration plan includes distribution consolidation, systems integration, store conversions, transaction costs, store closures, and administration integration. The following table presents the components of the merger related costs: 3rd Quarter Ended 3 Quarters Ended -------------------------- ----------------------- November 6, October 3, November 6, October 3, (in millions) 1999 1998 1999 1998 ---------------------------------- ----------- ----------- ----------- ---------- CHARGES RECORDED AS CASH EXPENDED Distribution consolidation $ 14 $ - $ 24 $ 14 Systems integration 22 13 65 32 Store conversions 21 6 43 42 Transaction costs 4 1 91 33 Administration integration 6 4 19 11 ----- ---- ----- ------ 67 24 242 132 NONCASH ASSET WRITE-DOWN Distribution consolidation - - - 29 Systems integration - 2 3 23 Store closures - - 3 25 Administration integration 1 - 14 3 ----- ---- ----- ------ 1 2 20 80 ACCRUED CHARGES Distribution consolidation - - 5 - Systems integration - - - 1 Transaction costs - 2 - 6 Store closures 1 - 5 7 Administration integration - 3 32 12 ----- ---- ----- ------ 1 5 42 26 ----- ---- ----- ------ Total merger related costs $ 69 $ 31 $ 304 $ 238 ===== ==== ===== ====== TOTAL CHARGES Distribution consolidation $ 14 $ - $ 29 $ 43 Systems integration 22 15 68 56 Store conversions 21 6 43 42 Transaction costs 4 3 91 39 Store closures 1 - 8 32 Administration integration 7 7 65 26 ----- ---- ----- ------ Total merger related costs $ 69 $ 31 $ 304 $ 238 ===== ==== ===== ====== 6 7 Distribution Consolidation -------------------------- Represents costs to consolidate manufacturing and distribution operations and eliminate duplicate facilities. Third quarter 1999 Tolleson warehouse expenses of $14 million were recorded as the cash was expended. Severance costs of $5 million were accrued year-to-date 1999 for distribution employees in Phoenix. The year-to-date 1998 costs include a $29 million write-down to estimated net realizable value for a distribution center in Southern California. The facility is held for sale. The year-to-date 1998 costs also include $13 million for incremental labor incurred during the closing of the distribution center and other incremental costs incurred as a part of the realignment of the Company's distribution system. Systems Integration ------------------- Represents the costs of integrating systems and the related conversion of all corporate office and store systems. Charges recorded as cash was expended totaled $22 million and $13 million in the third quarter of 1999 and 1998, respectively, and $65 million and $32 million year-to-date 1999 and 1998, respectively. These costs represent incremental operating costs, principally labor, during the conversion process, payments to third parties and training costs. The year-to-date 1998 costs include a $19 million write-down of computer equipment and related software that have been abandoned and $2 million of depreciation associated with computer equipment which is being written off over 18 months at which time it will be abandoned. Store Conversions ----------------- Includes the cost to convert store banners. All costs represented incremental cash expenditures for advertising and promotions to establish the banner, changing store signage, labor required to remerchandise the store inventory and other services which were expensed as incurred. Transaction Costs ----------------- Represents fees paid to outside parties, employee bonuses that were contingent upon the completion of the mergers, and an employee stay bonus program. The Company incurred costs totaling $4 million and $1 million in the third quarter of 1999 and 1998, respectively, and $91 million and $33 million year-to-date 1999 and 1998, respectively, related to fees and employee bonuses recorded as the cash was expended. All accrued amounts relate to the employee stay bonus program. Store Closures -------------- Includes the costs to close stores identified as duplicate facilities and to sell stores pursuant to settlement agreements. Year-to-date 1999 costs of $5 million were accrued to close seven stores identified as duplicate facilities and to sell three stores pursuant to a settlement with the Federal Trade Commission ("FTC Stores"). Included in the year-to-date 1998 were costs to close four stores identified as duplicate facilities and to sell three stores pursuant to a settlement agreement with the State of California ("AG Stores"). The asset write-down of $25 million year-to-date 1998 relates to the AG Stores. Termination costs totaling $7 million were accrued year-to-date 1998. Administration Integration -------------------------- Includes labor and severance costs, charitable contributions, and costs to conform accounting policies. Year-to-date 1999 the Company accrued $12 million for severance costs and $20 million in connection with the Fred Meyer merger for charitable contributions that will be made to a foundation. 7 8 The following table presents the activity in the reserve accounts. Lease (in millions) Other Obligation Severance Total ---------------------------- ------- ---------- --------- ------- Balance at December 27, 1997 $ - $ - $ - $ - Expense 6 7 13 26 Payments (6) (2) (8) (16) ---- ---- ---- ---- Balance at January 2, 1999 - 5 5 10 Expense 20 4 17 41 Payments - (2) (10) (12) ---- ---- ---- ---- Balance at November 6, 1999 $ 20 $ 7 $ 12 $ 39 ==== ==== ==== ==== Severance --------- Relates to administrative, systems, and distribution employees. All of the employees have been terminated or notified of their terminations. Under severance agreements, the amounts of severance will be paid over a period following the date of termination. Lease Obligation ---------------- The lease obligation represents future contractual lease payments on a closed store and several AG Stores and FTC Stores over the expected holding period, net of any sublease income. The Company is actively marketing the stores to potential buyers and sub-lease tenants. Other ----- The 1998 costs represent amounts that were paid under a stay bonus program in the fourth quarter of 1998. The Company accrued $20 million in 1999 in connection with the Fred Meyer merger for charitable contributions that will be made to a foundation. 4. ONE-TIME EXPENSES ----------------- In the second quarter of 1998, the Company incurred a $41 million one-time expense for logistics projects. This expense included the costs associated with ending a joint venture related to a warehouse operation that formerly served the Company's Michigan stores and several independent customers. The warehouse is now operated by a third party that distributes the Company's inventory to its Michigan stores. These expenses also included the transition costs related to one of the Company's new warehouses, and one new warehouse facility operated by an unaffiliated entity that provides services to the Company. These costs included carrying costs of the facilities idled as a result of these new warehouses and the associated employee severance costs. The expenses described above included non-cash asset writedowns of $16 million and were included in merchandise costs, including warehouse and transportation. The remaining $25 million of expenses are summarized as follows: Facility Employee Carrying Joint (in millions) Severance Costs Venture Total - -------------------------------------- --------- -------- ------- ----- Balance at December 27, 1997 $ - $ - $ - $ - Expense 11 9 5 25 Payments (7) (3) (5) (15) --- --- --- --- Balance at January 2, 1999 4 6 $ - 10 === Payments (4) (4) (8) --- --- --- Balance at November 6, 1999 $ - $ 2 $ 2 === === === The carrying costs of the idled warehouse facilities will be paid through 2001. 8 9 Additionally, in the second quarter of 1998, the Company incurred one-time expenses of $12 million associated with accounting, data and operations consolidations in Texas. These included the cost of closing eight stores and relocating the remaining Dallas office employees to a smaller facility. These expenses, which included non-cash asset writedowns of $2 million, were included in operating, general and administrative expenses. Cash expenses paid to date are $3 million and the remaining accrual of $7 million at November 6, 1999 represents estimated rent or lease termination costs that will be paid on closed stores through 2013. 5. ACCOUNTING CHANGE ----------------- In the second quarter of 1998, Kroger changed its application of the Last-In, First-Out, or LIFO method of accounting for store inventories from the retail method to the item cost method. The change was made to more accurately reflect inventory value by eliminating the averaging and estimation inherent in the retail method. The cumulative effect of this change on periods prior to December 28, 1997 cannot be determined. The effect of the change on the December 28, 1997 inventory valuation, which includes other immaterial modifications in inventory valuation methods, was included in restated results for the quarter ended March 21, 1998. This change increased merchandise costs by $90 million and reduced earnings before extraordinary loss and net earnings by $56 million. The item cost method did not have a material impact on earnings subsequent to its initial adoption. 6. INCOME TAXES ------------ The effective income tax rate differs from the expected statutory rate primarily due to the effect of certain state taxes and non-deductible goodwill. 7. EARNINGS PER COMMON SHARE ------------------------- Earnings per common share equals net earnings divided by the weighted average number of common shares outstanding, after giving effect to dilutive stock options. The following table provides a reconciliation of earnings before extraordinary loss and shares used in calculating basic earnings per share to those used in calculating diluted earnings per share. 9 10 For the quarter ended For the quarter ended November 6, 1999 October 3, 1998 ---------------------------- ------------------------- Income Shares Per Income Shares Per (Numer- (Denomi- Share (Numer- (Denomi- Share ator) nator) Amount ator) nator) Amount ------- -------- ----- ------- -------- ----- (in millions, except per share amounts) -------------------------------------------------------- Basic earnings per common share . . . . . . . $129 832 $0.16 $ 151 821 $ 0.18 Dilutive effect of stock options and warrants . . . . - 25 - 34 ---- ----- ----- ----- Diluted earnings per common share . . . . . . . $129 857 $0.15 $ 151 855 $ 0.18 ==== ===== ===== ===== For the 3 quarters ended For the 3 quarters ended November 6, 1999 October 3, 1998 --------------------------- -------------------------- Income Shares Per Income Shares Per (Numer- (Denomi- Share (Numer- (Denomi- Share ator) nator) Amount ator) nator) Amount ------- -------- ----- ------- -------- ----- (in millions, except per share amounts) -------------------------------------------------------- Basic earnings per common share . . . . . . . $392 829 $0.47 $ 231 813 $ 0.28 Dilutive effect of stock options and warrants . . . - 31 - 35 ---- ----- ----- ----- Diluted earnings per common share . . . . . . . $392 860 $0.46 $ 231 848 $ 0.27 ==== ===== ===== ===== On May 20, 1999, the Company announced a distribution in the nature of a two-for-one stock split, to shareholders of record of common stock on June 7, 1999. All share amounts prior to this date have been restated to reflect the split. 8. SEGMENTS -------- The Company operates retail food and drug stores, multi-department stores and convenience stores in the Midwest, South and West. The Company's retail operations, which represent approximately 98% of consolidated sales, are its only reportable segment. All of the Company's operations are domestic. 9. COMPREHENSIVE INCOME -------------------- The Company has no items of other comprehensive income in any period presented. Therefore, net earnings as presented in the Consolidated Statement of Operations equals comprehensive income. 10. RECENTLY ISSUED ACCOUNTING STANDARDS ------------------------------------ In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities". This standard, as amended, is effective for fiscal years beginning after June 15, 2000. Given current activities, the Company expects that the adoption of the standard will not have a material impact on the financial statements. 10 11 11. GUARANTOR SUBSIDIARIES ---------------------- Certain of the Company's Senior Notes and Senior Subordinated Notes (the "Guaranteed Notes") are jointly and severally, fully and unconditionally guaranteed by certain Kroger subsidiaries (the "Guarantor Subsidiaries"). At November 6, 1999 a total of approximately $4.8 billion of Guaranteed Notes were outstanding. The Guarantor Subsidiaries and non-guarantor subsidiaries are wholly-owned subsidiaries of Kroger. Separate financial statements of Kroger and each of the Guarantor Subsidiaries are not presented because the guarantees are full and unconditional and the Guarantor Subsidiaries are jointly and severally liable. The Company believes that separate financial statements and other disclosures concerning the Guarantor Subsidiaries would not be material to investors. The non-guaranteeing subsidiaries represent less than 3% on an individual and aggregate basis of consolidated assets, pretax earnings, cash flow, and equity. Therefore, the non-guarantor subsidiaries' information is not separately presented in the tables below. There are no current restrictions on the ability of the Guarantor Subsidiaries to make payments under the guarantees referred to above, except, however, the obligations of each guarantor under its guarantee are limited to the maximum amount as will result in obligations of such guarantor under its guarantee not constituting a fraudulent conveyance or fraudulent transfer for purposes of Bankruptcy Law, the Uniform Fraudulent Conveyance Act, the Uniform Fraudulent Transfer Act, or any similar Federal or state law (e.g. adequate capital to pay dividends under corporate laws). The following tables present summarized financial information as of November 6, 1999 and for the three quarters ended November 6, 1999 and October 3, 1998. For the summarized financial information as of November 6, 1999 and for the three quarters then ended, the Kroger column includes approximately $3.1 billion of debt issued by Fred Meyer that has been jointly and severally guaranteed by Kroger. As a result, this amount is not also included in the Guarantor Subsidiaries column. SUMMARIZED FINANCIAL INFORMATION AS OF NOVEMBER 6, 1999 AND FOR THE THREE QUARTERS THEN ENDED: Guarantor (in millions of dollars) Kroger Subsidiaries Eliminations Consolidated ------------------------------ ---------- -------------- ---------------- -------------- Current assets $ 724 $ 4,873 $ - $ 5,597 Non-current assets 11,156 10,838 (9,653) 12,341 Current liabilities 1,437 4,862 - 6,299 Non-current liabilities 8,035 1,196 - 9,231 Sales 7,062 27,520 (471) 34,111 Gross profit 1,491 7,500 (38) 8,953 Operating profit (22) 1,210 - 1,188 Net earnings 382 691 (691) 382 SUMMARIZED FINANCIAL INFORMATION FOR THE THREE QUARTERS ENDED OCTOBER 3, 1998: Guarantor (in millions of dollars) Kroger Subsidiaries Eliminations Consolidated ------------------------------ ---------- -------------- ---------------- -------------- Sales $ 7,273 $ 25,076 $ (472) $ 31,877 Gross profit 1,402 6,762 (72) 8,092 Operating profit 72 850 - 922 Net earnings 3 61 (61) 3 12. COMMITMENTS AND CONTINGENCIES ----------------------------- The Company is a 50% owner of Santee Dairies, L.L.C. ("Santee") and has a 10 year product supply agreement with Santee that requires us to purchase 9 million gallons of fluid milk and other products annually. The product supply agreement expires on July 29, 2007. Upon acquisition of Ralphs/Food 4 Less, Santee became excess capacity and a duplicate facility. The Company is currently engaged in efforts to dispose of its interest in Santee that may result in a loss. 11 12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS The following discussion summarizes our operating results for the third quarter and first three quarters of 1999 compared to the third quarter and first three quarters of 1998. Amounts included in the consolidated financial statements for the third quarter and three quarters ended November 6, 1999 include the results of operations of the Company for the 12 week quarter and 40 week period ended November 6, 1999. The information for the quarter ended October 3, 1998 includes the results of operations of The Kroger Co. for the 16 week quarter ended October 3, 1998, its wholly-owned subsidiary Dillon Companies, Inc. ("Dillon") for the 13 week quarter ended September 26, 1998, and its wholly-owned subsidiary Fred Meyer, Inc. ("Fred Meyer") for the 12 week quarter ended November 7, 1998. The information for the three quarters ended October 3, 1998, includes the results of operations of The Kroger Co. for the 40 week period ended October 3, 1998, Dillon for the 39 week period ended September 26, 1998 and Fred Meyer for the 40 week period ended November 7, 1998. It was not practicable to recast the 1998 quarterly amounts for The Kroger Co. or Dillon to conform to the quarterly reporting periods of Kroger's newly adopted fiscal year. Because of these differing periods, 1999 results cannot be directly compared to 1998 results. BUSINESS COMBINATIONS On May 27, 1999 Kroger issued 312 million shares of Kroger common stock in connection with a merger, for all of the outstanding common stock of Fred Meyer, Inc., which operates stores primarily in the Western region of the United States. The merger was accounted for as a pooling of interests, and the accompanying financial statements have been restated to give effect to the consolidated results of Kroger and Fred Meyer for all years presented. MERGER RELATED COSTS We are in the process of implementing our integration plan relating to recent mergers. The integration plan includes distribution consolidation, systems integration, store conversions, transaction costs, store closures, and administration integration. The following table presents the components of the merger related costs: 3rd Quarter Ended 3 Quarters Ended ---------------------- ----------------------- November 6, October 3, November 6, October 3, (in millions) 1999 1998 1999 1998 --------------------------------- ----------- ---------- ----------- ---------- CHARGES RECORDED AS CASH EXPENDED Distribution consolidation $ 14 $ - $ 24 $ 14 Systems integration 22 13 65 32 Store conversions 21 6 43 42 Transaction costs 4 1 91 33 Administration integration 6 4 19 11 ------ ----- ------ ----- 67 24 242 132 NONCASH ASSET WRITE-DOWN Distribution consolidation - - - 29 Systems integration - 2 3 23 Store closures - - 3 25 Administration integration 1 - 14 3 ------ ----- ------ ----- 1 2 20 80 12 13 ACCRUED CHARGES Distribution consolidation - - 5 - Systems integration - - - 1 Transaction costs - 2 - 6 Store closures 1 - 5 7 Administration integration - 3 32 12 ------ ----- ------ ----- 1 5 42 26 ------ ----- ------ ----- Total merger related costs $ 69 $ 31 $ 304 $ 238 ====== ===== ====== ===== TOTAL CHARGES Distribution consolidation $ 14 $ - $ 29 $ 43 Systems integration 22 15 68 56 Store conversions 21 6 43 42 Transaction costs 4 3 91 39 Store closures 1 - 8 32 Administration integration 7 7 65 26 ------ ----- ------ ----- Total merger related costs $ 69 $ 31 $ 304 $ 238 ====== ===== ====== ===== Distribution Consolidation - -------------------------- Represents costs to consolidate manufacturing and distribution operations and eliminate duplicate facilities. Third quarter 1999 Tolleson warehouse expenses of $14 million were recorded as the cash was expended. Severance costs of $5 million were accrued year-to-date 1999 for distribution employees in Phoenix. The year-to-date 1998 costs include a $29 million write-down to estimated net realizable value for a distribution center in Southern California. The facility is held for sale. The year-to-date 1998 costs also include $13 million for incremental labor incurred during the closing of the distribution center and other incremental costs incurred as a part of the realignment of our distribution system. Systems Integration - ------------------- Represents the costs of integrating systems and the related conversion of all corporate office and store systems. Charges recorded as cash was expended totaled $22 million and $13 million in the third quarter of 1999 and 1998, respectively, and $65 million and $32 million year-to-date 1999 and 1998, respectively. These costs represent incremental operating costs, principally labor, during the conversion process, payments to third parties and training costs. The year-to-date 1998 costs include a $19 million write-down of computer equipment and related software that have been abandoned and $2 million of depreciation associated with computer equipment which is being written off over 18 months at which time it will be abandoned. Store Conversions - ----------------- Includes the cost to convert store banners. All costs represented incremental cash expenditures for advertising and promotions to establish the banner, changing store signage, labor required to remerchandise the store inventory and other services which were expensed as incurred. 13 14 Transaction Costs - ----------------- Represents fees paid to outside parties, employee bonuses that were contingent upon the completion of the mergers, and an employee stay bonus program. The Company incurred costs totaling $4 million and $1 million in the third quarter of 1999 and 1998, respectively, and $91 million and $33 million year-to-date 1999 and 1998, respectively, related to fees and employee bonuses recorded as the cash was expended. All accrued amounts relate to the employee stay bonus program. Store Closures - -------------- Includes the costs to close stores identified as duplicate facilities and to sell stores pursuant to settlement agreements. Year-to-date 1999 costs of $5 million were accrued to close seven stores identified as duplicate facilities and to sell three stores pursuant to a settlement with the Federal Trade Commission ("FTC Stores"). Included in the year-to-date 1998 were costs to close four stores identified as duplicate facilities and to sell three stores pursuant to a settlement agreement with the State of California ("AG Stores"). The asset write-down of $25 million year-to-date 1998 relates to the AG Stores. Termination costs totaling $7 million were accrued year-to-date 1998. Administration Integration - -------------------------- Includes labor and severance costs, charitable contributions, and costs to conform accounting policies. Year-to-date 1999 we accrued $12 million for severance costs and $20 million in connection with the Fred Meyer merger for charitable contributions that will be made to a foundation. The following table presents the activity in the reserve accounts. Lease (in millions) Other Obligation Severance Total ---------------------------- ------- ---------- -------------- ------- Balance at December 27, 1997 $ - $ - $ - $ - Expense 6 7 13 26 Payments (6) (2) (8) (16) --- --- --- --- Balance at January 2, 1999 - 5 5 10 Expense 20 4 17 41 Payments - (2) (10) (12) --- --- --- --- Balance at November 6, 1999 $20 $ 7 $12 $39 === === === === Severance - --------- Relates to administrative, systems, and distribution employees. All of the employees have been terminated or notified of their terminations. Under severance agreements, the amounts of severance will be paid over a period following the date of termination. Lease Obligation - ---------------- The lease obligation represent future contractual lease payments on a closed store and several AG Stores and FTC Stores over the expected holding period, net of any sublease income. The Company is actively marketing the stores to potential buyers and sub-lease tenants. 14 15 Other - ----- The 1998 costs represent amounts that were paid under a stay bonus program in the fourth quarter of 1998. The Company accrued $20 million in 1999 in connection with the Fred Meyer merger for charitable contributions that will be made to a foundation. In addition to the merger related costs mentioned above, we incurred costs related to the merger of $18 million in the third quarter of 1999, $3 million in the third quarter of 1998, $36 million for the first three quarters of 1999 and $7 million for the first three quarters of 1998. These costs related to inventory adjustments to inventory made obsolete or marked down for liquidation as a result of the store integration program. These costs were reported in merchandise costs. We also incurred incremental labor costs of $6 million in the third quarter of 1999 and costs from unwinding specific interest rate swap contracts of $17 million in the second quarter of 1999. These costs were reported as operating, general and administrative expenses. ONE-TIME EXPENSES In the second quarter of 1998, we incurred a $41 million one-time expense associated with logistics projects. This expense included the costs associated with ending a joint venture related to a warehouse operation that formerly served our Michigan stores and several independent customers. The warehouse is now operated by a third party that distributes our inventory to our Michigan stores. These expenses also included the transition costs related to one of our new warehouses, and one new warehouse facility operated by an unaffiliated entity that provides services to us. These costs included carrying costs of the facilities idled as a result of these new warehouses and the associated employee severance costs. The expenses described above included non-cash asset writedowns of $16 million and were included in merchandise costs, including warehouse and transportation. The remaining $25 million of expenses are summarized as follows: Facility Employee Carrying Joint (in millions) Severance Costs Venture Total ---------------------------- --------- -------- ------- ----- Balance at December 27, 1997 $ - $ - $ - $ - Expense 11 9 5 25 Payments (7) (3) (5) (15) --- --- --- --- Balance at January 2, 1999 4 6 $ - 10 === Payments (4) (4) (8) --- --- --- Balance at November 6, 1999 $ - $ 2 $ 2 === === === The carrying costs of the idled warehouse facilities will be paid through 2001. Additionally, in the second quarter of 1998, we incurred one-time expenses of $12 million associated with accounting, data and operations consolidations in Texas. These included the cost of closing eight stores and relocating the remaining Dallas office employees to a smaller facility. These expenses, which included non-cash asset writedowns of $2 million, were included in operating, general and administrative expenses. Cash expenses paid to date are $3 million and the remaining accrual of $7 million at November 6, 1999 represents estimated rent or lease termination costs that will be paid on closed stores through 2013. ACCOUNTING CHANGE In the second quarter of 1998, Kroger changed its application of the Last-In, First-Out, or LIFO method of accounting for store inventories from the retail method to the item cost method. The 15 16 change was made to more accurately reflect inventory value by eliminating the averaging and estimation inherent in the retail method. The cumulative effect of this change on periods prior to December 28, 1997 cannot be determined. The effect of the change on the December 28, 1997 inventory valuation, which includes other immaterial modifications in inventory valuation methods, was included in restated results for the quarter ended March 21, 1998. This change increased merchandise costs by $90 million and reduced earnings before extraordinary loss and net earnings by $56 million. The item cost method did not have a material impact on earnings subsequent to its initial adoption. THIRD QUARTER 1999 VS. THIRD QUARTER 1998; AND FIRST THREE QUARTERS 1999 VS. FIRST THREE QUARTERS 1998. Sales - ----- Adjusting for the change in our fiscal calendar and excluding sales from divested stores, total sales for the third quarter of 1999 increased 6.6% to $10.3 billion and total sales year-to-date increased 5.7% to $34.0 billion. Identical food stores sales, which include stores in operation and not expanded or relocated for five quarters, grew 1.6%. Comparable food stores sales, which include relocations and expansions, rose 2.5%. Identical and comparable sales include stores that changed names during the past year. Excluding our Fry's division, which has converted 35 former Smith's stores to the Fry's banner, identical food store sales grew 1.9% and comparable food store sales rose 2.8%. Merchandise Costs - ----------------- Merchandise costs include advertising, warehousing and transportation expenses. Merchandise costs, net of one-time items and LIFO, as a percent of sales were 73.5% in the third quarter of 1999 and 74.3% in the second quarter of 1998. On this same basis, year-to-date merchandise costs as a percent of sales were 73.6% in 1999 and 74.1% in 1998. Merchandise costs were affected positively by strong private label sales, strategic initiatives in coordinated purchasing, category management and operating improvements due to logistics and technology related efficiencies. Operating, General and Administrative Expenses - ---------------------------------------------- Operating, general and administrative expenses as a percent of sales were 18.2% in the third quarter of 1999 and 18.3% in the third quarter of 1998. No specific cost reduction caused the decline. Year-to-date operating, general and administrative expenses, net of one-time items, as a percent of sales were 18.2% in 1999 and 18.2% in 1998. Income Taxes - ------------ The effective tax rate differs from the expected statutory rate primarily due to the effect of certain taxes and non-deductible goodwill. Goodwill amortization was $23 million in the third quarter of 1999 and $23 million in the third quarter of 1998. Year-to-date goodwill amortization was $76 million in 1999 and $66 million in 1998. Net Earnings - ------------ Earnings before extraordinary loss, excluding one-time items, were $202 million or $0.24 per diluted share in the third quarter of 1999. These results represent an increase of approximately 33% over estimated earnings before extraordinary loss of $0.18 per diluted share for the third quarter of 16 17 1998. On this same basis, year-to-date 1999 earnings before extraordinary loss were $635 million or $0.74 per diluted share. These results represent an increase of approximately 25% over estimated year-to-date 1998 earnings before extraordinary loss of $0.59 per diluted share. The prior year estimate includes the actual results, net of one-time items, of Fred Meyer and an estimate of Kroger's results, net of one-time items, to reflect the change to our new fiscal year. EBITDA - ------ Our bank credit facilities and the indentures underlying our publicly issued debt, contain various restrictive covenants. Many of these covenants are based on earnings before interest, taxes, depreciation, amortization, LIFO, extraordinary losses and one-time items or EBITDA. The ability to generate EBITDA at levels sufficient to satisfy the requirements of these agreements is a key measure of our financial strength. We do not intend to present EBITDA as an alternative to any generally accepted accounting principle measure of performance. Rather, we believe the presentation of EBITDA is important for understanding our performance compared to our debt covenants. The calculation of EBITDA is based on the definition contained in our Credit Agreement. This may be a different definition than other companies use. We were in compliance with all EBITDA-based bank credit facilities and indenture covenants on November 6, 1999. The following is a summary of the calculation of EBITDA for the third quarters of 1999 and 1998 and for the first three quarters of 1999 and 1998. 3rd Quarter Ended 3 Quarters Ended ---------------------- ---------------------- November 6, October 3, November 6, October 3, (in millions) 1999 1998 1999 1998 - --------------------------------------------------- ----------- ---------- ----------- ---------- Earnings before tax expense and extraordinary loss. $ 240 $ 255 $ 693 $ 433 Interest........................................... 148 170 495 489 Depreciation....................................... 198 200 647 580 Goodwill amortization.............................. 23 23 76 66 LIFO............................................... (6) 9 6 28 One-time items included in merchandise costs....... 18 3 36 138 One-time items included in operating, general and administrative expenses.......................... 6 - 23 12 Merger related costs............................... 69 31 304 238 ----- ----- ------ ------ EBITDA............................................. $ 696 $ 691 $2,280 $1,984 ===== ===== ====== ====== LIQUIDITY AND CAPITAL RESOURCES Debt Management - --------------- We had several lines of credit totaling $4.0 billion, with $1.3 billion in unused balances at November 6, 1999. In addition, we had a $500 million synthetic lease credit facility and a $100 million money market line with unused balances of $56 million and $100 million, respectively, at November 6, 1999. Net debt increased $247 million to $8.7 billion at the end of the third quarter of 1999 compared to the prior year. Net debt is defined as long-term debt, including capital leases and current portion thereof, less investments in debt securities and prefunded employee benefits. Cash Flow - --------- We generated $1,311 million of cash from operating activities year-to-date 1999 compared to $1,465 million year-to-date 1998. Cash flow from operating activities decreased in 1999 largely due to increased inventory for the holiday season in anticipation of our customers' needs for the millennium. 17 18 Investing activities used $1,402 million of cash year-to-date 1999 compared to $1,313 million year-to-date 1998. Financing activities provided $111 million of cash year-to-date 1999 compared to $74 million used year-to-date 1998. Debt prepayment costs and new financing charges used $12 million of cash year-to-date 1999 compared to $411 million year-to-date 1998. The change in the balance of book overdrafts used $58 million of cash year-to-date 1999 compared to $118 million year-to-date 1998. CAPITAL EXPENDITURES Capital expenditures totaled $625 million in the third quarter of 1999 compared to $495 million in the third quarter of 1998. During the third quarter of 1999 we opened, acquired, expanded, or relocated 104 stores. We had 11 operational closings and completed 40 within the wall remodels. Square footage increased 5.9% excluding divested stores. Year-to-date capital expenditures totaled $1,470 million compared to $1,164 million year-to-date 1998. Year-to-date we opened, acquired, expanded, or relocated 167 stores. We had 55 operational closings and completed 107 within the wall remodels. EFFECT OF INFLATION While management believes that some portion of the increase in sales is due to inflation, it is difficult to segregate and to measure the effects of inflation because of changes in the types of merchandise sold year-to-year and other pricing and competitive influences. By attempting to control costs and efficiently utilize resources, we strive to minimize the effects of inflation on operations. RECENTLY ISSUED ACCOUNTING STANDARDS In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities". This standard, as amended, is effective for all fiscal years beginning after June 15, 2000. Given current activities, we expect that the adoption of the standard will not have a material impact on the financial statements. OTHER ISSUES On May 20, 1999, we announced a distribution in the nature of a two-for-one stock split, to shareholders of record of common stock on June 7, 1999. All share amounts prior to this date have been restated to reflect the split. On January 6, 1999, we changed our fiscal year-end to the Saturday nearest January 31 of each year. This change is disclosed in our Current Report on Form 8-K dated January 15, 1999. Our first new fiscal year will end January 29, 2000. It includes a 16-week first quarter ending May 22, 1999, and 12-week second, third and fourth quarters ending August 14, 1999, November 6, 1999 and January 29, 2000, respectively. We filed separate audited financial statements covering the transition period from January 3, 1999 through January 30, 1999 on a Current Report of Form 8-K dated May 10, 1999. These financial statements include Kroger and its consolidated subsidiaries before the merger with Fred Meyer. We are a 50% owner of Santee Dairies, L.L.C. ("Santee") and have a 10 year product supply agreement with Santee that requires us to purchase 9 million gallons of fluid milk and other products annually. The product supply agreement expires on July 29, 2007. Upon acquisition of Ralphs/Food 4 Less, Santee became excess capacity and a duplicate facility. We are currently engaged in efforts to dispose of our interest in Santee that may result in a loss. 18 19 OUTLOOK Statements elsewhere in this report and below regarding our expectations, hopes, beliefs, intentions or strategies are forward looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. While we believe that the statements are accurate, uncertainties and other factors could cause actual results to differ materially from those statements. In particular: - We obtain sales growth from new square footage, as well as from increased productivity from existing locations. We expect 1999 full year square footage to grow 4.0% to 4.5%. We expect to continue to realize savings from economies of scale in technology and logistics, some of which may be reinvested in retail price reductions to increase sales volume and enhance market share. - We expect combination stores to generate higher sales per customer by the inclusion of numerous specialty departments, such as pharmacies, seafood shops, floral shops and bakeries. We believe the combination store format will allow us to withstand continued competition from other food retailers, supercenters, mass merchandisers and restaurants. - We believe we have adequate coverage of our debt covenants to continue to respond effectively to competitive conditions. - We expect to continue capital spending in technology focusing on improved store operations, logistics, manufacturing procurement, category management, merchandising and buying practices, which should continue to reduce merchandising costs as a percent of sales. - We expect to reduce working capital by a total of $500 million over the next 5 years. - Our earnings per share target is a 16%-18% average annual increase over the next three years effective with the year 2000. - We expect capital expenditures for the year to total $1.7-$1.8 billion, net of acquisitions, compared to $1.6 billion during 1998. Capital expenditures reflect Kroger's strategy of growth through expansion and acquisition as well as our emphasis, whenever possible, on self-development and ownership of store real estate, and on logistics and technology improvements. - We are dependent on computer hardware, software, systems and processes ("IT Systems") and non-information technology systems such as telephones, clocks, scales and refrigeration controllers, and other equipment containing embedded microprocessor technology ("Non-IT Systems"). These systems are used in several critical operating areas including store and distribution operations, product merchandising and procurement, manufacturing plant operations, inventory and labor management, and accounting and administrative systems. - We expect to achieve $380 million in synergy savings over the next three years as a result of our mergers. We project the timing of the annual savings by fiscal year to be as follows: $155 million in 1999, $260 million in 2000, $345 million in 2001, and $380 million in 2002 and beyond. YEAR 2000 READINESS DISCLOSURE We are currently working to resolve the potential effect of the year 2000 on the processing of date- sensitive information within our various systems. The year 2000 problem is the result of computer programs being written using two digits (rather than four) to define the applicable year. Any of our programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000, which could result in miscalculations or system failures. We have developed a plan to assess and update our IT Systems and Non-IT Systems for year 2000 compliance requirements and provide for continued functionality. The plan consists of three major 19 20 phases: 1) create an inventory of systems subject to the year 2000 problem and assess the scope of the problem as it relates to those systems 2) remediate any year 2000 problems 3) test and implement systems subsequent to remediation The chart below shows the estimated completion status of each of these phases expressed as a percent of completion as of November 6, 1999. Phase 1 2 3 ---------------- ---- ---- ---- IT Systems 99% 99% 97% Non-IT Systems 99% 99% 98% Our ability to timely execute our Plan may be adversely affected by a variety of factors, some of which are beyond our control, including the potential for unseen implementation problems, delays in the delivery of products, or inefficiencies in store operations resulting from loss of power or communication links between stores, distribution centers, and headquarters. Critical business partners have been contacted for their status on year 2000 readiness. Based on our assessment of their responses, we believe that the majority of our business partners are taking action for year 2000 readiness. Notwithstanding the substantial efforts by us and our key business partners, we could potentially experience disruptions to some aspects of our various activities and operations. Consequently, in conjunction with the Plan, management is formulating contingency plans for critical functions and processes, which may be implemented to minimize the risk of interruption to our business in the event of a year 2000 occurrence. Contingency planning, which utilizes a business process approach, focuses on the following priorities: ability to sell products to customers, continuously replenish stores with goods (ordering and distribution), pay employees, collect and remit on outstanding accounts, meet other regulatory and administrative needs, and address merchandising objectives. Documented contingency plans for critical business processes are in place. The total estimated cost for the project, over a four year period, is $47 million. This cost is being funded through operating cash flow. This represents an immaterial part of our information technology budget over the period. Costs incurred to date totaled $44 million at November 6, 1999. If we, our customers or vendors are unable to resolve processing issues in a timely manner, it could result in the disruption of the operation of IT Systems and or Non-IT Systems, and in a material financial risk. We believe that we have allocated the resources necessary to mitigate all significant year 2000 issues in a timely manner. Our ability to achieve the expected increases in sales and earnings could be adversely affected by the increasingly competitive environment in which we operate. In addition any labor dispute, delays in opening new stores, or changes in the economic climate could cause us to fall short of our sales and earnings targets. Sales per square footage expectation may not be achieved if the impact of new square footage on our other stores is greater than anticipated or if our competitors are able to increase their share of market. While we expect to reduce working capital, our ability to do so may be impaired by any changes in vendor payment terms or systems problems that result in increases in inventory levels. Our capital expenditures could fall outside of the expected range if we are unsuccessful in acquiring suitable sites for new stores, if development costs exceed those budgeted, or if our logistics and technology projects are not completed in the time frame expected or on 20 21 budget. While we expect to achieve benefits through logistics and technology, development of new systems and integration of systems due to our merger with Fred Meyer carry inherent uncertainties, and we may not achieve the expected benefits. Unforeseen difficulties in integrating Fred Meyer with Kroger, or any other acquired entity could cause us to fail to achieve the anticipated synergy savings, and could otherwise adversely affect our ability to meet our other expectations. 21 22 PART II - OTHER INFORMATION Item 1. Legal Proceedings On September 13, 1996, a class action lawsuit titled McCampbell, et al. v. Ralphs Grocery Company, et al, was filed in the Superior Court of the State of California, County of San Diego, against Ralphs Grocery Company ("Ralphs/Food 4 Less") and two other grocery store chains operating in the Southern California area. The complaint alleged, among other things, that Ralphs/Food 4 Less and others conspired to fix the retail price of eggs in Southern California. The plaintiffs claimed that the defendants' actions violated provisions of the California Cartwright Act and constituted unfair competition. The plaintiffs sought damages they purported to have sustained as a result of the defendants' alleged actions, which damages were subject to trebling under the applicable statute, and an injunction from future actions in restraint of trade and unfair competition. A class was certified consisting of all retail purchasers of white chicken eggs sold by the dozen in Los Angeles, Riverside, San Diego, San Bernardino, Imperial and Orange counties from September 13, 1992. The case proceeded to trial before a jury in July and August 1999. On September 2, 1999, the jury returned a verdict in favor of Ralphs/Food 4 Less and against the plaintiffs. Judgment was entered in favor of Ralphs/Food 4 Less on November 1, 1999. Ralphs/Food 4 Less anticipates that plaintiffs will appeal the judgment. Item 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBIT 3.1 - Amended Articles of Incorporation of the Company are hereby incorporated by reference to Exhibit 3.1 of the Company's Quarterly Report on Form 10-Q for the quarter ended October 3, 1998. The Company's Regulations are incorporated by reference to Exhibit 4.2 of the Company's Registration Statement on Form S-3 as filed with the Securities and Exchange Commission on January 28, 1993, and bearing Registration No. 33-57552. 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. EXHIBIT 27.1 - Financial Data Schedule. EXHIBIT 27.2 - Financial Data Schedule. EXHIBIT 99.1 - Additional Exhibits - Statement of Computation of Ratio of Earnings to Fixed Charges. 22 23 (b) The Company disclosed and filed an indenture and supplemental indentures related to issuance of $900,000,000 of Senior Notes in three tranches, and supplemental indentures to add the Company and subsidiary guarantors to indentures of certain outstanding debt of subsidiaries in its Current Report on Form 8-K dated August 20, 1999; the text of prepared remarks for a presentation to analysts in its Current Report on Form 8-K dated September 10, 1999; its earnings release for the second quarter 1999, and the text of prepared remarks for an investor conference call, in its Current Report on Form 8-K dated September 14, 1999; pricing agreements, supplemental indentures, and a calculation agency agreement related to the issuance of $775,000,000 of debt securities in three tranches in its Current Report on Form 8-K dated September 22, 1999; the text of prepared remarks for a presentation to analysts in its Current Report on Form 8-K dated October 21, 1999; and its audited consolidated financial statements for fiscal years ended January 2, 1999, December 28, 1997, and December 28, 1996, in its Current Report on Form 8-K dated October 29, 1999. 23 24 SIGNATURES ---------- 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. Dated: December 20, 1999 By: (Joseph A. Pichler) Joseph A. Pichler Chairman of the Board and Chief Executive Officer Dated: December 20, 1999 By: (J. Michael Schlotman) J. Michael Schlotman Vice President and Corporate Controller 24 25 Exhibit Index ------------- Exhibit 3.1 - Amended Articles of Incorporation of the Company are hereby incorporated by reference to Exhibit 3.1 of the Company's Quarterly Report on Form 10-Q for the quarter ended October 3, 1998. The Company's Regulations are incorporated by reference to Exhibit 4.2 of the Company's Registration Statement on Form S-3 as filed with the Securities and Exchange Commission on January 28, 1993, and bearing Registration No. 33-57552. 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. Exhibit 27.1 - Financial Data Schedule. Exhibit 27.2 - Financial Data Schedule. Exhibit 99.1 - Additional Exhibits - Statement of Computation of Ratio of Earnings to Fixed Charges. 25