The Kroger Co. (KR) Earnings Call Transcript & Summary

Good morning and welcome to the Kroger UFCW Tentative Pension Agreement Update conference call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Rebekah Manis, Director, Investor Relations. Please go ahead.

Thank you, Gary. Good morning and thank you for joining us. Before we begin, I want to remind you that today's discussion will include forward-looking statements. We want to caution you that such statements are predictions and actual events or results can differ materially. A detailed discussion of the many factors that we believe may have a material effect on our business on an ongoing basis is contained in our SEC filings. The Kroger assumes no obligation to update that information. Both our press release announcing our new pension arrangements and our prepared remarks from this conference call will be available on our website at ir.kroger.com. Additionally, in response to questions we've been receiving from our investors, we have posted a Multi-Employer Pension Plan Primer to our website to help further explain our pension plans. After our prepared remarks, we ask that you please limit yourself to questions regarding the pension fund. It is not our intention to provide a business update during the call. With that, I'd like to turn it over to Gary Millerchip, our Chief Financial Officer. Gary?

Thanks, Rebekah, and good morning, everyone. For many years, Kroger has sought opportunities to address the funding challenges facing the pension plans in which our associates participate. We believe challenges related to pension funding can be mitigated if plans are reviewed and addressed on a regular basis. We have been proactive in communicating the gap in multiemployer pension plan funding to investors for a number of years in our 10-K, and we have initiated a number of restructures and withdrawals since then. This includes creating the UFCW Consolidated Pension Plan and the IBT consolidated pension plan. We have also frozen our single employer corporate plan. In an environment when pensions are faced with funding shortfalls, we are pleased that we can find an opportunity to improve the security and stability of future retirement benefits for our associates in a way that is also a good financial decision for our shareholders. In that vein, yesterday, we announced a tentative agreement with the United Food and Commercial Workers Local unions to withdraw from the UFCW International Union-Industry Pension Fund a multiemployer pension plan known as the National Fund. This would allow 33,000 associates across 14 divisions to participate in a new plan for future service for their retirement benefits. This agreement has been approved by Kroger, the National Fund board of trustees and the UFCW Local unions. The tentative agreement is subject to ratification by associates in 20 local UFCW unions covering 40 separate contracts. Our strong financial position is allowing us to make this investment, which also supports our commitment to deliver sustainable and attractive total shareholder returns by reducing projected future pension cost increases and minimizing Kroger's future exposure to the market risk associated with the current plan. The decision to withdraw was weighed against other projects and has a high internal rate of return relative to alternative uses of capital. We modeled several cash flow scenarios for remaining in the plan and withdrawing, and after contemplating projected contributions, future status, current conditions and various tax rates, we determined the best financial decision was to withdraw from the plan. For our associates, we understand the pensions and retirement security is an important part of their total rewards benefits package at Kroger. This agreement represents a significant financial commitment to our associates to help protect the benefits they have accrued for past service, benefits that would otherwise be at risk. The newly announced plan modernizes the current plan and will stabilize future benefits. This investment and the approximately $800 million of associated investments we are making through Restock Kroger from 2018 to 2020, plus our recent COVID-19-related investments, all demonstrate our continued commitments to be an employer of choice. This is in addition to providing comprehensive benefits that many of our competitors don't offer. Our strong free cash flow and confidence in our financial model is allowing us to pursue this opportunity in addition to our other capital priorities, including continued investments to grow the business and returning cash to shareholders via our growing dividend and share repurchase program. We are also committed to maintaining our current investment-grade debt rating. We remain confident in our financial model and continue to expect to exceed the 2020 outlook shared in our April 1 business update for identical sales without fuel, adjusted FIFO operating profit, adjusted EPS and adjusted free cash flow. Turning now to the specific details of the transaction. It's important to keep in mind every multiemployer pension plan is unique and evaluated based on the individual set of circumstances involved. Based on the specific circumstances of the National Fund, the actuaries project the current plan will continue to deteriorate and, without intervention, will require significant future contribution increases and/or benefit reductions. The current opportunity also presents a unique window to coordinate 40 separate contracts with varying expiration dates, making it possible to withdraw in a single plan year and minimize withdrawal liability. The tentative agreement announced yesterday would fulfill Kroger's obligation for acute -- accrued benefits for past service and address Kroger's projected future pension costs by establishing a formula for Kroger's pension contributions through June 2028. The tentative agreement also moves future associate benefit accruals from a traditional defined benefit model to a variable benefit model that is tied to market performance. Together, Kroger, Stop & Shop and the UFCW plan to create a new variable annuity pension plan for future benefits. As part of a tentative agreement to withdraw from the plan, Kroger expects to pay the National Fund withdrawal liability of $962 million on a pretax basis. This would fulfill our obligations for past service for associates and retirees in the National fund. Kroger would also make a $27 million contribution to a transition reserve in the new variable rate annuity pension plan. On an after-tax basis, the withdrawal liability and contribution to a transition reserve total approximately $760 million. The company's withdrawal liability would be satisfied by installment payments to the National Fund over the next 3 years. In a withdrawal, the liability is recognized and taken as a charge to the income statement once the employer and the union agree to the termination of the employer's contributions obligation to the multiemployer pension plan. The company would incur a charge to net earnings during the quarter in which the UFCW members ratify the tentative agreement. We expect this to be in the third quarter of 2020. The charge is expected to affect net earnings by approximately $0.96 per diluted share on a GAAP basis. This does not affect our adjusted net earnings per diluted share results, which are provided on a basis that excludes adjustment items such as this contribution. In closing, I'd like to remind you that the tentative agreement announced yesterday is subject to ratification by 33,000 Kroger family of companies' associates from 20 UFCW Local unions covering 40 separate UFC (sic) [ UFCW ] contracts. The Stop and Shop Supermarket Company LLC and Albertsons Companies, Inc. have also entered into separate agreements with the UFCW to withdraw from the National Fund. Kroger's withdrawal is also conditioned upon the ratification of the agreement reached between various UFCW locals and the 18,000 Stop & Shop employees. The possibility exists that the membership of one or more of the UFCW locals of Kroger family of companies or Stop & Shop will fail to ratify the tentative agreement. If this were to occur, Kroger would not move forward with this transaction and would not withdraw from this fund or transition its affected associates to the new variable annuity pension plan. As I shared earlier, in an environment where pensions are faced with funding challenges, we are pleased to have the opportunity to improve the security and stability of future retirement benefits for our associates in a way that is also a good financial decision for our shareholders. With that, I'd now like to open the call up for your questions on yesterday's announcement.

[Operator Instructions] Our first question comes from John Heinbockel with Guggenheim Securities.

Gary, let me -- 2 quick things. One is if you think about the impact on pension cost going forward limited to this contract, it sounds like it is very similar or you plan it to be very similar to what it had been before, the issue being more certainty and you're unlikely to be surprised to the upside. Is that fair? And then secondly, when you look at opportunities to do more of this going forward, was there anything unique here? I don't know the 3 of you had a very sizable piece of this. That makes this a little easier to do than maybe some other plans out there. Thoughts on that would be great.

Sure. Yes. Thanks for the question, John. So first of all, yes, I think you've characterized it correctly in terms of how we think about the financial impact of the transaction. There are really 3 main benefits I outlined in my earlier comments as to why we believe, from a shareholder perspective, this makes sense, in addition, of course, to the important benefits for our associates about protecting their own benefits and modernizing the plan. When we look at the financial impact, really the way that we think about the benefit of this plant from an OG&A perspective is we look at it really versus doing nothing. And if we want to move forward with the plan, all of the fund's actuarial analysis, which is supported by our own analysis, would show that we would expect the cost to significantly increase. And so this is really about thinking about how we de-risk our plan looking forward and how we effectively are able to essentially hold those costs flat looking forward over the next 8 years. It also, of course, does move us to a new variable rate plan, as I mentioned earlier, which removes really most of the market risk that's typically associated with more of a defined benefits plan. And of course, it also makes sure that we're providing labor stability on what's a major topic in our labor negotiations, and this covers 40 collective bargaining agreements. But the headline would absolutely be correct, but it's really about how we mitigate future cost increases and ensure that we are able to deliver on our TSR growth that we've outlined at our Investor Day last year. As we think about the opportunities moving forward, really every multiemployer plan is unique. And in this specific case, we were able to achieve really what we think about are the main objectives when we're trying to look at an opportunity to negotiate a better structure going forward. I mentioned a number of them earlier, but the first are how can we protect associate benefits and make sure that we're modernizing the plan in a way that drives those market-driven returns and create more flexibility. From a shareholder perspective, it's how do we make sure it's got a strong IRR in terms of supporting our TSR model looking forward. Is it modernizing the plan to take away that market risk around the defined benefit structure? And is it supporting our overall labor strategy? I would say that when we think about future plans, we'd be very much looking at them through that lens. Does it drive that mix of benefits? And does it allow us to be able to support both of those, the associate part of our strategy and being an employer of choice? And does it support delivering on our TSR model? And we'd be assessing future plans against that same criteria. I would point out specifically around the National Fund plan that it was a pretty unique situation because if you looked at the reporting that we share in our 10-K filing, it would have been in green status historically. Green is very much a -- the way that the status works on these plans is very much a single point in time, and it's a very blunt definition. As I mentioned earlier, most -- all of the current information that we look at and the actuaries looked at would say that this plan was heading in a very particular direction where the cost would significantly increase if we didn't take this action, and it really reinforced the decision that we've reached as part of the negotiated withdrawal. I would emphasize that this plan was very unique in that regard, that we wouldn't typically see that in a green plan. It's kind of is an outlier in terms of everything I just characterized around the actuarial analysis that wouldn't be typical in a green plan when we look at the other green plans that we're participating in.

The next question is from Karen Short with Barclays.

This is actually Renato Basanta in for Karen. So I just want to get just want to get a better sense of your overall liability after withdrawing from this particular plan. I think your estimate at the end of last year was $2.3 billion for your share of the MEPP. But when we sort of think about what that number could be at the end of this year, sort of all else equal, should we sort of think about it as down by that $260 million 1Q contribution and then down another $960 million for this transaction?

Yes. Thanks for the question. Certainly, I'll caveat what I provided in answer with your initial comment, which is, I think, all other things being equal because, as you know, the number will move every year as we see market performance on each of the individual plans that we participate in, and that will significantly change the answer that we show in our 10-K filing as it has changed in recent years if you look historically at the numbers that are reported there. And so even when we've had times where we may have made significant structural interventions into certain plans, sometimes you don't always see that reflect either up or down in the final outcome because of those market conditions. But if I talk specifically about the impact of this transaction and the things that we're doing, there certainly would be an impact on the number that we report in our 10-K filing as a result of the actions that we took in Q1 and the action that were tentatively announced today as part of the agreement with the UFCW national plan. Now that being said, it wouldn't be a dollar-for-dollar match because those 2 calculations, i.e., a withdrawal liability compared to an estimate of Kroger's share of the liability -- unfunded liability in MEPP in which we participate, are actually calculated quite differently. So it certainly would reduce that liability in the reporting. But a withdrawal liability calculation is significantly more complex. It will use discount rates that are very specific to that plan. And the calculation there follows a very prescribed process around sort of what's the market rate, if you will, of exiting that plan at a given time. The 10-K calculations are very much a high level estimate of Kroger's share of the unfunded liability of the MEPPs that we participate in. And as you mentioned, that amount would be -- was $2.3 billion at the end of 2019, as we shared in our 10-K. And so that number will certainly reduce because of the actions that we're taking but will fluctuate at a different level because the calculations are different.

The next question is from Ken Goldman with JPMorgan.

Two questions from me. Two questions from me. One, just to follow up on Renato's question. I totally appreciate the differences in calculations and the lack of complete information right now. Is there any size you can give us, though, to how we should think about even roughly in our heads for what your MEPP exposure will be net-net of everything? And we're not going to hold you to this, but we just kind of want to get something for our models. And then the second thing is, I just wanted to make sure I understood. So you'll be excluding the third quarter charge for this, but you're still including -- in terms of your adjusted numbers, you're still including your first quarter charge for the contribution to the multiemployer plan. I understand these are slightly different transactions here, but it does seem a little bit -- so you're excluding one, including another. Why not just exclude them all for consistency's sake given the way people like to model things? Again, just I'll leave it at that.

Yes. Thanks for the questions, Ken. On the first one, it is a really difficult number to really get precise around or even a range around because there are so many moving parts in the calculation. I would say that we'd expect it to be a lower number just because the discount rate that would be used in the 2 calculations would be different. So it would be, I think, lower than the number that we would be sharing in the specific announcement yesterday. But it would be really tough to get into a more of a clear guide on that, especially as, I think, again, the numbers will play out this year as the market performance on the broader range of plans will also obviously determine what the future estimate is for the end of our 2020 fiscal year. On the question around the consistency of the way in which we report the numbers, thanks for that question because I know we did get some questions around that on the first quarter earnings call. I know it's something that a number of the investors have sort of asked for us to maybe provide some more clarification around, so I'm glad we have the opportunity to do that. I think the way I would maybe try and help to explain it is that in Q1, as you know, we made the voluntary contribution of $236 million to the UFCW consolidated fund, and that's a fund where Kroger has oversight of asset allocation and manager selection. And that's part of a restructuring that we did a few years ago. And the plan is slightly different now because the vast majority of employees in that plan are Kroger family of store associates. And so we have a much bigger preponderance of that plan that actually is really focused on Kroger employees, Kroger associates versus typical multiemployer plans that have a much wider range of employees in them. We have no obligation to fund that plan within our agreements beyond the negotiated contribution rates that are within the terms of our collective bargain agreement, hence why we called it out in the quarter, so that the investor could really understand it was a separate cash payment that we made into that plan. Really we view that plan and the contributions that we make when we make those lump sum contributions are really about preserving our financial flexibility looking forward because they will reduce our future contributions as it gets the funds closer to 100%. So that could be multiple years out, but it certainly gives us flexibility to be able to manage future investments in that plan as we continue on the journey to make that plan fully funded. Because that plan is made up almost entirely of Kroger employees, it's the -- and the IBT plan will be the same, it's the one exception where we would make those onetime contributions because the vast majority of the participants are Kroger associates. It wouldn't make sense to be doing that in other plans because others would be gaining in the benefit of that transaction, unlike the 2 plans that I just referred to. We've -- on a number of different occasions, we've made accelerated contributions or pull-forward contributions into that plan when company performance is strong. The reason we don't adjust those out of our EPS and operating results is really because we see them part of normal ongoing costs and that they are really ultimately pulling forward our future investments that we might need to make into those plans. And it gives us the ability to be able to manage that more from -- as we deliver on our long-term TSR goals, whereas the withdrawal liability or the restructuring transactions, whenever we do those, they're really more about how we're dealing with historical liabilities that we need to address. And so we do and consistently have when we've announced those previously. We've taken those out of our earnings because we don't really -- and adjust it for them, I should say, versus the GAAP reporting to really demonstrate that they're not part of our ongoing cost looking forward.

The next question is from Chuck Cerankosky with Northcoast Research.

Gary, if we look at -- and to ask the previous question another way, rather than subtracting the $900-some payment from the $2.3 billion, should we think of Kroger being relieved of $900-and-some million in liability as a result of this?

I think it's really bridging across a couple of the questions earlier, Chuck. Part of it is obviously calculating how do we put the pension plans into a much more stable position for the future relationship with our associates and supporting those collective bargaining agreements, and I think that's a very important part of our overall strategy, as you know. I think from a financial point of view, it's really about saying that this plan, unadjusted, if you like, would start to experience some significant financial headwinds and would require significant incremental contributions to maintain the level of benefits that our associates have earned and are expecting. And so the way -- what we -- how we feel about this is protecting those benefits for the associate. But just as importantly, it's taken away future cost increases that we would need to introduce in our business model to be able to support those benefits, and we effectively eliminated that cost, that risk from our model to be able to deliver on our long-term TSR growth model. So it really allows us -- when we're saving our $1 billion of costs a year, it allows us to think about how we're investing those in our business to drive shareholder return and growth versus having to offset increases in OG&A in the future of our model. So I think that's probably the way really as we looked at it and thought about why is it a strong IRR for our investors. It's really about eliminating that future risk. And as I mentioned earlier, it's also about restructuring the plan so that going forward, we're not going to have for future benefit calculations the potential of market exposure, market volatility because the returns of the future plan are tied more to market performance rather than a defined benefit structure.

And as a follow-up, do -- for these specific local contracts, is the hourly contribution by Kroger to the plan at all modified?

There are -- so essentially, for the 8 years we've locked in now, it's -- there are a couple of minor increases in the outer years in the plan, in the pension contribution. But for all intents and purposes, it locks us in essentially a flat rate for those 8 years. It's not material to our results.

The next question is from Edward Kelly with Wells Fargo.

I wanted to maybe go about this line of questioning a little bit differently. So I'm curious about what this buyout tells us about the true cost to resolve the underfunding of the MEPP plans that you're participating in. So the way I'm thinking about this is that you're paying $960 million for a plan that was -- it was a green plan. It seems to represent less than 10% of your employees, less than 10% of your annual MEPP contribution. So why doesn't that suggest that the $2.3 billion underfunding number in total is just too low? And I would -- I know that withdrawal liability and on the funding are different, but I would also assume that you're not paying a withdrawal liability that's greater than what your real liability would be in the future. Just help us sort of bridge that gap.

Yes. Thanks for the question, Ed. It's one of those areas, as I mentioned in my prepared comments. Part of the challenge is that there is no one single answer to the multiemployer pension plan calculations because every plan is very different and unique in the same way that this green plan, if you look at the spot data point last year, was -- certainly on that headline definition, you would say, potentially should be in relatively good shape. When we did all the actuarial analysis around it in this particular case, very clearly the data showed a different answer, and we feel confident that the financial decision that we're making is the right one and secures the plan but also delivers on our long-term financial model. I think it would -- as I mentioned earlier, it's really an outlier in terms of the green plan, so I don't think you -- we would look at this and say you could extrapolate that to other green plans and then there'd be plans that are in other levels of staffs where some of them are obviously declining. We've addressed -- some of them are actually improving over time. So I think there's a real difference by plan. And I think you're hitting on a point that it's very -- it -- I wouldn't say there's one number that we would believe is the right number to be using for a factual single data point on what's the exposure. It's very much a case-by-case basis. We believe that we've been as proactive as anybody and a leader in our approach to be addressing it. This, along with the UFCW consolidated plan, addresses 2 of the top 3 or 4 plans that we are participating in, so we believe we're being very proactive in taking this on in bite-size chunks. I don't think there is a silver bullet to the challenge. It's very much about looking at it case-by-case and identifying where we can shore up the plan from a -- for -- to protect our associates where we can identify a financial model that we believe works for us, then we are actively executing on those plans and we chip away at them. But I think we believe what we've shared in our 10-K, we did it proactively, I think, before most others. We felt it was important to try and highlight what the exposure is. But there are multiple ways of calculating those numbers, and every plan is very unique and very different. And so I think we'll continue to work at being as transparent as we can and certainly chipping away at solving the challenge on every opportunity where it makes sense for associates and for our shareholders.

And part of the problem, I guess, with the $2.3 billion is that -- is what rate to use on discounting the liabilities, I guess, right? And I believe that you're using an actuarial rate to do that. Is that fair?

It's the rates that are used by the individual MEP plans. So we essentially blend those together when you get to the total number. So whatever the plans are calculating as their liabilities and calculating as the funding and then discounting at the rate that those individual plans use. So it's effectively a blended rate based on those individual MEPP planned discount rates.

Okay. And just one last one for you. I mean there is no doubt that you've been leading in trying to resolve the MEPP issue. To that end, in December of '17, you withdrew from Central States. The cost of that withdrawal actually looked more reasonable. And I don't think there was any VAPP associated with that. Is that just an example of why all of these withdrawals could just be very different and maybe that's why we can't extrapolate this? Maybe just some help in why they're also different.

Yes. It's a great example, Ed, and that's -- yes, I think you called it out very well. That is a good example of why there is not one-size-fits-all and every plan is unique. It'll depend on a number of factors. Like we said, it will depend on exactly how the benefits of those plans are defined and, therefore, how that's creating a future liability. It's going to depend on what's the balance of new associates into the plan versus the number of retirees in the plan. It's going to depend on how proactively the contributions have been increased to be able to meet those future obligations. And then the example that we talked about are the discount rates that are being used by those individual plans. So I think you've got all those factors that are at play that mean essentially, we look at this on an individual case-by-case basis to make sure that we're making the best decision. But it's definitely eating the elephant at one bite at a time.

The next question is from Michael Lasser with UBS.

As you take this action and maybe others, are there any changes tactically or strategically that these deals allow you to do that you would not have been able to do otherwise?