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

Good Afternoon. I'm Alan Tannenbaum and I'm responsible for the investment in Corporate Bank at BMO Capital Markets. And on behalf of all of my colleagues, I want to welcome and thank all of you for joining us at the 8th Annual BMO Global Farm to Market Conference, which is the biggest and best that we've ever put on, and I just want to start by acknowledging and thanking in particular, all of our research department members who really are the driving force behind the success. So thank you all. I also have the honor today of introducing our keynote lunch. And we have with us today from Kroger Mary Ellen Adcock, who is Senior Vice President of Operations; and Gary Millerchip, who's the Senior Vice President and CFO for the company. Mary Ellen has had a number of roles at the company, including manufacturing, operating, merchandising and brings a wealth of experience to her role today. And insight on Gary, who started out on the dark side as a banker, joined his client, Kroger and then moved on to become the CFO starting in 2019, bring both of them bring a wealth of insight and experience around the organization to help shape today's conversation. Moderating today's conversation is going to be Kelly Bania, our star food retailing analyst. In my selfish and humble opinion, the best on the street today, who is acknowledged for her thoughtful and insightful work. I can't think of a better company to have at a venue like this today. Kroger, for those of you who don't know, is the second largest food retailer in the United States with sales of over $125 billion. The company also has a private label business that generates $28 billion of revenue a year, which alone would be the ninth largest consumer products group in the United States. The company generates $10 billion of digital sales. They serve 60 million households and transact over 11 million times every day. In addition to that, this team is managing 60,000 vendors and service providers. What that all means is that with us today are 2 individuals who have such a unique insight into the consumer, the economy, spending habits and so many of the topics that our investors' minds today. So I want to thank you and Kroger for being a long-time participant and supporter of this conference as evidenced with your presence here today. So thank you very much. Really looking forward to the conversation. And Kelly, over to you.

Thank you. Thank you very much, Alan. I want to just thank you first for making the trip from Cincinnati as well and also to Rob Faist for always helping me and helping arrange this today. So Yesterday, we had a very interesting panel on regenerative agriculture. But today, we're going to really refocus on the consumer, and I'm happy to kick it off with Kroger. So my first question, I really -- a lot of questions about the state of the consumer. We're kind of in the middle of Q1 earnings. I've heard more this week. But it's kind of a strange environment right now where we're hearing about weakness in discretionary consumer under more pressure. The food has kind of been a bright spot across consumer. And I was just curious how you would describe the consumer and their ability to absorb this magnitude of inflation that we've been seeing because it used to be over 4% is going to be tough. But we've had 12 months of double-digit inflation. It looks like it's starting to pull back. But what do you see in your own business with the consumer and their ability to handle this inflation so well, which has kind of been surprising over the last year or so.

Sure. Well, good afternoon, Kelly. Glad to be with you. Thank you for having us at the conference. I'm sure Mary Ellen want to share some insights on this question as well, we'll give you both of our perspectives on it. I think what we're seeing is some trends that we've talked about probably pretty consistently over the last year or so is that, generally speaking, I think the customer has obviously managed what they've been dealing with for the last year or 2 as we've come through COVID and seeing the inflationary environment, handling it pretty well. I think it though does -- it does depend on sort of where you are in the income spectrum and how you've come through all the challenges that we've all dealt with over the last few years. And if I think about the higher income customer, I think their balance sheet, if you think of a personal balance sheet of liquidity and cash and investments that are built up over the pandemic, I think still that consumer seems to be in pretty good shape. But I do think they're also recognizing the environment is challenging and are trying to make smart decisions. So we see with the higher income customer, not necessarily the need to cut back, but the sort of -- they feel, I think it's the right thing to do. And so for our business, we've seen certainly more consolidation of shopping at that higher income customer to the convenience of Kroger, for example, because maybe those customers were shopping in 3 or 4 specialty stores in the past and now think of, well, I want to act smartly, I want to sort of spend my dollars wisely knowing that the economy is likely heading into more difficult times. And so I think the adoption there is more moving to higher-quality private label products, meal solutions in the store, focusing on those opportunities to be a smart shopper, recognizing the environment. I think where you see more of the strain is certainly with the low-income customer. And I think that's partly inflation. And I think it's also some of the other changes that are happening in the macro environment right now when you think about the emergency Snap dollars that were still flowing through in many states up until recently, you've pretty much seen all of those dollars now dissipate out of the market. If you think about some of the changes in Medicare that have happened as well over the last sort of few months and taking away some of those funds from these sort of parts of the economy. And I think what you see with the value customer is they obviously prioritize dollars on the sort of nondiscretionary items like food. And so customers obviously are still buying food to your point, but ultimately are really trying to stretch their dollars as far as they possibly can. So we're certainly focusing Kroger on how do we recognize that change, whether it's offering promotions at different times of the month when their cash might be more strain when they get towards the end of the pay cycle. It's about offering smaller item sizes at the end of that month. So you can stretch the dollars to put food on the table. It's about personalizing more of the promotions to be the most relevant for that customer. And we're certainly seeing a continued trend of customers on the low income spectrum, engage in more of those sort of tools, looking for more ways to save and to more ways to stretch their dollars. And I do think that consumer is certainly in a situation right now where they're really feeling the impact of all those elements that I just mentioned.

Yes. We definitely see the customer seeing the effects of inflation across the spectrum and in different ways, though, and different choices based on their needs. And -- but it doesn't mean that they're not spending because they're always going to prioritize too. They just may make different choices, and that's what we're seeing. And our model has proven to be flexible and durable. And that's actually what we're focused on is continuing to change to be there to meet their needs with where they are. So for example, on -- with our premium customer, we see them actually gravitating more to fresh to natural and organics, also to our Starbucks and our Murray's brand in places where they still are eating at home or a private selection or brand, and that's resonating. And actually, as they spend more and increases that backed, they're actually creating more margin and higher value customer there. And then on the other side, we do see customers that are even more stretched as the Snap has been decreased. And so that's where we've really even focused more in terms of Our Brands and how we have broader offerings with our new Smart Way brand. We introduced over a couple of hundred new products that are innovated just for that customer to be able to meet them in that place. And then also from an operational perspective, we've gotten even more data driven by store in terms of how we use the data where we display items for the different customers and the different needs to meet them where they are as well as improving the in-stock is that super important. And this is across all channels because they're also wanting to shop in different ways at the store, pickup and delivery. And so being there across all those channels is really what's continuing to drive the sales for the model.

What have you noticed -- and by the way, feel free to submit the question. I see one popping up. I'll try to loop them in. But -- what's different about what we're seeing now today versus past cycles where we see the consumer start to trade down or still trading up in some areas. I mean, have you gone back and looked at past cycles and said, okay, this tells me Kroger needs to add more of these low price point SKUs or just any kind of historical analysis that you've looked at so far?

So there's some similarities in terms of stretching the value and the value proposition. And so that's where we've been even more with innovation in terms of Our Brands because we know that resonates and we're even in a better place to have more offering there. And then also our value total proposition in ways to show that customer they can save because it's not just Our Brands, but it's also our promotion, which we continue to do fuel rewards and that combination for the customer is a place that we see them looking at that total value proposition in ways that they can stretch the spend.

Yes. I'm not sure I'd say that -- I agree with Mary Ellen completely that there's been like some dramatic difference. I think it's a lot of similarities of when you see customers enter different sort of economic cycles and they're dealing with that, how they change their behavior. I think a lot of it is very similar. I think some of the differences would be how the customer engages has changed because of the pandemic. So I think you've got -- we were actually talking about this with some investors earlier today. If you think about prior to the pandemic while we've seen a significant growth in digital sales, so by digital sales, I mean order online, pick up at the store, order online, delivered to home, we've seen an even greater increase in the number of customers that are digitally engaged. So what I mean by that is they may not be shopping digitally, but they start their shopping journey online. So they're using their phone to start the shopping list to decide what to buy, to identify the best value. And so what I think that means is it changes the way you engage with the customer and helping them find value. And it actually -- it's actually very helpful for us because, as I think many of you know, we have a large data science company called 84.51° which essentially uses all the data that we have on our customers to really help them engage with Kroger more effectively, how can they save money, save time. And so when you've got a significantly high number of customers that are now engaging digitally, you can personalize what you're giving them. And so I have to think about the value we're giving. I think if you compare how Kroger or other retailers, I think, can give value now compared to, say, 5 years ago, you can be a lot more targeted. So you may be actually spending very similar dollars, but actually the value you can give to people that really need those dollars because you can really understand their shopping behavior, but then target on a one-to-one basis, the promotions at the right time, the coupons at the right time. And that could be different products. They could vary by the time of the month, depending on how that customer's behavior is changing based on how they're financially positioned at that point in their budgeting cycle, the size of the product that you're offering, depending on the budget they have and the types of products. whether it's Our Brands versus a national brand product that you're offering. So I think what it's enabled us to do is really kind of bring some of that science to an ever higher level of personalization and really to be able to offer more directly to the customer what they need at the right time with the right offer.

So I want to give you a chance to dispel maybe one of the questions that we get often on not only Kroger but just the food retail space because I'm glad you mentioned the digital and the targeting because prepandemic promotional activity seems like it was much higher. And we try to track it and it looks like it's creeping up, but it's nowhere near what it was like before. And I hear the answer a lot from some of the companies that had just were more targeted. We're all smarter, the whole industry got smarter. Is that the answer to why we're not going back to a very promotional environment because that's one of the key things that I think investors continue to worry that we'll go back there.

Well, I think that, I guess, from a Kroger perspective, we would answer probably a little bit differently from some just because we did continue promoting throughout the pandemic. Now we pivoted the way in which we were spending those dollars. So in some cases, we may have moved to HBC products because customers were looking for safe and Sanofi type products and sanitation products. We would have moved maybe in some cases to our brand product promotions because we knew we could control the availability there manufacturing the products ourselves. So I think we've kind of viewed it more as a constant. And certainly, when we look at our data, we continue to promote, we expect the market will always be competitive. So we assume the market will get more competitive. We build into our model every year, the assumption that we'll need to invest in value for the customer because we just assume our industry is always going to be competitive. For us, we believe that as we've matured our value model, our value creation model that there are ways in which we can fund those investments from things like alternative profit streams from improving our brand penetration from growing the fresh categories, all these things can be margin accretive. And we're also seeing some tailwinds in the model now. I think supply chain is finally becoming more of a normalized environment, and we can see some -- you probably saw in our fourth quarter results, some improvement in gross margin being helped by supply chain efficiency. So I think our view is that we expect the market will continue to get more competitive because it's how it's always been as long as we've been in the industry. I would certainly agree with the point that I think it is a lot more personalized than targeted now. I think you see a lot more of it being on a one-to-one basis with the customer, taking advantage of this ability to do. I think it's better for the customer. And I think he helps us be more efficient in the way we're allocating those dollars to people that need it the most. But I wouldn't say that we would look at it as being -- we certainly think it's rational, but we wouldn't look at it being extreme in terms of different from at least the way we're approaching the market.

Yes. We've been very consistent, different than some other competitors, and that's actually designed with our strategy, both in terms of promotional investment and price investment. And that's built into our model and we get feedback from our customers that, that's one thing that resonates and actually builds loyalty is our promotion as well as combined with the personalization, and that's both in the store as well as the digital and even being more personalized and further using the data even new ways with 8451 -- and that's been a part of continuing with -- bringing our loyal customers, which are 8x more valuable.

I think maybe, Kelly, one of the thing I would say, too, is that the way we look at it is, again, I'm sure some of you are familiar with Kroger's go-to-market strategy. But our overall approach is that we want to be really good on value. And what we mean by being really good on value is we aim to have our everyday pricing within a certain range of the everyday low-price operators. Then we layer on all the components of how Kroger can personalize and differentiate the experience, whether it be personalized coupons, promotions, fuel rewards. And we look at it through the lens of, are we on an everyday basis where we think we should be relative to what customers tell us they view as how Kroger delivers value. And then when you layer on all the different ways we create loyalty, how does that then bring down the overall basket and create the overall value for the customer. And then really the differentiator for Kroger is we believe the freshness of our products, the quality of our brands and our ability to use our data to personalize the experience by saving the customer time, saving them money, making their lives easier. They are the things that differentiate for Kroger. So when we look at our value equation, we -- certainly in the data that we track, we've kind of maintained throughout the pandemic, from prior to the pandemic price position relative to the everyday low price. And then when we layer in the value we're giving, essentially that brings the value to a comparable level when you add in fuel rewards and personalized promotions for those customers that are really focused on value. So we have a fairly sophisticated way of measuring how have we maintained and that's why we say we're sort of a reasonably high degree of confidence that we feel like we've maintained that kind of level of investment in the customer over that time period.

Right. No, that's helpful. What about the vendors? Everybody is just constantly asking, when are the vendors going to start promoting again, -- what are you hearing? Is there any line of sight into that kind of picking back up to where it would be? What are those conversations like today?

So our vendor partnerships are very important, and we have joint business plans with the vendor and in terms of what is the right products to have the promotional planning on and to the right customer. So this really becomes back to the whole value proposition of how do we promote in the right places with fresh. We know that, that's more important to the customer, and that's a place where they're looking to see opportunities, and we're partnering to say, where is the best place to continue to promote fresh. But it's not just about the promotion. It's also how we continue to improve the experience as well as how we've made changes throughout the whole supply chain to give more freshness to the customer. And so it's the combination of all of these and partner with our vendors that are creating more value. in combination with promotional planning in a balanced way to continue to give the value for the customer, but also in a way that meets our guidance that we have put together, Yes.

And so if vendors get promotional activity back to normal, I guess the impact of that is it's kind of a deflationary impact on the pricing, right? But it's not necessarily a margin impact for Kroger and you're just passing it on. So how does that fit into your inflation outlook in terms of what you're seeing in costs, what you're hearing from the vendors? I know there's -- it's not easy on inflation, but presumably, you have more insight than the rest of us. So are we headed in the right path in terms of where people are expecting inflation to kind of moderate as we go through the year.

Yes, I think it's a great question, and we are -- I mean, I'm not sure we have certainly insights in our business. I think everybody is still figuring out what does the crystal ball tell us around what happens later in the year because there's obviously a lot of factors that can influence that. I think so far, we've seen kind of the trends we would have expected to see. I know we all see the published data. I wouldn't say that our data is dramatically different from that. As a recap, we shared at the beginning of the year when we gave our guidance for the year that we would expect inflation would take us throughout the year. We don't sort of model as a sort of main assumption deflation. We think there's certainly a scenario where that could happen, and we make sure that we have plans that can adapt in that scenario, but that's not our central view. It's pretty unusual to have deflation in grocery and food at home. I think it's happened twice in the last 50 years. So it's not even in a recessionary environment. It's not a typical situation that occurs. But our view is always that we would see inflation decelerate back to more normal sort of low single-digit type levels by the end of the year or a range between low single to mid-single. I think we were conservative in our expectation for our LIFO charges to make sure we didn't get caught out by that as we think about the rest of the year. And what we're starting to see, as you've seen in the public data available, I think that curve has started to happen. I think if you look at meat and produce, they would be sort of more back towards normalized type levels now. It is the -- I think the grocery category that's still more stun it is starting to decelerate we see in our numbers. So there is some of that sign showing through. But I think that's definitely the laggard in the categories in what we see in the data. And I think sort of connecting it maybe to your point earlier, I think we view it very much as at the end of the day, we build our models to get a flex based on what we see because we're not experts in predicting inflation. We certainly try to use our central view as our base plan, and then we recognize there are scenarios that could play out and manage them effectively through those different periods. Working with our CPG partners, our goal is to grow their business together through the joint business plans that Mary Ellen mentioned. Certainly, as we accept cost increases as we have for the last year or 2, we're always monitoring what's driving that cost increase. So if we see some of those pressures abating and we see commodity prices changing or we see transportation costs that are starting to normalize. Then obviously, we're back talking to our CPG partners around, well, how does that translate to how the price changes. We want to be good partners in managing and growing the business, but we also want to be good custodians of supporting our customers in managing those costs where we see them. So that's another important part of the conversation. And then I think the way we believe this all gets calibrated is we're fortunate and that we do have a strong Our Brands program, a private label program, where what we've seen in prior recessions is that when the customer gets more constrained, there is a tipping point where they look at the value between a national brand and a private label brand. And if that sort of gets out of sync, if you like, the customer makes a mental decision that maybe I'm going to try these private label brands. And what we've seen in prior recessions is more customers we'll try the private label and the penetration level goes up, and typically, it doesn't come back to the prior level because we certainly cut our main private label brand to be at the same quality as a national brand and then a private selection premium to be a premium level. So in that regard, we don't push our private label. We don't push national brands. We want the customer to win. We use our data to promote both. But at the end of the day, the customer gets to choose. And I think if you see the costs getting too far out of sync, then the customer ultimately adapts and changes their behavior. And I think that naturally creates an equilibrium to make sure everybody's focused on growing the business that helps...

No, that's very helpful. I want to come back -- go ahead ma'am.

I'm just going to add. We also think of margin broader than just around the price as well, but it's also about the mix and ways that we can continue to enhance margin through the mix that actually enhances the customer experience, especially as fresh as more important is that as we improve process pressure product, an example with that is having what we call value-added product where you have a piece of a [indiscernible] meat selection. And then we add seasonings, we add enhancements to that. And those are margin accretive examples that help the mix, but in a way that actually adds to the customer experience as well. So the -- it's multifaceted in terms of how we're looking to think of margin, how we address that to have the right offerings for the customer all the time.

That makes a lot of sense. I want to come back to private label, but I have one couple more maybe on inflation deflation because it's so topical. But does it matter for your business if prices are coming down quicker on the proteins and the fresh. And I ask because some of our distributors kind of price that on a dollar basis in terms of their profit. And so just curious if it has any different impact on the profitability, whether it's dry grocery seems like it's still kind of more stubborn and the fresh is coming down. But how do you view -- are you just managing to gross profit dollars? Or how should we think about modeling as this kind of comes back down to earth?

Yes. I think, ultimately, we probably disconnected too in that we focus on the customer plan of how do we make sure that as we want to deliver on the value that I mentioned earlier being competitive every day, while also layering on the incremental value. So we kind of -- I would say, as a company, we have a customer plan that says, how do we make sure we're executing on that plan. And then really the levers that we're pulling in the company to manage the margin for the company are really broader than the sort of the connection to the price. So as you think about our sourcing practices, $1 billion of operational efficiency that we're creating in the business model, the growth in alternative profit streams. So I think we try and look at it less at a transaction level and say, how are we building an ecosystem that you can invest in the customer where we need to, to drive the traffic in the business and then how do we create value in our overall ecosystem to supply wheel effect, if you like, we've talked about where you kind of pull the different levels. And I think -- what we've tried to do in the last few years as we built this plan is how do we make sure we're building enough flexibility within our ecosystem to be able to manage that effectively. And so I think we've tried to compartmentalize a little bit more of making sure we really connect and stay with the customer, but then are also ensuring our model is able to manage that environment.

Yes. Strategically, we very intentionally put the customer at the center of our go-to-market strategy. And that is the basis in terms of guiding the decisions, using the data is where the customer trends, that's the driving force of the strategic choices that we make on how we go to market. And then behind that, we're managing the deflate because we have seen inflation and deflation across the commodities. And so that's always work that's happening with the customer being the driving and then looking at ways that we take cost out in other places. -- through more efficiency through automation, ways that we can simplify process for the associates so that we have that flexibility to always to be consistent to deliver our total shareholder return, but be dynamic and make sure that we're being there for the customer, but often managing these changes in inflation of or other dynamics in the business as well.

Right. And I guess on the private label, one of the questions that we get a lot is just where is that gap right now with your private label and what you would consider the brand, national brand equivalent. What does that price gap look like? Has it widened? Do you see it widening? And how does the margin compare versus the national brand?

Yes, from a sort of an everyday value perspective, it varies, as you might imagine, by category. But typically, we would see our own brands, private label products would be anywhere between 20% to 30% lower price to the consumer or any sort of given product depending on the category. And obviously, not every product that we -- a customer buys in our stores is available in private label. So when you sort of translate it to an overall basket, we've looked at sort of that data before, directionally, the customer can save 10% or so on the basket if they made a choice to sort of select a Kroger branded product versus, say, a national branded product in the areas that they're buying today. So we haven't just artificially that's really based on how customers shop today, there's an ability for the customer to essentially, I guess, offset the inflationary impact if they decided to use different products. From a profitability perspective, yes, anywhere between from -- on a rate perspective, anywhere between 600 to 800 basis points of incremental margin that Kroger achieved when it's our own private label product. So that kind of comes back a little bit to the margin improvement where that can help with offsetting some of the -- maybe the challenges you might face is certain products you need to invest in value, we're able to kind of pull different levers to really manage that equation.

Okay. And we'll get to alternative profits and Ocado, those are on my list, but I wanted to ask about pharmacy. I know we don't talk about it a lot, but we're hearing some positive trends, number one, from some competitors in pharmacy. Some of the diabetes drugs are doing really well. So I was curious if you wanted to comment on that, but we're also hearing about some headwinds from some others, cycling some of the COVID and the vaccines and the test kits. And so and you're in the midst of changing your pharmacy agreements -- and so that can sometimes have some disruption on customers who are loyal and have that pattern. So let's just have a deep dive on pharmacy and all of those 3 things. So the change with Express strips, the obesity diabetes drugs and the cycling of COVID dynamics.

Sure. Yes, a lot to unpack, Yes. The thing I would say about Express Scripts, obviously, we never make those decisions lightly because we always want to support and serve our customers where we can. We look at the business, and sometimes you make difficult decisions that are about setting the business up for the next 10 years and beyond to support the ability to sustain the investment in customers. And this was a situation where, unfortunately, to have sort of maintained that contract would have essentially meant us having to either expect our shareholders to carry the burden of that negative impact or raise our grocery prices. And in this environment, we just didn't feel that was the right long-term decision for the business. So obviously, we've shared publicly the impact of that. We expect it to be about 150 basis points of impact on our ID sales, and we've reflected that in our guidance for the year. I think the obvious thing to say is I remember when you hear other people talking about their pharmacy, Kroger has a pretty big pharmacy business. So if you reverse 150 basis points, that's probably close to $2 billion of sales. So somebody else is getting the benefit of that $2 million of sales. So you're probably seeing a double impact in a sense that it's lowering our number, it's hiring other people because those scripts at Express Scripts are being filled somewhere else in the market. Our team has done a phenomenal job. We believe in looking after the customer and making sure that we use all of the tools that we have from a personalization point of view to make sure that we wouldn't expect that to have a broader impact on our grocery business because we bring all that capability to show all the value that Kroger delivers. And our expectation when we shared that decision is that we wouldn't expect it to have a material impact on our overall business, but it will, for sure, impact ID sales. It will probably mean that -- I think I shared this on the earnings call, the gross margin rate probably gets elevated a bit, and the OG&A rate creates deleverage because it's high volume at low margin, so it will change a little bit of the optics in the P&L. But that was the reason for the decision and that's how we think that's impacting us and also how we expect it's probably causing others to see inflated pharmacy results as the beneficiaries of that volume.

Right. And one of the other benefits on that point is that we are more of a multicare provider. And so there's other services that we offer. And I'm always impressed with our pharmacists and our team and how they connect with the customer. And so they've been able to offset in other ways with services within the store, and it's also a place that we see opportunity to continue to be more efficient and take cost out of the processes as well in the pharmacies as part of that total picture as well as being with the goal being to have minimal impact, which because of all of that work to maintain the customers.