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

Good morning, and welcome to the Kroger Company 2020 Investor 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 of Investor Relations. Please go ahead.

Thank you, Brandon. Good morning, and thank you for joining us for our investor update. We will start the meeting with prepared remarks and a presentation from Rodney McMullen and Gary Millerchip. After the formal presentation, we will have time for questions. For those in our analyst community, we ask that you also join the webcast to view the slides during our prepared remarks. Once we transition to Q&A, we ask that you pose your questions via phone as you would normally. We look forward to hosting a full Investor Day with you in spring of 2021. At that time, we will share our outlook and drivers of our long-term growth model. Before we begin, I want to remind you that today's discussions 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, but Kroger assumes no obligation to update that information. Prepared remarks and presentation from this conference call will be available on our website at ir.kroger.com. I will now turn the call over to Kroger's Chairman and Chief Executive Officer, Rodney McMullen.

Thank you, Rebekah. Good morning, everyone, and thank you for joining us for today's business update. With me today is Chief Financial Officer, Gary Millerchip. As Rebekah mentioned, we've pushed our Investor Day to spring of 2021 in hopes that travel restrictions have eased by then, and we can meet face-to-face. We still felt it was important to provide you with an update as we approach the 1-year mark from our last Investor Day and near the end of our 3-year Restock Kroger transformation. Through Restock Kroger, we have made significant strategic choices to evolve our business and financial model. Additionally, these key changes and investments have positioned us to more effectively respond to the pandemic and successfully operate as an essential business. I could not be prouder of the way our associates have come together, from stores to pharmacies, distribution facilities and manufacturing plants, during this unprecedented time to protect and support each other and our customers. We also share in the grief of so many whose loved ones have lost their lives and livelihoods as a result of this awful pandemic. Since our fall 2019 Investor Day, we have delivered on our total shareholder return commitments, with improving trends in our supermarket business before the pandemic that have accelerated and continue today. We are growing market share, and our total shareholder return is outperforming the market and our peer group. As we provide our update this morning, we'd first like to take a step to reflect on where we were a few years ago when we saw a rapidly shifting marketplace and evolving customer base. Our customer obsession led us to make several big decisions 3 years ago that would help guide our transformation. We believe that the customers would continue to accelerate movement to a seamless shopping platform that combine the best experiences of a physical store environment with convenient e-commerce solution, and during the pandemic, that acceleration has been defined even more. We shifted the way we allocated capital and invested more in digital to build a seamless experience that would deliver anything anytime and anywhere. We knew that our decision to invest in digital would be rewarded by our customers. Over time, digitally engaged household spend more with Kroger, and from a profitability stand perspective, we will reach a point of indifference, regardless of which channel they choose to engage with us. At the same time, we increased investments in our associates and talent development because our associates serve the most essential role in creating the customer experience. We also knew that customer investments in value would remain important. Consistent with the Kroger way, we committed to take a disciplined approach to cost savings and process changes to balance all these investments. We also leveraged our unique assets to transform our growth model and drive value for both our customers and shareholders in the form of alternative profit streams, like media and personal finance. And lastly, we continued our longstanding commitment to ESG and living our purpose by showing our customers, associates and other stakeholders what we are doing to take care of people, communities and the planet. The sum of all these parts translate directly into our ability to grow the business and to create shareholder value. Kroger's success has always been tied to our ability to see where the customer is going and proactively address those changes, so we set off on a journey to transform our business model. And while this journey hasn't been perfect, we have made significant progress. Through Restock Kroger, we have transformed our business by focusing on our customer, our associates, our purpose and our shareholders. We have improved the customer experience by widening and deepening our competitive moats. Kroger is the market leader, holding the #1 or #2 market share position in 90% of the major markets we operate. In 2020, we have gained market share. We changed the way we allocate capital to support technology and digital to build a seamless infrastructure, expanding our seamless ecosystem to reach 98% of Kroger households through delivery and pickup, resulting in digital sales that are 4x higher compared to the end of 2017. When it comes to alternative profit streams, we're even more excited about the advantage they present than we were before. Gary will provide more detail, but we are extremely encouraged by the results of using our data and shopping platform to create new value for our customers and shareholders and see tremendous opportunity for growth. Partnerships with companies like Walgreens and Ocado are also helping us transform our business model and deepen our connection with customers. We will share more information about these partnerships during our spring Investor Day. Through our approach to develop talent, we have worked to ensure that we have the right balance of both internal and external talent teams and structure in the right focus areas. We have been deliberate in our recruitment and development in areas like merchandising and digital, bringing in talent from the outside to bolster existing talent. Overall, about 1/3 of our Senior Officers, Group Vice Presidents and Presidents have been hired from the outside. Kroger has been investing to raise the wages of our front-line associates for the last several years. We are increasing associate wage investments incrementally by approximately $800 million through the end of 2020. As a result of this continued investment, Kroger has increased its average wage rate to over $15 per hour. And with our comprehensive and best-in-class benefits, including health care, paid time off and retirement plans, our average hourly rate is over $20. Our focus on culture and talent led to a 15% reduction in turnover from 2017 to 2019, and our retention rates continue to trend better than the retail industry average. Live our purpose is both a critical driver of our transformation and an authentic expression of our company culture. As the largest grocery retailer in America, Kroger is committed to being a force for good in the communities we serve. Since launching our ambitious Zero Hunger | Zero Waste social impact plan in 2017, we achieved our goal to donate more than 1 billion meals to feed hungry families in our communities by 2020. We also continue to increase Kroger's diversion of waste from landfill, reaching 80% diversion last year, on our path to achieve 90% diversion or 0 waste. This year, Kroger outlined several new long-term environmental commitments, and they can be found in our annual Environmental, Social and Governance report. Lastly, we were pleased to be recognized as fourth on the Wall Street Journal's list of the top 20 most diverse Fortune 500 companies. And just yesterday, we announced a series of 10 deliberate actions we are taking to advance diversity, equity and inclusion in our business and our communities. By executing against our strategy, we are creating shareholder value. We are achieving cost savings of over $1 billion each year, and we are investing savings back into the business with an emphasis on talent, price, digital and the customer experience, and that creates sustainable total shareholder return. We have returned approximately $6.4 billion to shareholders via dividends and repurchased shares since the beginning of fiscal 2017, and we continue to generate strong free cash flow. During last year's Investor Day, we shared this slide and laid out our plan to grow the business and deliver strong and attractive total shareholder returns. We expect total shareholder returns of between 8% and 11%. We are confident we can deliver on this attractive TSR because of our strong free cash flow and sustainable net earnings growth. We remain as committed now as we were last fall when we introduced this to you. We believe there are significant incremental opportunities through partnerships that make the future even more exciting, and Gary will provide more detail in his section later. Our competitive moat, fresh, our brands, data and personalization, and seamless are strengths today. As a result, we are growing market share in 2020 and expect to continue to gain share because we can believe we can do even better. Customers make decisions about where to shop based on their perception of a retailer's food freshness. Our fresh offering is both an important sales driver for Kroger and a competitive advantage because customers rank our fresh department higher than our largest competitors. We continue to innovate and position ourselves to win with the customer in fresh. Our brands also provide a unique reason to shop at Kroger. Customers tell us they love our brands and choose them over leading competitor brands. Simple truth is the largest natural and organic brand in the U.S. A recent third-party industry study reconfirmed that Simple Truth is the most loved natural and organic private label brand. Compared to CPG brands operating in our industry, Kroger's Our Brand portfolio would be in the top 10 for U.S. sales. We continue to innovate and look for new products and strive to be at the forefront of product innovation, using our unique data and customer insights. The quality of Kroger's data is a massive advantage because it allows us to personalize every touch point in our ecosystem, making the customer experience even better, improving our operations and developing a significant alternative profit business that generates a profit from the traffic that personalization helps generate. Many retailers have transactional data, but no one has the customer data and the insights that Kroger has. Personalized communications is an important lever that drives strong incremental trips and units. We utilize best-in-class personalization science to send the right offers to customers based on their shopping habits and household needs. Customers have a significantly higher level of engagement in our offers and rate Kroger as the best at inspiring them with personalized recommendations. We have a continued opportunity to accelerate growth in seamless, and we have a clear path to improved digital profitability. We are reducing our costs to serve through technology and productivity improvements. Ocado will help accelerate those efficiencies. We are leveraging our personalization tools to improve sales mix and accelerating growth in media revenue generated from media -- from digital sales. Customer behavior is evolving through the pandemic, and we believe several of these shifts are structural and will last well beyond the pandemic. Customers are rediscovering their passion for cooking at home, learning to cook and have an aspiration to eat more healthy foods. As families prepare more meals at home, Kroger's reputation as a leading choice for fresh product, plus the quality, value and selection of our brands becomes an even more important driver of customer choice. As customers continue to rediscover their passion for making food and gathering around the dinner table and pass on dining and restaurants, Kroger will be there to provide food inspiration. Before I hand it off to Gary, I'd like to summarize the key takeaways to remember from this morning. Our associates remain relentlessly focused on our customers, who are at the center of everything we do. By reinventing the customer and financial model, Kroger is positioned to deliver beyond 2020 for our customers, associates and shareholders. The investments we are making to strengthen our competitive moats bridge strongly to the trends we are seeing in customer behavior. We will build upon this momentum and make current strengths more compelling because we are not satisfied. We will leverage this momentum to continue to deliver consistently strong and attractive TSR. Now I will turn it over to Gary to provide additional commentary on how we've built our business model for the future and creating shareholder value. Gary?

Thanks, Rodney, and good morning, everyone. I'd like to start by echoing Rodney's sentiment that during these difficult times, I could not be more proud of the way our associates have come together to protect and support each other and our customers. This morning, I plan to focus on 3 topics. First, I'd like to remind you of the key components of our value creation model that we shared at our Investor Day in 2019. Second, I'll update you on the progress we are making in executing on this model. And finally, I will share why we are confident in our ability to continue to generate strong free cash flow and deliver on our TSR target in the future. At our Investor Day last year, we laid out our plan to grow the business and deliver strong and attractive total shareholder returns. Our financial model is built upon a strong and durable core driven by our retail supermarket, fuel and health and wellness businesses. It begins with the customer and our relentless focus on increasing customer loyalty. Our intensified focus on execution and continued improvements in the value and the experience we deliver for our customers drive increased identical sales with our fuel across our seamless ecosystem. To drive sustainable sales growth, we continue to invest in areas of the business that are important to our customers. This includes ongoing investments in talent, price, digital and store experience, with an even greater emphasis on our competitive moats that Rodney discussed earlier. Importantly, we are also committed to being disciplined in balancing these investments with execution of cost saving initiatives that simplify work for our associates and remove activities that do not add value for our customers. And the final part of our model is to leverage Kroger's unique assets to drive accelerated growth in our asset-light, margin-rich alternative profit streams. This includes Kroger personal finance, media, customer data insights and ventures. By executing on this framework, we are targeting total shareholder return of between 8% and 11%. This will be driven by 3% to 5% growth in earnings and by returning cash to shareholders through a combination of share repurchase and dividends. This range excludes any potential change in our PE multiple and the opportunity for additional growth through our strategic partnerships. As a result of our robust execution against our plans, we are making strong progress and delivering upon our commitments across all stakeholder groups. During our second quarter earnings call, we updated our full year 2020 guidance, and today, we are reconfirming that guidance. Taking a step back from COVID-19 and looking over a slightly longer time horizon, we delivered solid growth in 2019 with improving identical sales, $1 billion of cost savings and more than $100 million of incremental operating profit from alternative businesses. This resulted in net earnings growth in line with our TSR model. Prior to the pandemic, our early results in 2020 were also strong. And while the pandemic has clearly been a tailwind to our business, we've been very pleased with the underlying progress across all key elements of our model this year, including sales and market share growth, cost saving initiatives and growth in alternative profit streams. I'd now like to spend a few minutes going deeper into 3 key elements of our model, which should help illustrate why we are well positioned to achieve our TSR expectations. First, I'll talk about cost savings and how our success in this area is underpinning our ability to continue to invest in the business and drive future growth. As you know, we generated over $1 billion of cost savings in each of the last 2 years, and we are on track to deliver an incremental $1 billion of savings this year. We believe improving operating efficiency has now developed into a core competence through our Restock Kroger transformation and would expect to continue to achieve significant savings into the future. Our cost saving efforts include productivity improvements through process improvements and automation, sourcing of goods for sale and goods not for resale, administrative efficiencies and waste reduction. As we look towards 2021, we have clear line of sight to many additional cost saving opportunities through continued improvements in processes and the application of technology, automation and machine learning. An example of innovation in this area of our business is the group purchasing organization with Walgreens. We would expect this partnership to drive significant benefit from purchasing efficiencies next year. Another example of our innovative approach to improving efficiency is the recent opening of a pickup-only location in our Cincinnati market in response to COVID-19. This facility has proven to be a great test and learn center, allowing us to identify significant efficiencies that can be applied to our pickup operation across all stores. By applying learnings from this facility, we have achieved meaningful reductions in the cost to fulfill a digital order, and we are in the process of implementing additional improvements and technology enhancements that will further reduce cost and improve digital profitability. Over the last 3 years, we have built a platform that allows almost all of our customers to access to digital and e-commerce solutions. Customers who engage with us digitally are more loyal, visit more frequently, and their basket size is significantly greater. I'd like to walk you through how we think about digital profitability, as this is a question we often receive. We've previously talked about the pass-through rate on incremental sales through our stores as being north of 15%. For digital, the pass-through rate is also positive, though significantly lower, predominantly due to the incremental labor associated with picking an order. We were pleased with the progress we made to improve digital profitability in the second quarter and have a clear road map to achieve further improvement. Our comprehensive plan includes continuing to drive efficiency and fulfilling a digital order via process improvements and automation; leveraging our personalization tools to improve sales mix and grow customer basket size through opportunities, such as our recently launched marketplace; and accelerating growth in media revenue generated from digital sales. We expect to make meaningful progress on these metrics over the next 12 months, and we're excited about the opportunity to realize further improvements in the future as we build out a flexible network of fulfillment centers, including our innovative partnership with Ocado. We look forward to sharing more about our digital strategy and Ocado plans at our spring Investor Day. We are equally as encouraged about our progress with alternative profit businesses. And as we approach the end of our 3-year Restock Kroger transformation, we are confident that alternative profit streams will be a major accelerator of our long-term growth model. In 2019, we delivered in excess of $100 million of incremental operating profit, and we are on track to deliver another $100 million of incremental operating profit growth in 2020. This year, we have been most excited about progress in our media business. COVID-19 has accelerated digital customer engagement with food by a number of years, and this has translated into a tailwind for our media revenue. In the second quarter of 2020, Kroger Precision Marketing achieved a significant acceleration in business, and we now expect revenue growth will be greater than 100% this year. Kroger Precision Marketing is designed to make digital advertising more effective for CPG brands by using the power of our data and personalization science. Our market-leading loyalty program provides Kroger the opportunity to connect customers directly to brands through advertising that inspires purchases online and in store. Our ability to close the loop and match media exposure to an actual purchase allows us to help our partners improve their return on ad spend. As a reminder, our media business is now providing over 1,000 CPG partners with new tools and better ways to invest marketing dollars that are currently being spent with advertising platforms and digital media companies. This is in addition to continuing to invest trade-offs with Kroger in joint promotional plans to drive sales. As a further demonstration of the effectiveness of our media platform, a recent Kantar report on the state of e-commerce placed Kroger #1 for ability to measure ROI out of 16 popular digital media platforms. Turning now to our financial model. Our cash flow remains strong and has proven to be resilient throughout the economic cycle. Over the course of 2017 to 2020, we expect to generate at least $7.6 billion of free cash flow, excluding the sale of strategic assets and company-sponsored pension contributions. Our free cash flow yield in 2020 is expected to be greater than 9%. Our financial strategy and prioritization of free cash flow remains the same, and we are being disciplined in our approach to financial management. We are committed to investing in the business to drive profitable growth, maintaining our current investment-grade debt rating and returning excess free cash to investors via share repurchases and a growing dividend over time. Since 2017, we have returned approximately $6.4 billion to shareholders via dividends and repurchase shares. In June, we increased the dividend by 13%, marking the 14th consecutive year of dividend increases and double-digit compounded annual growth since reinstatement in 2006. On September 11, 2020, the Board of Directors authorized a new $1 billion share repurchase program, replacing the prior authorization. Looking forward, we remain confident in our business model. Based on the strength of our execution against our competitive moats, our food expertise, unparalleled data insights and expected structural shift to food consumption at home as a result of COVID-19, we believe Kroger is well positioned to continue to differentiate and grow our core business in the future. This, combined with strong momentum in cost savings and alternative profit streams, mean that one year on from announcing our TSR target, we are well positioned to deliver on this commitment. Looking towards next year specifically, we believe that our performance in 2021 will be stronger than we would have expected prior to the pandemic when viewed as a 2-year stacked result for identical sales growth under the compounded growth rate over 2020 and 2021 for adjusted earnings per share growth. We also expect to generate excess free cash flow over the next 2 years. As the future impact of COVID-19 becomes clear, we will, through the lens of our capital allocation framework, determine the best use of this cash to support our long-term growth and TSR model. We look forward to providing more color on our 2021 plans and future use of cash during our 2021 Investor Day. Since launching our TSR model, we are delivering improved operating results and strong free cash flow, and this has translated into a total shareholder return that has outperformed the S&P 500 and our peer group over the last 12 months. Our underlying business model is strong, and our strategy positions us well to continue to deliver consistently in the future as we move beyond the COVID-19 pandemic. That concludes our formal presentation, and we'll now open the line up for questions.

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

So let me start with -- when you think about 2 things as we start to move past COVID, general magnitude of business that you can retain that you've picked up, right? Some of that is macro and some of it is what you're doing. And then secondly, what can you do -- what will you do sort of in a disciplined way to maintain as much of that business as possible? Those 2 thoughts.

Thanks, John, for the question, and I'll start. And Gary, add anything. If you look at retaining the business, I would put it in 2 buckets. One, in some of the comments I made in the prepared remarks, customers are -- time and time again, we're having customers tell us they are learning how to cook. They didn't know how, and they're learning. And the second thing that's more inspiring for us is they're telling us they enjoy it, and they really enjoy it when they do it as a family. And what we're doing is trying to build upon that and personalize it for that person individually. One of the things that we've done through the pandemic is new customers, we treat them like existing customers from personalizing offers to them, personalizing magazines with recipes and other pieces, both digitally and physical sending to them. And obviously, the experience they get in store or pickup or delivery are things that is glue. And if somebody is doing in store, obviously, our associates are critical to that or pickup in delivery. If you look at the progress that we've made during COVID on -- continued on fresh in those aspects, plus the in-stock and other key parts, are all the things where, if you look at the sum of all pieces. And obviously, we want people to fall in love with our fresh product. Our associates, our brands and all of those things, they're telling us that we're doing a good job on. Those are the things where it's -- I look at it as we're getting our opportunity for our associates to show how good they are and our products, how fresh it is, and by showing and delivering against that shows. And then obviously, we've continued to provide value throughout the pandemic. Some of our competitors stop doing ads at different times. Some of our competitors have been not as aggressive on promotion or raising prices. And we want to make sure that our customers see that we treat them the same as always and not taking advantage of them during the pandemic. And we really believe those things together, in terms of people learning how to cook and then us and our associates taking care of them and personalizing that offer and creating a great, seamless experience, all of those things together is how we'll retain that business. I don't know, Gary, any point you'd want to raise, add to?

I think you covered the key points, Rodney. I think it does tie back to the competitive moats that we talked about in the prepared remarks that as customers are experiencing the fresh, quality and experiencing the digital ecosystem that makes it easier to shop, then we believe that, we've recently called them moats because we believe they are creating a stickiness with customers that we -- our customers tell us they enjoy and appreciate. And then I think continuing to invest in value and demonstrating that, while, today, customers or -- over the pandemic, I maybe should say as customers have been less focused on price directly, we think long term, that's something that customers feel as very important. And we believe as we navigate through the current environment, that customers look at those periods of time how you operated as a brand and how you delivered value, and we believe that will continue to be important and will allow us to retain that business in the future as well.

Yes. And then just secondly, you talked about, I think, getting the incremental profitability, right, of digital up to stores. Can you close that gap completely? Is that a 3- or 4-year process? And then how much does digital penetration have to go up to get there?

Yes. It's Lee. We have a clear path to continue to improve our digital profitability that Gary mentioned through process change increasing using technology. If you look at our Ocado relationship, also the learnings from the fulfillment store -- dedicated fulfillment store in Cincinnati and micro fulfillment centers, and the continued improvement of media, especially in alternative profit, we haven't set a time frame publicly. We will share more detail, but we can clearly see a path to improved incremental profitability from digital. And over time, we aspire and would expect to where we're indifferent between that customer shopping in store or online. And as you know, what we find is customers are -- generally that shop online still come into the store, but they come into the store when they want to, not because they have to. But they like going into the store. They like the experience of our associates. They like the inspiration of touching and seeing the food, in addition to the pickup. So it's really both of those things together.

And then more of a sort of a practical point, John, too, just to build on Rodney's comments, which I completely agree with, it's going to be interesting with digital as you think about growth in the future as well because, at some point, we expect digital is going to continue to grow and become a bigger part of the business. But if you start to create value in those levers that Rodney mentioned, they can essentially become a tailwind on the base business as well, right? So if you think about, if you're able to take $1 out of a cost of an order or you're able to dollar -- add $1 on media business, that's not just on the incremental growth that we're seeing in digital. It's on that base business. And so it can start to be -- even though you may not be at parity, you can start to generate some tailwinds in the model because of the growth you've invested in, in the early phase of digital as you look towards 2021 and 2022.

And the other thing that we're just getting started on is selling those customers other products that, in the past, we haven't offered. And obviously, in the marketplace, that's the start of that journey.

Our next question comes from Simeon Gutman with Morgan Stanley.

Actually, a follow-up to John's actual first question. Do you know what percentage -- or can you share what percentage of your comp growth is coming from new customers if you look over the last few quarters, inclusive of the pandemic? And how does it compare to the percentage pre-pandemic?

We haven't talked about those numbers specifically. We continue to be pleased on -- I would say, on both fronts, Simeon, as we think about what we're seeing with the customer today. We're seeing continued growth in loyalty of our most loyal customers as they've obviously grown their basket size and increased their spend across the store. We're seeing strong ID sales growth across all categories in the store, which I think demonstrates how our existing customers are kind of consolidating trips into their retailers of choice, and we're seeing deepening loyalty across those customers. I would say it's really been over the last few months, but as we obviously spent a significant amount of investment over 3 years at Restock Kroger to build out our digital capability, we've seen many customers come into Kroger, both in the store because of their desire to go to one place and fill the full basket need, but also taking advantage of those digital opportunities. And so as we brought customers in with the fee-free promotion on pickup, we've really thought to use those personalization tools that Rodney talked about earlier to really make sure that we deepen that relationship and ensuring those customers remain sticky.

Yes. And if you look at our market share growth, we're having the strongest market share growth that we've had in 10 years. And when you look at the makeup of that market share growth, as Gary mentioned, it's -- a good part of it is because the customers are spending more with us, either existing customers through bigger basket size and that this bigger basket size is driven by pickup and in-store. A meaningful chunk of that is also driven by the new customers coming to our stores and engaging with us digitally as well. So it's a meaningful percent, but we would look at the market share growth and see that we're actually being successful on both fronts.

Okay. And then my follow-up, also revisiting this, Gary mentioned this 15% the store incremental margin. I don't know if you could do the math linearly, but if you take what Rodney had said to us in the past, that it takes -- it could take 3 to 4 years to become indifferent with that omnichannel shopper, would that mean that the incremental margin for digital is somewhere in the very, very low single digits today? And you mentioned getting there will -- you'll improve the economics of the digital purchase, plus some of the advertising spend. Can you maybe parse out how much better can the incremental margin get on the purchase? And then how much of that gap you're going to try to make up, vis-à-vis some of the advertising spend?

Yes. Thanks for the question. I would say, think about the digital pass-through is sort of in the mid-single-digit growth range would be a ballpark figure to be thinking about as the equivalent to the store, to answer that question for you, Simeon. In terms of the growth opportunity, I think, as Rodney mentioned just a little bit earlier, we definitely believe that we're already seeing a large growth in the basket size of a digital customer because we have that ability to really curate the offer for the customer. We can use a lot more of those personalization tools and the data that we have in our loyalty program to be able to fine tune and improve the experience. And so we see significant runway to continue to broaden the basket size through that personalization and also through the launch of the marketplace solution that we announced earlier this year, which obviously comes at a more effective, higher pass-through rate in the sense that we're not carrying many of those products, and they deliver straight to the consumer. So they're all adding and supporting both the growth in sales, but also the sales mix improvement. Alongside that, we do believe that media is going to continue to grow. It's one of those areas where, when we think about the investment that we're making in digital to support the store model, it's almost the opposite side of that coin where COVID is proving to be a tremendous accelerator of digital growth. And therefore, it's allowing us to springboard the future growth of that digital media business, and we think that has significant opportunity to continue to grow. And as we mentioned, the cost savings, we're continuing to find short-term savings. We invest in technology and invest in process improvement continuously and are seeing the benefits of that flow through. As we get beyond the short-term plan, Ocado and some of those new innovative fulfillment centers become really important in sort of continuing to accelerate that momentum as we look more 2, 3 years out in that overall plan. So I think we would see opportunity in all 3 areas. I wouldn't really put a percentage on breaking EBIT down between. We actually think there's opportunity in all 3 of those, and it will be a combination of working on those different elements that will allow us to continue to improve the model and to create more parity between the channels.

Yes. And we also -- as Gary mentioned, we get significantly higher share within each household. And when you start looking at the profitability in dollars of that household, it improves faster than our margins improve as well for that digital customer.

Our next question comes from Edward Kelly with Wells Fargo.

The first thing I wanted to ask you about is it's just whether you could provide some color on what you're seeing so far on the cadence of IDs in the third quarter, what you're currently running at. And then, Gary, you mentioned sort of like a 2-year stack, next year being stronger than what you would have anticipated pre-COVID. Any color on -- initial color on what we should be thinking there?

If you look at third quarter identicals, they would be slightly double digit, which is consistent with what we expected and we outlined when we talked about it at the second quarter earnings release. And we would remain confident with the guidance we gave for the year on identicals as well. So it's tracking where we expected it to be. We are seeing different parts of the country different. If you look in the West where you still have more lockdowns, our identical sales would be stronger there than in the Midwest where things have reopened more than what they have. So there is some regional differences based on region and where they are on COVID as well.

Yes. And I think you mentioned earlier, Rodney, but I would add that we continue to see market share growth in both of those. There's just a -- obviously a different dynamic going on in the different regions right now based on the different restrictions that exist. In terms of the second part of your question, Ed, I think, really, we'll be looking to use our spring Investor Day to provide, obviously, a lot more color around the way we think about next year. We are doing a lot of modeling on that, as you might expect. I think we've shared before, our base view model is between -- we think we need 2% to 3% IDs for the model to work. And when we made that comment, we'd be expecting the 2-year stack to be north of the sort of traditional view of the model that we shared previously. We do believe, as Rodney mentioned earlier, not only will the pandemic likely to continue to have some impact leading into the first part of next year, but we actually believe there'll be some structural changes that will continue around customers eating more food at home, whether that be because of more of a rebalance between working from home and working from an office or also just because of customers who found more passion for eating food at home and spending time with family. And then, of course, the economic impact has a role to play out and what does the new world look like in a post-COVID environment for restaurants as well. So we would expect all those things really to lead to a view. We are -- we're doing a lot of work on that. We have some initial views around it, but I think we feel more comfortable sharing that color in the spring as we kind of get more data points on how the winter plays out with COVID.

Yes. And just to give you a little bit of additional insight. One of the things that Gary and his team are doing is really modeling multiple scenarios in terms of the continuation of COVID look like it does today, is a vaccine created -- when is a vaccine created. And what we're trying to do is to make sure that we're agile in terms of what is happening. The -- and we think that's incredibly important. And we continue to focus on improving in stocks in the supply chain because that will be as equally as important. We -- Gary mentioned it before, but we do expect 2021 to have been better than 2021 would have been without COVID, and that is a good floor spot. And we tie back to the 8% to 11% TSR and the earnings growth of 3% to 5% and the cash flow that Gary outlined and I outlined both at Investor Day and updated today.

Great. And just a follow-up as it relates to the gross margin. Just kind of curious as to how we should be thinking about things here. So if the COVID top line benefit takes a little while to unwind, and maybe some of it sticks around, how do we think about the gross margin benefit? You've certainly seen a benefit in areas like shrink, but I would think, next year, pricing and promotion maybe normalizes here. I'm just kind of curious, as we think going forward, how you're thinking about that line item.

Yes. Thanks for the question. I think I would really kind of bring you back to our overall perspective on our model. Like I do think, as you've heard us say, we are continuing to invest in the customer and continuing to invest where we believe the customer is really valuing it today and how we think it will make sure we can protect that business that we've gained and be able to deliver value for them consistently in the future. Alongside that, we feel very confident in our overall model because, as I've mentioned in some of the prepared remarks, we continue to drive significant cost savings, and some of that would be in cost of goods, some of it would be in the OG&A lines. But overall, we feel good about our ability to drive cost savings to support the investments that we believe we need to make to continue to grow and win long term. And then, of course, over time, our alternative profit streams will continue to accelerate. We wouldn't expect to be going backwards from the growth that we're seeing in that model. And again, we'll share more at the Investor Day in the spring, but that obviously becomes a tailwind to gross margin over time as well. So we feel very comfortable with our ability to manage the environment. We would expect to continue to deliver value for customers, both in price, but in promotions, personalization, different investments and experience. But we feel good about our ability to balance those investments in the model.

Our next question comes from Michael Lasser with UBS.

Is the assumption of a mid-single-digit contribution margin on the digital sales include the expectation that you're going to be able to retain the $5 delivery fee? Or does that exclude the $5 delivery fee? And do you have plans to reinstate that $5 fee?

Yes. Thanks for the question. So I think there's 2 different points there. On the first point, the data that we shared directionally earlier and the sort of the illustrative chart that we showed in the presentation will be based on our current performance from digital, so it would exclude the fee. It's really talking about where we are today based on how we're delivering value for the customer and what we see in terms of behavior and customer metrics. And what we've really seen over the last 6 months, I would say, is the acceleration in digital media growth and the improvements we've been able to make in the cost to fill -- fulfill an order have really offset the impact of the fee being temporarily removed. As regards to how we think about that long term, I know we've talked a little bit about this before, we will continue to evaluate that. And really, we always look at it through the lens of the customer and where does the customer give us most credit for the value we're providing. Historically, pre-COVID, the $5 fee, when we tested removing that fee hasn't proven to be a key driver of the way customers thought about where value was being given to them as they shop across Kroger. When we went through the pandemic, it became clear that was an important measure. And so we'll continue to look at customer insights and decide whether it makes sense to continue to give value in that way or whether we pivot, but it will always be driven by our customer insights and what our customers tell us they value the most.

And Gary mentioned that part of the continued expectation of improving margin is our teams are doing a great job on process change and identifying new ways of reducing the cost to pick an order. And when Ocado gets at scale, that would be a significant step reduction versus the current cost as well. So it's really all of the pieces working together, and the team is also making good progress on selling customers incremental items that wasn't on the -- in the core before between expansion of the store availability of product and the marketplace, and that has improved mix as well.

And Rodney, on that point, do you think you can make enough progress next year, either with the process improvements because of the Ocado relationship or further penetration of alternative profit stream to offset the potential that your in-store business is down, and we're going to probably think about a 15% decremental margin on that, and yet your digital business will continue to grow, and we'll think about a mid-single-digit margin on that to next year? It could be a difficult profitability year if you don't make considerable progress on those aforementioned initiatives.

Yes. It's a great question. And when we have our Investor Day in March, we'll get into a lot more detail on that and the mix of expectation. I don't think, at this point, I would go in additional detail versus what Gary and I have already shared in terms of the mix of the various pieces.

Yes. The only thing I would add, Rodney, is I think there's a lot of moving parts in next year's model, and so there's going to be a lot, obviously, of onetime costs and investments that we made this year that wouldn't be recurring again next year in that model. You mentioned our profit growing. As I mentioned in my prepared comments, we would expect to see significant continuation of cost savings. It's not a done sort of journey, if you like, when you think about where we've gone with cost and Restock Kroger. It's very much continuing that momentum. And then I think you're right, there's certainly going to be some headwinds around cycling the sales and the impact of the business there. So I would just emphasize that there's a lot of puts and takes, and I think there's not one driver that's going to sort of result in the outcome. That's why we think it's important to take everybody through that full detail when we reach the spring. But we do believe that when you look at the 2-year journey, we're going to be pleased with where that will position us versus what we had originally expected and relative to our commitments on TSR overall.

Our next question comes from Karen Short with Barclays.

A couple of questions. Just on the digital flow-through, I just want to clarify. You are talking about EBITDA margins, correct? Because I asked in the context of the fact that when you start opening the Ocado facilities, D&A will kick in. So presumably, that will have a negative -- some negative offset on the flow-through on operating margins.

Yes. So to answer the first part of your question, Karen, yes, think about it as equivalent of an EBITDA rate. So we take all of the costs that we incur incrementally for fulfilling a digital order and then we offset -- or we -- I should say we ignore in the model what we believe is not incremental value from that transaction. So where we believe there are sales that we're getting from digital that would have been coming into the store anyway, we take that out. We don't give ourselves benefit for that. While you could argue it's certainly retaining that customer, and we might lose them if we didn't do it, we're not showing that in -- through our calculation. We're just showing the incrementality that we're driving from extra sales and the value that we're driving through things like media revenue. So yes, that's how we think about the model. And then over time, certainly, we'll share more color, as you might expect on -- in spring next year because around that time, we'll be real close to the first 2 facilities opening, and we'll give you a lot more insights into how to think about Ocado. But you're right, there will be a ramp-up period that's fully contemplated for next year in our thinking around our model. But certainly, there'll be a ramp-up period in those first 2 facilities as you build volume, and there's going to be an element of fixed costs in that model that will, obviously, over time, get covered by the scale of volume and the efficiencies that come through the automation, but it's going to be a journey that the Ocado piece will take a few years before that really shows up in our numbers on that slide that I provided in my prepared remarks. But as we mentioned earlier, we still see a lot of short-term opportunities to continue to make progress in digital profitability, and then really Ocado comes behind and takes it to that next level.

Yes. And if you look at Ocado in the U.K., certainly, where they have maturity with the sheds, the margin on that business is very strong and stronger than what you would see it in store.

Okay. That's helpful. And then just on the guidance. Obviously, you reiterated the share repurchase of $600 million to $1 billion, but you were close to $3 billion on the balance sheet at 2Q. And obviously, you'll be higher than that when we get your third quarter results. So wondering how we should think about the buyback beyond this $1 billion that you've -- you're obviously authorized because that will -- I mean, I'm assuming you'll run through that by the end of this calendar year. And again, still, we'll have probably a solid $2 billion of excess -- plus $2 billion or more of excess cash on the balance sheet.

Yes. We agree with you, Karen, that we do expect to have strong free cash flow through the rest of this year. And overall, over the 2 years of 2020 and 2021, we would expect to be generating cash beyond the level that was contemplated in our TSR model. At this point, some of those dollars, I should point out, I think we talked about it on the previous earnings call, some of that would be tax dollars that are being delayed. And some of it will be working capital that would unwind. So I think there's an inflated number from what would be the true number, and so we're working through all of those pieces, as you might expect. But fundamentally, we would agree that we'd expect to have a higher level of cash than we had originally expected due to the stronger performance and the impact of COVID. We've taken a very deliberate approach to that cash because there are still -- while we feel very confident in what we're seeing in our model and how we're managing the business, when you think about where does the COVID environment and what does it -- how does it change the U.S. consumer, how does it change the economic environment, there's obviously questions around what the economy will look like going forward. There could be changes that impact the business with a government changing next year, if that were to happen. So as we think about where we are and what's changing in the -- with the U.S. consumer and the U.S. market, we think it's prudent to remain some flexibility and to make sure that we maintain our options. The way we'll think about using that cash flow will certainly be very much focused on the capital allocation framework that we've shared. So we'll start with, do we believe there are capital investments that we should be making that will strengthen our moats, will allow us to deliver the growth and beyond the growth that we've committed to as part of our TSR framework. We're obviously committed to maintaining our investment-grade debt rating, but that's not an issue based on the strength of our free cash flow and our current position. And once we get beyond that priority, we'll certainly be looking at what would be the ways in which we would deploy that excess free cash and return to shareholders. But at this point, we'll want to use our March Investor Day to really provide more of that color because we think it's important to make sure we're clear on both what's happening with the consumer in the marketplace and also that we can provide more color on the longer-term growth plans when we get to our spring Investor Day as well.

Our next question comes from Robby Ohmes with Bank of America Global Research.

I had a follow-up. Just on the 3Q ID trends, you guys are seeing the slight double digit. Am I right that you kind of have to maintain that level to get to the 13-plus in the fourth quarter as well? And then -- and just with that thinking, how are you guys thinking about November and December this year, Thanksgiving and the holidays? Should these be better ID months in the COVID-19 environment than the other months? Just any kind of thoughts you have on that. And then just one other question just on -- can we get an update just on the pharmacy profit outlook and COVID-19 impact on that?

Sure. Thanks for the questions, Robby. On the first part of the question, so the guidance that we shared for the IDs for the year would sort of require a range in sort of, as a minimum, 8% to 9% for the second half of the year. So we'd be trending, to Rodney's point, where we would have expected to be at this point and feel good -- feel really that the guidance that we gave actually was very much appropriate, and everything we're seeing will be consistent with that. We feel like we're trending slightly above the sales range. And the guidance that we shared for earnings growth of 20% to 30%, we feel like is -- was meant to be a realistic view of what we think the year will play out likely based on the investments and the puts and takes and the continued accelerated growth that we're experiencing in the business. So I would say that, right now, we feel like everything is playing out in the way that we had envisaged in general and would be in line with the guidance, hence, why we reconfirmed that in the communication this morning. As we think about pharmacy, I'd say it's a continuation of the things that we've shared previously, and it was certainly going to be an interesting area of the business as you head towards 2021. We've seen continued growth in script counts and continued growth in market share in pharmacy. We continue to see some pressure on reimbursement rates that we're managing through, continuing to take cost out of the business through efficiencies and continuing to recalibrate our product offerings to make sure that we're driving revenue in different places. For 2021, I think it's going to be an interesting year because we would expect some sort of returning to normal in the customers starting to use medical facilities. And certainly, as COVID vaccine hopefully becomes available, Kroger would hope to play a meaningful role in supporting that and supporting our customers and the country rebounding with getting that vaccine as quickly as possible.

Yes. I would add just a couple of comments on Gary's part about the fourth quarter. As you look at the holidays, we do expect people to celebrate the holidays. But obviously, it will be smaller family gatherings. We have invested in some additional warehouse capacity and inventory products for things that are holiday oriented. Our belief is that to support those celebrations. And we don't see much change from a COVID standpoint. We still see people working from home a lot and taking vacations at home on staycations and things like that. So we've built our assumptions around what we've shared on guidance, but we are also managing the business around those things as well.

Our next question will come from Kelly Bania with BMO Capital Markets.

You may want to push this question to March, but I'm hoping we can just talk about Ocado a little bit in more detail and just a candid assessment of how you feel about the capabilities that you're building there because, clearly, while the environment over the past several months has pulled forward digital and e-commerce engagement, a lot of consumers have also signed up for membership programs that are primarily same-day services from Instacart to Walmart+ to Amazon to Ship. And so just would love a candid assessment about how you feel about the capabilities that you're setting up with Ocado longer term, same day, next day, the percent of your markets that will be able to support that demand. And also how you envision your relationship with Instacart evolving as you ramp up Ocado. I think investors would love to hear some candid assessment of this topic.

Yes. I'll do a little bit, but your -- the more detailed conversation will be in March. If you look at overall, as we've mentioned before, Ocado was part of an overall supply ecosystem between supplying stores -- or between stores, micro fulfillment centers, dedicated smaller locations and Ocado, what we find is a meaningful percentage of customers submit their orders in advance, so that next day is not a problem. Ocado will also have same-day capabilities for part of the trade area based on how close it is to the facility. We feel very good about the overall partnership with Ocado and the continued progress that they are making. Obviously, they've -- we're continuing to learn from some of the ramp-ups in other parts of the world, in Canada, in France, plus the continued growth in the U.K. So it's part of the overall ecosystem and how we will serve customers in a seamless way. The efficiency of Ocado is incredibly efficient, and what we find is there are certain assortments that the customer appreciates same day. There's other assortment where next day is not a problem. And we will use the combination of all of our assets together and the capabilities together as well to deliver against that.

The only thing, Rodney, I would add with, Kelly, just to your question around Instacart, they -- obviously, they're an important partner of ours today. We work very closely with them, and they provide fulfillment services for delivery to home. One thing -- I think we've clarified this before, but just to confirm. Today, we have a slightly different relationship with Instacart, where we essentially -- you can certainly use Instacart as a customer and go on to their website and shop at Kroger, but we also have a service where the customer comes into the Kroger ecosystem and then Instacart picks the product based on the customer engaging through kroger.com or Kroger's mobile app. And we think that's important because we really do see the value in owning the overall relationship and creating a seamless experience to all the personalization we can do and giving customers the full value. And the majority of our volume today would be on the latter solution of customers coming into the Kroger ecosystem and feeling the part of being a member of Kroger, if you like, and that's something that we'll continue to partner with Instacart on in making sure that we're deepening that relationship with the customer.

Okay. That's helpful. And I guess, Rodney, when you mentioned micro fulfillment, are you thinking -- how many micro fulfillment centers are you thinking about? Is that Ocado-based micro fulfillment? And where are you -- how does that fit in with your commitments that you made to Ocado in terms of the original 20 facilities? Just where are we with that commitment and how does micro fulfillment fit into that.

Micro fulfillment will be a combination of automation and non-automation. We would expect Ocado to be an important partner in that. And obviously, one of the keys is getting the economics to work, and a lot of the models that are out there today really don't have the right level of SKU offering and they're incredibly expensive to operate. So it's really -- we're all learning together. Obviously, a big Ocado shed is what got the most experience in the marketplace and how it performs.

Our last question comes from Joseph Feldman with Telsey Advisory Group.

I was wondering, could you share some more thoughts on the dark store test in Cincinnati and kind of what you're seeing so far and how we might think about that going forward?

Yes. We would look at it -- we wouldn't -- internally, we don't even call it a dark store. It's just one additional way of providing service to customers. And Gary mentioned it before, but the most meaningful thing is it's provided a lot of learnings that we're able to scale back into all the Kroger stores. It's a great test and learn lab. And I can tell you, there's changing stuff in that facility every week on identifying additional delivery points, additional pickup points and supporting that via several different ways. But it's been a great test and learn lab to help us reduce the cost of pickup in all stores, and that's probably been the best leverage point so far from it.

Got it. That's helpful. And my last one was on the alternative profit stream, it seems like this year, you're getting an incremental $100 million. Last year was a little more than that. And I get that, as the business grows, it might be less as we go forward. But how should we think about it going forward in terms of the growth or maybe the profit level? Can you keep kind of doing that $100 million for a couple more years? Do you guys have line of sight on that? Or do you think it will kind of moderate, I don't know, $50 million to $75 million or where it might go in the next few years?

Yes. I won't give the specifics. And if Gary wants to give the specifics, he can after I finish. But we see alternative profit being a huge opportunity for the foreseeable future, the next several years. And if you look at this year, obviously, COVID has affected part of the alternative profit streams, especially with Kroger Personal Finance and gift card sales. So if you look within media, we've continued to have tremendous growth there. Kroger Personal Finance growth wouldn't have been as much as expected, but we believe it will still grow. So we still see solid growth this year that's meaningful, and we would expect to see continued opportunities going forward. When you look at media, we believe we're just getting started in terms of the opportunity there and our ability to provide CPG partners great insight in terms of what people do. And the recognition that Kantar gave in terms of the #1 ROI from a media channel versus 15 other companies, so 16 total, those are things that we'll continue to leverage. So we still see meaningful opportunity, and we're continually looking for additional opportunities to create the next alternative profit stream because we have over 11 million people a day coming into our stores and 3.5 million and growing on our website. All of those things, we should be able to personalize and continue to grow.

Yes. I think you said it well, Rodney. I wouldn't have a lot to add. I certainly would agree that I -- it's one of those areas where we'll provide more color in the spring, of course, but we wouldn't see it as something that's going backwards in the short term. It's moving forward. And when we think about the areas that Rodney mentioned, we've talked before COVID, the KPS has the ability, we believe, to potentially double in size just based on using our personalization tools, execute -- better execution we can offer consistently across the company to create the same level of engagement we have in our best markets on those products. But this year, it wasn't the year to achieve that with COVID, as Rodney mentioned, but I wouldn't say that our belief that the opportunity there is less than it was when we started the journey. Media has been the opposite direction where it's demonstrated the ability for us to pull that forward, which we're really excited about, and see media as a huge market where we're still really tapping into a small part of that. But we believe we have unique assets that give us the right to be able to create a much bigger place to -- space to play in there. And then as Rodney mentioned, there are constant innovation going on in that alternative business team on new opportunities. And looking in, we've talked about before health care and other ways to tap into our data and identify future growth. Some of those areas become investments in the early years, but then they play out into growth in the outer year. So it's very much a journey in our mind that we expect to continue.

And thanks, everyone, again, for joining us today. Under Restock Kroger, we have made significant investments to transform our business. These investments, combined with the structural shifts related to customers eating more meals at home, give us more confidence that Kroger's performance in both 2020 and 2021 will be even stronger than previously anticipated, and we are incredibly excited about the future. During our spring Investor Day, which we've talked about several times, we will share how we will continue to grow market share by accelerating our competitive moats. We'll provide more color on our digital strategy and our path to strong profitability. We'll address how partnerships, including Ocado, will add capabilities and unlock value. And we'll outline how our alternative profit streams and data will accelerate growth even more in the future. We look forward to hopefully seeing you in person in the spring. And thank you again for your time and your interest in Kroger, and we look forward to spending time together soon. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.