UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
OR
Commission file number 1-303
THE KROGER CO.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(513) 762-4000
(Registrant’s telephone number, including area code)
Unchanged
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨.
There were 751,379,788 shares of Common Stock ($1 par value) outstanding as of June 27, 2003.
PART I—FINANCIAL INFORMATION
Item 1. Financial Statements.
CONSOLIDATED STATEMENTS OF EARNINGS
(in millions, except per share amounts)
(unaudited)
May 24,
2003
May 25,
2002
Sales
Merchandise costs, including advertising, warehousing, and transportation
Operating, general and administrative
Rent
Depreciation and amortization
Restructuring charges and related items
Merger-related costs
Operating profit
Interest expense
Earnings before income tax expense and cumulative effect of an accounting change
Income tax expense
Earnings before cumulative effect of an accounting change
Cumulative effect of an accounting change, net of income tax benefit of $10
Net earnings
Earnings per basic common share:
Cumulative effect of an accounting change, net of income tax benefit
Average number of common shares used in basic calculation
Earnings per diluted common share:
Average number of common shares used in diluted calculation
Certain per share amounts may not sum accurately due to rounding.
The accompanying notes are an integral part of the Consolidated Financial Statements.
1
CONSOLIDATED BALANCE SHEETS
(in millions)
February 1,
ASSETS
Current assets
Cash
Accounts receivable
Inventories
Prepaid and other current assets
Total current assets
Property, plant and equipment, net
Goodwill, net
Fair value interest rate hedges (Note 12)
Other assets
Total Assets
LIABILITIES
Current liabilities
Current portion of long-term debt including obligations under capital leases
Accounts payable
Accrued salaries and wages
Other current liabilities
Total current liabilities
Long-term debt including obligations under capital leases
Face value long-term debt including obligations under capital leases
Adjustment to reflect fair value interest rate hedges (Note 12)
Other long-term liabilities
Total Liabilities
Commitments and Contingencies (Note 11)
SHAREOWNERS’ EQUITY
Preferred stock, $100 par, 5 shares authorized and unissued
Common stock, $1 par, 1,000 shares authorized: 909 shares issued in 2003 and 908 shares issued in 2002
Additional paid-in capital
Accumulated other comprehensive loss
Accumulated earnings
Common stock in treasury, at cost, 159 shares in 2003 and 150 shares in 2002
Total Shareowners’ Equity
Total Liabilities and Shareowners’ Equity
2
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash Flows From Operating Activities:
Adjustments to reconcile net earnings to net cash provided by operating activities:
LIFO charge
Item-cost conversion
Store closing liabilities
Deferred income taxes
Other
Changes in operating assets and liabilities net of effects from acquisitions of businesses:
Prepaid expenses
Accrued expenses
Accrued income taxes
Contribution to company-sponsored pension plan
Net cash provided by operating activities
Cash Flows From Investing Activities:
Capital expenditures, excluding acquisitions
Proceeds from sale of assets
Payments for acquisitions, net of cash acquired
Net cash used by investing activities
Cash Flows From Financing Activities:
Proceeds from issuance of long-term debt
Reductions in long-term debt
Financing charges incurred
Increase (decrease) in book overdrafts
Proceeds from interest rate swap terminations
Proceeds from issuance of capital stock
Treasury stock purchases
Net cash used by financing activities
Net increase (decrease) in cash and temporary cash investments
Cash and temporary investments:
Beginning of year
End of quarter
Supplemental disclosure of cash flow information:
Cash paid during the year for interest
Cash paid during the year for income taxes
Non-cash changes related to purchase acquisitions:
Fair value of assets acquired
3
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Certain prior-year amounts have been reclassified to conform to current-year presentation and all amounts presented are in millions except per share amounts.
Basis of Presentation and Principles of Consolidation
The accompanying financial statements include the consolidated accounts of The Kroger Co. and its subsidiaries. The February 1, 2003 balance sheet was derived from audited financial statements and, due to its summary nature, does not include all disclosures required by generally accepted accounting principles (“GAAP”). Significant intercompany transactions and balances have been eliminated. References to the “Company” in these Consolidated Financial Statements mean the consolidated company.
In the opinion of management, the accompanying unaudited Consolidated Financial Statements include all normal, recurring adjustments that are necessary for a fair presentation of results of operations for such periods but should not be considered as indicative of results for a full year. The financial statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been omitted pursuant to SEC regulations. Accordingly, the accompanying consolidated financial statements should be read in conjunction with the fiscal 2002 Annual Report on Form 10-K of The Kroger Co. filed with the SEC on May 2, 2003.
The unaudited information included in the Consolidated Financial Statements for the first quarters ended May 24, 2003 and May 25, 2002 includes the results of operations of the Company for the 16-week periods then ended.
Stock Option Plans
The Company applies Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations to account for its stock option plans. The Company grants options for common stock at an option price equal to the fair market value of the stock at the date of the grant. Accordingly, the Company does not record stock-based compensation expense for these options. The Company also makes restricted stock awards. Compensation expense included in net earnings for restricted stock awards totaled approximately $2, after-tax, for the first quarters of 2003 and 2002. The Company’s stock option plans are more fully described in the Company’s fiscal 2002 Annual Report on Form 10-K.
The following table illustrates the effect on net earnings, net earnings per basic common share and net earnings per diluted common share as if compensation cost for all options had been determined based on the fair market value recognition provision of Statement of Financial Accounting Standards (“SFAS”) No. 123:
Net earnings, as reported
Add: Stock-based compensation expense included in net earnings, net of income tax benefits
Subtract: Total stock-based compensation expense determined under fair value method for all awards, net of income tax benefits
Pro forma net earnings
Net earnings per basic common share, as reported
Pro forma earnings per basic common share
Shares used in basic calculation
Net earnings per diluted common share, as reported
Pro forma earnings per diluted common share
Shares used in diluted calculation
4
The Company is continuing the process of implementing its integration plan related to recent mergers. In the first quarter of 2002, the Company recorded pre-tax, merger-related costs of $2 for the issuance of restricted stock and the related market value adjustments. Restrictions on the stock awards lapsed in the second quarter of 2002 based on the achievement of synergy goals established in connection with the Fred Meyer merger. All synergy-based awards were earned provided that recipients were still employed by the Company on the stated restriction lapsing date. No such costs were recorded in 2003.
The following table is a summary of the changes in accruals related to various business combinations:
Facility
Closure Costs
Employee
Severance
Incentive Awards and
Contributions
Balance at February 2, 2002
Additions
Payments
Balance at February 1, 2003
Balance at May 24, 2003
On December 11, 2001, the Company outlined a Strategic Growth Plan (“Plan”) to support additional investment in its core business to increase sales and market share. The Plan has three key elements: reduction of operating, general and administrative expenses; centralization and increased coordination of merchandising and procurement activities; and targeted retail price reductions. As of May 24, 2003, execution of the Plan had reduced expenses by approximately $377. Restructuring charges related to the Plan totaled $13, pre-tax, in the first quarter of 2002. The majority of these expenses related to severance agreements, distribution center consolidation and conversion costs. No restructuring charges were incurred in 2003.
The following table summarizes the changes in the balances of liabilities associated with the Plan:
Severance &
Other Costs
5
In addition to the merger-related costs and restructuring charges described in Notes 2 and 3, the Company incurred other income and expense items that were included in merchandise costs, operating, general and administrative expense and interest expense in 2003 and 2002. These items totaled $91 of pre-tax expense for the first quarter of 2002. The items had an immaterial pre-tax effect for the first quarter of 2003. Details follow:
Other income and expense items in merchandise costs
Other income and expense items in operating, general and administrative expense
Costs related to mergers
Excess energy purchase commitments
Other income and expense items in interest expense
Total
In 1998, prior to the merger with Fred Meyer, the Company changed its application of the LIFO method of accounting for certain store inventories from the retail method to the item-cost method. The change improved the accuracy of product cost calculations by eliminating the averaging and estimation inherent in the retail method.
During the fourth quarter of 2002, the Company adopted the item-cost method for the former Fred Meyer divisions. The cumulative effect of this change on periods prior to February 3, 2002, cannot be determined. The effect of the change on the February 3, 2002, inventory valuation, which includes other immaterial modifications in inventory valuation methods, was included in results for the quarter ended May 25, 2002. This change increased merchandise costs by $91 and reduced net earnings by $57. The Company did not calculate the pro forma effect on prior periods because cost information for these periods was not determinable. The item-cost method did not have a material effect on earnings subsequent to its adoption on February 3, 2002.
Costs related to mergers included expenses recognized as a consequence of the continued integration of the Company’s divisions. Integration primarily resulted from the Company’s merger with Fred Meyer. These expenses primarily related to severance agreements and enterprise system conversions.
6
In 2001 and 2000, the Company recorded pre-tax expenses of $20 and $67, respectively, for the present value of lease liabilities related to store closings. These liabilities were the result of two distinct, formalized plans that coordinated the closings of several locations over relatively short periods of time. The liabilities pertained primarily to stores acquired in the Fred Meyer merger, or to stores operated prior to the merger that were in close proximity to stores acquired in the merger, that were identified as under-performing stores. Therefore, liabilities were recorded for the planned closings of the stores.
Due to operational changes, performance improved at five stores that had not yet closed. As a result of this improved performance, in the first quarter of 2003, the Company altered its original plans and made a determination that these five locations will remain open. Additionally, closing and exit costs at other locations included in the original plans were less costly than anticipated.
In total, in the first quarter of 2003, the Company recorded pre-tax income of $10 to adjust these liabilities to reflect the outstanding lease commitments at the locations remaining under the plans. Sales at the stores remaining under the plans totaled $75 and $137 for the rolling four-quarter periods ended May 24, 2003, and May 25, 2002, respectively. Net operating income or loss for these stores cannot be determined on a separately identifiable basis. The following table summarizes the changes in the balances of the liabilities:
Balances at January 29, 2000
Lease liabilities recorded
Balances at February 3, 2001
Balances at February 2, 2002
Balances at February 1, 2003
Lease liabilities reversed
Payments, including $12 related to the synthetic lease buyout
Balances at May 24, 2003
During March through May 2001, the Company entered into four separate commitments to purchase electricity from one of its utility suppliers in southern California. At the inception of the contracts, forecasted electricity usage indicated that it was probable that all of the electricity would be utilized in the operations of the Company. The Company, therefore, accounted for the contracts in accordance with the normal purchases and normal sales exception under SFAS No. 133, as amended, and no amounts were initially recorded in the financial statements related to these purchase commitments.
During the third quarter of 2001, the Company determined that one of the contracts, and a portion of a second contract, provided for supplies in excess of the Company’s expected demand for electricity. This precluded use of the normal purchases and normal sales exception under SFAS No. 133 for those contracts, and required the contracts to be marked to fair value through current-period earnings. The Company, therefore, recorded a pre-tax charge of $81 in the third quarter of 2001 to accrue liabilities for the estimated fair value of these contracts through the December 2006 ending date of the commitments. The remaining portion of the second contract was re-designated as a cash flow hedge of future purchases. The other two purchase commitments continued to qualify for the normal purchases and normal sales exception under SFAS No. 133 through the end of the first quarter of 2003.
7
SFAS No. 133 required the excess contracts to be marked to fair value through current-period earnings each quarter. In the first quarter of 2003, the Company recorded a $3 pre-tax charge to mark the excess contracts to fair value as of May 24, 2003. Market value adjustments in the first quarter of 2002 resulted in pre-tax income of $7. During the first quarter of 2003, the Company made net cash payments totaling $3 to settle the excess commitments for the first quarter of 2003. Details of these liabilities follow:
Net payments for excess purchase commitments
Revaluation (net decrease in liabilities due to changes in forward market prices)
Revaluation (increase in liabilities due to changes in forward market prices)
On July 3, 2003, the Company announced that it had reached an agreement to settle litigation and restructure supply arrangements with a supplier of electricity in California related to these four power supply contracts. Under the terms of the proposed settlement agreement, which must be approved by the Federal Energy Regulatory Commission (“FERC”), the Company will pay a net amount of $110 to settle outstanding litigation at FERC related to prior over-payments, terminate two of the four contracts, and restructure the remaining two agreements. The FERC is expected to rule on the proposed settlement within 60 days of the date of the agreement. The Company estimates that it will incur an after-tax charge of approximately $41 in the second quarter of 2003 as a result of the settlement.
Other items in interest expense
The Company adopted SFAS No. 145 on February 2, 2003. This Statement eliminates the requirement that gains and losses due to the extinguishment of debt be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect. Adoption of SFAS No. 145 required the Company to reclassify the debt extinguishments recorded as extraordinary items in the first quarter of 2002 as interest expense in that period. These debt extinguishments totaled $4 of pre-tax expense.
The Company adopted SFAS No. 142 on February 3, 2002. Accordingly, the Company performed a transitional impairment review of its goodwill. Goodwill totaled $3,594 as of February 3, 2002. The review was performed at the operating division level. Generally, fair value represented a multiple of earnings or discounted projected future cash flows. Impairment was indicated when the carrying value of a division, including goodwill, exceeded its fair value. The Company determined that the carrying value of the jewelry store division, which included $26 of goodwill, exceeded its fair value. Impairment was not indicated for the goodwill associated with the other operating divisions.
The fair value of the jewelry store division was subsequently measured against the fair value of its underlying assets and liabilities, excluding goodwill, to estimate an implied fair value of the division’s goodwill. As a result of this analysis, the Company determined that the jewelry store division goodwill was entirely impaired. Impairment primarily resulted from the recent operating performance of the division and review of the division’s projected future cash flows on a discounted basis, rather than on an undiscounted basis, as was the standard under SFAS No. 121, prior to adoption of SFAS No. 142. Accordingly, the Company recorded a $16 charge, net of a $10 tax benefit, as a cumulative effect of an accounting change in the first quarter of 2002.
8
Comprehensive income is as follows:
Reclassification adjustment for losses included in net earnings, net of tax of $4 in 2003 and $4 in 2002
Unrealized loss on hedging activities, net of tax of $1 in 2003 and $2 in 2002
Comprehensive income
During 2003 and 2002, other comprehensive income consisted of reclassifications of previously deferred losses on cash flow hedges into net earnings as well as market value adjustments to reflect cash flow hedges at fair value as of the respective balance sheet dates.
The effective income tax rate was 37.5% for 2003 and 2002. The effective income tax rate differs from the expected statutory rate primarily because of the effect of state taxes.
Earnings per common share equals net earnings divided by the weighted average number of common shares outstanding, after giving effect to dilutive stock options and warrants.
The following table provides a reconciliation of earnings before the cumulative effect of an accounting change and shares used in calculating basic earnings per share to those used in calculating diluted earnings per share:
First Quarter Ended
May 24, 2003
May 25, 2002
Earnings
(Numer-ator)
Shares
(Denomi-nator)
Basic earnings per common share
Dilutive effect of stock options and warrants
Diluted earnings per common share
The Company had options outstanding for approximately 43 shares and 21 shares during the first quarters of 2003 and 2002, respectively, that were excluded from the computations of diluted earnings per share because their inclusion would have had an anti-dilutive effect on earnings per share.
9
SFAS No. 143, “Asset Retirement Obligations,” was issued by the FASB in August of 2001. This standard addresses obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 became effective for the Company on February 2, 2003. Adoption of this standard did not have a material effect on the Company’s financial statements.
SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections,” was issued by the FASB in April 2002. The Company adopted SFAS No. 145 on February 2, 2003. This Statement eliminates the requirement that gains and losses due to the extinguishment of debt be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect. Adoption of SFAS No. 145 required the Company to reclassify the debt extinguishments recorded as extraordinary items in the first quarter of 2002 as interest expense in that period. These debt extinguishments totaled $4 of pre-tax expense. The provisions of SFAS No. 145 did not have a material effect on the Company’s financial statements.
FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” was issued by the FASB in January of 2003. FIN 46 provides guidance relating to the identification of, and financial reporting for, variable-interest entities, as defined in the Interpretation. FIN 46 is effective for all variable-interest entities created after January 31, 2003. For any variable-interest entities created prior to February 1, 2003, FIN 46 will become effective for the Company on August 17, 2003. The Company is analyzing its structured financing arrangements, joint ventures and partnerships to determine the effect this Interpretation will have on its financial statements. If the Company is required to consolidate any entity, the Company anticipates that such consolidation will not have a material effect on its financial statements.
The Company’s outstanding public debt (the “Guaranteed Notes”) is jointly and severally, fully and unconditionally guaranteed by The Kroger Co. and certain of its subsidiaries (the “Guarantor Subsidiaries”). At May 24, 2003, a total of approximately $6.9 billion of Guaranteed Notes were outstanding. The Guarantor Subsidiaries and non-guarantor subsidiaries are direct or indirect wholly owned subsidiaries of The Kroger Co. Separate financial statements of The Kroger Co. and each of the Guarantor Subsidiaries are not presented because the guarantees are full and unconditional and the Guarantor Subsidiaries are jointly and severally liable. The Company believes that separate financial statements and other disclosures concerning the Guarantor Subsidiaries would not be material to investors.
The non-guaranteeing subsidiaries represent less than 3% on an individual and aggregate basis of consolidated assets, pretax earnings, cash flow, and equity. Therefore, the non-guarantor subsidiaries’ information is not separately presented in the tables below.
There are no current restrictions on the ability of the Guarantor Subsidiaries to make payments under the guarantees referred to above. The obligations of each guarantor under its guarantee are limited to the maximum amount permitted under Bankruptcy Law, the Uniform Fraudulent Conveyance Act, the Uniform Fraudulent Transfer Act, or any similar Federal or state law (e.g. laws requiring adequate capital to pay dividends) respecting fraudulent conveyance or fraudulent transfer.
10
The following tables present summarized financial information as of May 24, 2003, and February 1, 2003, and for the first quarters ended May 24, 2003 and May 25, 2002:
Condensed Consolidating
Balance Sheets
As of May 24, 2003
Net inventories
Fair value interest rate hedges
Investment in and advances to subsidiaries
Total assets
Adjustment to reflect fair value interest rate hedges
Total liabilities
Shareowners’ Equity
Total liabilities and shareowners’ equity
11
As of February 1, 2003
12
Statements of Earnings
For the Quarter Ended May 24, 2003
Merchandise costs, including warehousing and transportation
Merger-related costs, restructuring charges and related items
Operating profit (loss)
Equity in earnings of subsidiaries
Earnings before tax expense
Tax expense (benefit)
For the Quarter Ended May 25, 2002
Earnings before cumulative effect of accounting change
Cumulative effect of accounting change, net of income tax benefit
13
Statements of Cash Flows
Cash flows from investing activities:
Capital expenditures
Cash flows from financing activities:
Net change in advances to subsidiaries
Net cash provided (used) by financing activities
Net (decrease) increase in cash and temporary cash investments
14
Guarantor
Subsidiaries
Net used by financing activities
Net decrease in cash and temporary cash investments
15
The Company continuously evaluates contingencies based upon the best available evidence.
Management believes that allowances for loss have been provided to the extent necessary and that its assessment of contingencies is reasonable. Allowances for loss are included in other current liabilities and other long-term liabilities. To the extent that resolution of contingencies results in amounts that vary from management’s estimates, future earnings will be charged or credited.
The principal contingencies are described below.
Insurance—The Company’s workers’ compensation risks are self-insured in certain states. In addition, other workers’ compensation risks and certain levels of insured general liability risks are based on retrospective premium plans, deductible plans, and self-insured retention plans. The liability for workers’ compensation risks is accounted for on a present value basis. Actual claim settlements and expenses incident thereto may differ from the provisions for loss.
Litigation—The Company is involved in various legal actions arising in the normal course of business. Although occasional adverse decisions (or settlements) may occur, the Company believes that the final disposition of such matters will not have a material adverse effect on the financial position or results of operations of the Company.
Purchase Commitment—The Company indirectly owns a 50% interest in the Santee Dairies, Inc. (“Santee”) and has a product supply arrangement with Santee that requires the Company to purchase 9 gallons of fluid milk and other products annually. The product supply agreement expires in fiscal 2007. Upon Fred Meyer’s acquisition of Ralphs/Food 4 Less, Santee became a duplicate facility. The joint venture is managed independently and has a board composed of an equal number of members from each partner, plus one independent member. When there is a split vote, this member generally votes with the other partner. The other partner has filed suit against the Company claiming, among other things, that the Company is obligated to purchase all of the requirements of fluid milk for its Ralphs and Food 4 Less divisions from Santee as opposed to minimum gallons.
Guarantees—The Company periodically enters into real estate joint ventures in connection with the development of certain properties. The Company usually sells its interests in such partnerships upon completion of the projects. As of May 24, 2003, the Company was a partner with 50% ownership in two real estate joint ventures and guaranteed approximately $8 of debt incurred by the ventures. Based on the covenants underlying this indebtedness as of May 24, 2003, it is unlikely that the Company will be responsible for repayment of these obligations. The Company also has guaranteed approximately $5 of promissory notes of a third real estate partnership. The Company believes that it is reasonably possible that the Company will be required to fund most of this obligation when the notes mature in 2012.
Assignments—The Company is contingently liable for leases that have been assigned to various third parties in connection with facility closings and dispositions. The Company could be required to assume leases if any of the assignees are unable to fulfill their lease obligations. Due to the wide distribution of the Company’s assignments among third parties, and various other remedies available, the Company believes the likelihood that it will be required to assume a material amount of these obligations is remote.
Benefit Plans—The Company administers certain non-contributory defined benefit retirement plans for substantially all non-union employees and some union-represented employees as determined by the terms and conditions of collective bargaining agreements. Funding for the pension plans is based on a review of the specific requirements and on evaluation of the assets and liabilities on each plan.
In addition to providing pension benefits, the Company provides certain health care benefits for retired employees. The majority of the Company’s employees may become eligible for these benefits if they reach retirement age while employed by the Company. Funding for the retiree health care benefits occurs as claims or premiums are paid.
16
The determination of the obligation and expense for the Company’s pension and other post-retirement benefits is dependent on the Company’s selection of assumptions used by actuaries in calculating those amounts. Those assumptions are described in the Company’s fiscal 2002 Annual Report on Form 10-K and include, among others, the discount rate, the expected long-term rate of return on plan assets, and the rates of increase in compensation and health care costs. Actual results that differ from the assumptions generally are accumulated and amortized over future periods and, therefore, generally affect the recognized expense and recorded obligation in such future periods. While the Company believes that the assumptions are appropriate, significant differences in actual experience or significant changes in assumptions may materially affect the pension and other post-retirement obligations and future expense.
Cash contributions to the company-sponsored pension plans are expected to be required in the current and upcoming years. Contribution amounts will be determined by the performance of plan assets as well as by the interest rates required to be used to determine the pension obligations.
The Company also participates in various multi-employer pension plans for substantially all union employees. The Company is required to make contributions to these plans in amounts established under collective bargaining agreements. Pension expense for these plans is recognized as contributions are funded. Benefits are generally based on a fixed amount for each year of service. A decline in the value of assets held by these plans, caused by performance of the investments in the financial markets in recent years, is likely to result in higher contributions to these plans (either by agreement or in order to avoid the imposition of an excise tax) and to create challenges in collective bargaining. Moreover, if the Company were to exit markets, it may be required to pay a potential withdrawal liability if the plans were under-funded at the time of withdrawal. However, the Company is unable to determine the amount of potential liability at this time. Any adjustments for withdrawal liability will be recorded when it is probable that a liability exists and it is determined that markets will be exited.
In the first quarter of 2003, the Company reconfigured a portion of its interest derivative portfolio by terminating six interest rate swap agreements. These six agreements were accounted for as fair value hedges. Approximately $114 of proceeds received as a result of these terminations were recorded as adjustments to the carrying values of the underlying debt and are being amortized over the remaining lives of the debt.
Also in the first quarter of 2003, the Company initiated six new interest rate swap agreements that are being accounted for as fair value hedges. As of May 24, 2003, assets totaling $34 have been recorded to reflect the fair value of these new agreements, offset by liabilities of the same amount to reflect the impact of the changes in interest rates on the fair values of the underlying debt.
On June 26, 2003, the Company’s Board of Directors (“Board”), at its regularly scheduled meeting, announced the implementation of its CEO successor plan:
17
As more fully described in Note 4, on July 3, 2003, the Company announced that it had reached an agreement to settle litigation and restructure supply arrangements with a supplier of electricity in California related to four power supply contracts.
18
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The following analysis should be read in conjunction with the Consolidated Financial Statements.
RESULTS OF OPERATIONS
Total sales for the first quarter of 2003 were $16.3 billion, an increase of 3.8% over total sales of $15.7 billion for the first quarter of 2002. Total food store sales for the first quarter of 2003 were $15.46 billion, an increase of 3.5% over total food store sales of $14.94 billion for the first quarter of 2002. The differences between total sales and total food store sales primarily related to sales at our convenience store and jewelry store divisions, as well as to sales by our manufacturing plants to outside firms.
We define a food store as an identical store in the quarter after the store has been in operation and has not been expanded or relocated for four full quarters. Identical food store sales, as used to calculate the percent change in identical food store sales, were $14.4 billion for the first quarter of 2003. Identical food store sales declined 0.1% in the first quarter of 2003 compared to the first quarter of 2002. We define a food store as a comparable store in the quarter after the store has been in operation for four full quarters, including expansions and relocations. Comparable food store sales, as used to calculate the percent change in comparable food store sales, were $14.9 billion for the first quarter of 2003. Comparable food store sales increased 0.7% in the first quarter of 2003 versus the first quarter of 2002. The differences between total food store sales and identical food store sales were primarily due to the increases in food store square footage discussed below in “Capital Expenditures.”
The increase in the percent of total food store sales attributable to sales at supermarket fuel centers has significantly affected our results. At the end of the first quarter of 2003, we operated 395 supermarket fuel centers compared to 268 supermarket fuel centers at the end of the first quarter of 2002. Excluding sales at supermarket fuel centers, identical food store sales decreased 1.1% in the first quarter of 2003 compared to the first quarter of 2002. On the same basis, comparable food store sales declined 0.5% in the first quarter of 2003 versus the first quarter of 2002.
Sales in the first quarter of 2003 were also affected by product cost deflation in various commodity groups, economic uncertainty, high unemployment, intense competition and the results of our Strategic Growth Plan (“Plan”). For the first quarter of 2003, we estimate that our product costs, including fuel, remained flat compared to our costs in the first quarter of 2002. Excluding fuel, we estimate that Kroger experienced product cost deflation of 0.5% in the first quarter of 2003 versus the year-ago period. We believe the effects of the weak economy and intense competition partially offset the benefits from Kroger’s execution of the Plan in the first quarter of 2003.
Gross Profit
Our gross profit rates were 26.65% and 26.41% in the first quarters of 2003 and 2002, respectively. In each quarter, we recorded a Last-In, First-Out (“LIFO”) charge of $12 million. Excluding these LIFO charges, our First-In, First-Out (“FIFO”) gross profit rates were 26.73%, and 26.49% in the first quarters of 2003 and 2002, respectively. Excluding fuel sales at our convenience stores and supermarkets, our FIFO gross profit rates were 27.60% and 27.07% in the first quarters of 2003 and 2002, respectively. Fuel sales have a negative effect on our overall gross profit rate due to the relatively low gross profit rate on fuel sales.
First quarter, 2002, gross profit results were adversely affected by a $91 million charge for the adoption of the item-cost method of accounting at the former Fred Meyer divisions. This charge reduced the first quarter, 2002 FIFO gross profit rate of our core business (which excludes fuel sales at our convenience stores and supermarkets) by 60 basis points. This charge is described below in “Other Income and Expense Items.”
Without fuel and the effect of the adoption of the item-cost method, our comparable gross profit rate declined in the first quarter of 2003 primarily due to our continued investment in lower retail prices as part of the Plan. The effect of our investment in the Plan was partially offset by decreases in product costs due to consolidated purchasing activities and improved private label sales and manufacturing plant results.
19
Operating, General and Administrative Expenses
Operating, general and administrative (“OG&A”) expenses, which consist primarily of employee related costs such as wages, health care benefit costs and retirement plan costs, as a percent of sales were 18.63% and 18.43% in the first quarters of 2003 and 2002, respectively. Excluding fuel sales at our convenience stores and supermarkets, our OG&A rate increased 49 basis points to 19.32% in the first quarter of 2003 versus 18.83% in the first quarter of 2002. Fuel sales have a positive impact on our overall OG&A expense rate due to the relatively low overhead costs associated with fuel sales. Higher health care benefit, pension and utility costs accounted for approximately 41 of the 49 basis point increase. Other income and expense items recorded as operating, general and administrative expense in the first quarters of 2003 and 2002 further affected our rates. These items are described below in “Other Income and Expense Items.”
Rent Expense
Rent expense, as a percent of sales, was 1.22% and 1.30% in the first quarters of 2003 and 2002, respectively. The decrease in this rate reflects the emphasis our current growth strategy places on ownership of real estate.
Depreciation Expense
Depreciation expense, as a percent of sales, was 2.18% and 2.06% in the first quarters of 2003 and 2002, respectively. The increase in depreciation expense was primarily due to Kroger’s capital investment program and the emphasis on ownership of real estate.
Interest Expense
Interest expense, as a percent of sales, was 1.17% and 1.23% in the first quarters of 2003 and 2002, respectively. As described below in “Other Income and Expense Items,” interest expense for the first quarter of 2002 included the reclassification of debt extinguishments totaling $4 million.
Income Taxes
Our effective income tax rate was 37.5% for the first quarters of 2003 and 2002. The effective income tax rates differ from the expected statutory rate primarily because of the effect of state taxes.
Net Earnings
Net earnings totaled $352 million, or $0.46 per diluted share, in the first quarter of 2003. These results represent an increase of approximately 21.1% over net earnings of $0.38 per diluted share for the first quarter of 2002. First quarter, 2002, earnings before the cumulative effect of an accounting change were $321 million, or $0.40 per diluted share. On this basis, earnings of $0.46 per diluted share for the first quarter of 2003 increased 15.0% over earnings of $0.40 per diluted share the first quarter of 2002. The cumulative effect of the accounting change, as well as other income and expense items that affected Kroger’s financial results during the periods presented, are described below in “Other Income and Expense Items.”
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OTHER INCOME AND EXPENSE ITEMS
The following table summarizes other income and expense items that affected Kroger’s financial results during the periods presented. These items include restructuring charges, merger-related costs and the cumulative effect of an accounting change, all of which are shown separately in the Consolidated Statements of Earnings. The items also include other charges and credits that were recorded as components of merchandise costs, operating, general and administrative expense and interest expense. The items totaled $82 million of after-tax expense in the first quarter of 2002. The items had an immaterial net effect for the first quarter of 2003.
Total in operating, general and administrative expense
Other expense items in interest expense
Total pre-tax expense
Income tax effect
After-tax expense
Cumulative effect of an accounting change, net of tax
Total after-tax expense
Diluted shares
Approximate diluted per share expense:
Before cumulative effect of an accounting change
After cumulative effect of an accounting change
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Items In Merchandise Costs and In Operating, General and Administrative Expense
In 1998, prior to the merger with Fred Meyer, we changed our application of the LIFO method of accounting for certain store inventories from the retail method to the item-cost method. The change improved the accuracy of product cost calculations by eliminating the averaging and estimation inherent in the retail method.
During the fourth quarter of 2002, we adopted the item-cost method for the former Fred Meyer divisions. The cumulative effect of this change on periods prior to February 3, 2002, cannot be determined. The effect of the change on the February 3, 2002 inventory valuation, which includes other immaterial modifications in inventory valuation methods, was included in results for the quarter ended May 25, 2002. This change increased merchandise costs by $91 million and reduced net earnings by $57 million. We did not calculate the pro forma effect on prior periods because cost information for these periods was not determinable. The item-cost method did not have a material effect on earnings subsequent to its adoption on February 3, 2002.
Costs related to mergers included expenses recognized as a consequence of the continued integration of Kroger’s divisions. Integration primarily resulted from the merger with Fred Meyer. These expenses primarily related to severance agreements and enterprise system conversions.
In 2001 and 2000, we recorded pre-tax expenses of $20 million and $67 million, respectively, for the present value of lease liabilities related to store closings. These liabilities were the result of two distinct, formalized plans that coordinated the closings of several locations over relatively short periods of time. The liabilities pertained primarily to stores acquired in the Fred Meyer merger, or to stores operated prior to the merger that were in close proximity to stores acquired in the merger, that were identified as under-performing stores. Therefore, liabilities were recorded for the planned closings of the stores.
Due to operational changes, performance improved at five stores that had not yet closed. As a result of this improved performance, in the first quarter of 2003, management altered their original plans and made a determination that these five locations will remain open. Additionally, closing and exit costs at other locations included in the original plans were less costly than anticipated.
In total, in the first quarter of 2003, we recorded pre-tax income of $10 million to adjust these liabilities to reflect the outstanding lease commitments at the locations remaining under the plans. Sales at the stores remaining under the plans totaled $75 million and $137 million for the rolling four-quarter periods ended May 24, 2003, and May 25, 2002, respectively. Net operating income or loss for these stores cannot be determined on a separately identifiable basis. Refer to Note 4 to the Consolidated Financial Statements for additional details of these liabilities.
During the third quarter of 2001, we recorded a pre-tax charge of $81 million to accrue liabilities for the estimated fair value of energy purchase commitments that provided for supplies in excess of our expected demand for electricity. SFAS No. 133 required the excess commitments to be marked to fair value through current-period earnings each quarter. In first quarter of 2003, we recorded a pre-tax charge of $3 million to mark the excess contracts to fair value as of May 24, 2003. Market value adjustments in the first quarter of 2002 resulted in pre-tax income of $7 million.
On July 3, 2003, Kroger announced that it had reached an agreement to settle litigation and restructure supply arrangements with a supplier of electricity in California related to four power supply contracts. Under the terms of the proposed settlement agreement, which must be approved by the Federal Energy Regulatory Commission (“FERC”), Kroger will pay a net amount of $110 million to settle outstanding litigation at FERC related to prior over-payments, terminate two of the four contracts, and restructure the remaining two agreements. The FERC is expected to rule on the proposed settlement within 60 days of the date of the agreement. Kroger estimates that it will incur an after-tax charge of approximately $41 million, or approximately $0.05 per diluted share, in the second quarter of 2003 as a result of the settlement. Kroger also expects that earnings per diluted share will increase by approximately $0.01 in 2003 and by approximately $0.02 in 2004 as a result of the ability to purchase electricity less expensively after the settlement. The net effect for 2003 is a reduction in earnings per diluted share of approximately $0.05. Refer to Note 4 to the Consolidated Financial Statements for additional details of these liabilities.
Kroger adopted SFAS No. 145 on February 2, 2003. This Statement eliminates the requirement that gains and losses due to the extinguishment of debt be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect. Adoption of SFAS No. 145 required us to reclassify the debt extinguishments recorded as extraordinary items in the first quarter of 2002 as interest expense in that period. These debt extinguishments totaled $4 million of pre-tax expense.
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Restructuring Charges
On December 11, 2001, we outlined our Strategic Growth Plan to support additional investment in core business to increase sales and market share. Restructuring charges related to the Plan totaled $13 million, pre-tax, in the first quarter of 2002. The majority of these expenses related to severance agreements, distribution center consolidation and conversion costs. No restructuring charges were incurred in 2003. Refer to Note 3 to the Consolidated Financial Statements for additional details of these charges.
Merger-Related Costs
In the first quarter of 2002, we recorded pre-tax, merger-related costs of $2 million for the issuance of restricted stock and the related market value adjustments. Restrictions on the stock awards lapsed in the second quarter of 2002 based on the achievement of synergy goals established in connection with the Fred Meyer merger. All synergy-based awards were earned provided that recipients were still employed by Kroger on the stated restriction lapsing date. No such costs were recorded in 2003.
Cumulative Effect of an Accounting Change
We adopted SFAS No. 142 on February 3, 2002. The transitional impairment review required by SFAS No. 142 resulted in a $26 million pre-tax non-cash loss to write-off the jewelry store division goodwill based on its implied fair value. Impairment primarily resulted from the recent operating performance of the division and review of the division’s projected future cash flows on a discounted basis, rather than on an undiscounted basis, as was the standard under SFAS No. 121, prior to adoption of SFAS No. 142. This loss was recorded as a cumulative effect of an accounting change, net of a $10 million tax benefit, in the first quarter of 2002. For further details of this charge, refer to Note 5 to the Consolidated Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flow Information
We generated $933 million of cash from operating activities during the first quarter of 2003 compared to $1.2 billion during the first quarter of 2002. This decrease in cash was due to a $142 million reduction of operating assets and liabilities realized during the first quarter of 2003 versus the $446 million reduction we realized during same period of 2002.
Investing activities used $656 million of cash during the first quarter of 2003 compared to $661 million in the first quarter of 2002. Due to decreased capital spending, including acquisitions, offset by decreases in the proceeds from the sale of assets, the amount of cash used by investing activities in 2003 was approximately equal to the amount used in 2002.
Financing activities used $292 million of cash in the first quarter of 2003 compared to $560 million in the first quarter of 2002. In the first quarter of 2003, we used approximately $336 million of cash to reduce outstanding debt versus a net $432 million of cash used in the first quarter of 2002. The decrease in the use of cash was also due to proceeds received in the first quarter of 2003 for the termination of six interest rate swap agreements.
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Debt Management
We had several lines of credit with borrowing capacity totaling approximately $2.5 billion at May 24, 2003. Outstanding credit agreement and commercial paper borrowings, and some outstanding letters of credit, reduce funds available under our lines of credit. In addition, we had a $75 million money market line, borrowings under which also reduce the funds available under our lines of credit. At May 24, 2003, our outstanding credit agreement and commercial paper borrowings totaled $32 million. We had no borrowings under the money market line at May 24, 2003. The outstanding letters of credit that reduced the funds available under our lines of credit totaled $309 million.
Our bank credit facilities and the indentures underlying our publicly issued debt contain various restrictive covenants. As of May 24, 2003, we were in compliance with these financial covenants. Furthermore, management believes it is not reasonably likely that Kroger will fail to comply with these financial covenants in the foreseeable future.
At February 1, 2003, we were a party to a financing transaction related to 16 properties that were constructed for total costs of approximately $202 million. Under the terms of the financing transaction, which was structured as a synthetic lease, a special purpose trust owned the properties and leased them to subsidiaries of Kroger. The lease had a term of five years, which expired on February 28, 2003. The owner of the special purpose trust made a substantive residual equity investment. The transaction, therefore, was accounted for as an operating lease and the related costs were reported as rent expense. Kroger purchased the assets for total costs of $202 million when the lease expired.
Total debt, including both the current and long-term portions of capital leases, decreased $153 million to $8.3 billion as of the end of the first quarter of 2003, from $8.4 billion as of the end of the first quarter of 2002. Total debt decreased $303 million as of the end of the first quarter of 2003 from $8.6 billion as of year-end 2002. The decreases in 2003 resulted from the use of cash flow from operations to reduce outstanding debt.
We purchased a portion of the debt issued by the lenders of some of our structured financings in an effort to reduce our effective interest expense. We also had prefunded employee benefit costs of $98 million at the end of the first quarter of 2003, $61 million at the end of the first quarter of 2002 and $300 million at year-end 2002. Additionally, the mark-to-market adjustments necessary to record fair value interest rate hedges of our fixed rate debt increased the carrying value of our debt by $143 million as of the end of the first quarter of 2003, $8 million as of the end of the first quarter of 2002, and $110 million as of year-end 2002. If we exclude the debt incurred to make the structured financing purchases, which we classify as investments, and the prefunding of employee benefits, and also exclude the SFAS No. 133 mark-to-market adjustments, our net total debt (which includes capital leases) would have been $8.0 billion as of the end of the first quarter of 2003 compared to $8.3 billion as of the end of the first quarter of 2002 and $8.1 billion as of year-end 2002. We believe net total debt is an important measure of our leverage due to the nature of the items described above. Therefore, we believe net total debt should be reviewed in addition to total debt. We do not intend the presentation of net total debt to be an alternative to total debt or to any generally accepted accounting principle measure of liquidity. A reconciliation of net total debt is illustrated below:
Total Debt, including capital leases
Mark-to-market adjustments
Investments in debt securities
Prefunded employee benefits (VEBA)
Net Total Debt, including capital leases
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Common Stock Repurchase Program
During the first quarter of 2003, we invested $134 million to repurchase 9.6 million shares of Kroger stock at an average price of $13.98 per share. These shares were reacquired under two separate stock repurchase programs. The first is a $500 million repurchase program that was authorized by Kroger’s Board of Directors in December of 2002. The second is a program that uses the cash proceeds from the exercises of stock options by participants in Kroger’s stock option and long-term incentive plans as well as the associated tax benefits. In the first quarter of 2003, we purchased 8.9 million shares under our $500 million stock repurchase program and we purchased an additional 0.7 million shares under our program to repurchase common stock funded by the proceeds and tax benefits from stock option exercises. At May 24, 2003, we had $313 million remaining under the $500 million authorization. At current prices, Kroger continues to repurchase shares.
The Board of Directors evaluates Kroger’s dividend policy on a regular basis. The goal of this policy is to maximize shareholder value. Currently, Kroger believes that goal can best be achieved by repurchasing stock.
CAPITAL EXPENDITURES
Capital expenditures excluding acquisitions totaled $664 million for the first quarter of 2003 compared to $609 million for the first quarter of 2002. Including acquisitions, capital expenditures totaled $670 million in the first quarter of 2003 compared to $718 million in the first quarter of 2002. Expenditures in 2003 and 2002 include purchases of assets totaling $202 million and $192 million, respectively, which were previously financed under a synthetic lease.
During the first quarter of 2003, we opened, acquired, expanded or relocated 23 food stores. We had 5 operational food store closings and completed 39 within-the-wall remodels. In total, we operated 2,496 food stores at the end of the first quarter of 2003 versus 2,429 food stores in operation at the end of the first quarter of 2002. Total food store square footage increased 4.1% over the first quarter of 2002. We also operated 792 convenience stores, 445 fine jewelry stores, 395 supermarket fuel centers and 41 manufacturing plants at the end of the first quarter of 2003.
OTHER ISSUES
On June 26, 2003, Kroger’s Board of Directors (“Board”), at its regularly scheduled meeting, announced the implementation of its CEO successor plan:
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We indirectly own a 50% interest in the Santee Dairy (“Santee”) and have a product supply arrangement with Santee that requires us to purchase 9 million gallons of fluid milk and other products annually. The product supply agreement expires in fiscal 2007. Upon acquisition of Ralphs/Food 4 Less, Santee became a duplicate facility. The joint venture is managed independently and has a board composed of an equal number of members from each partner, plus one independent member. When there is a split vote, this member generally votes with the other partner. The other partner has filed suit against Kroger claiming, among other things, that Kroger is obligated to purchase all of the requirements of fluid milk for its Ralph’s and Food 4 Less divisions from Santee as opposed to minimum gallons.
We have several major UFCW contracts that will expire in 2003: Peoria, Illinois; Portland, Oregon; Memphis, Tennessee; Charleston, West Virginia; Indianapolis, Indiana; Arizona and Ralphs in Southern California. We also have several other smaller contracts that will expire in 2003. In all of these contracts, rising health care and pension costs will continue to be an important issue in negotiations. We cannot be certain that agreements will be reached without work stoppage. A prolonged work stoppage affecting a substantial number of stores could have a material effect on the results of our operations.
SFAS No. 143, “Asset Retirement Obligations,” was issued by the FASB in August of 2001. This standard addresses obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. SFAS No. 143 became effective for Kroger on February 2, 2003. Adoption of this standard did not have a material effect on our financial statements.
SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections,” was issued by the FASB in April 2002. Kroger adopted SFAS No. 145 on February 2, 2003. This Statement eliminates the requirement that gains and losses due to the extinguishment of debt be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect. Adoption of SFAS No. 145 required Kroger to reclassify the debt extinguishments recorded as extraordinary items in the first quarter of 2002 as interest expense in that period. These debt extinguishments totaled $4 million of pre-tax expense. The provisions of SFAS No. 145 did not have a material effect on our financial statements.
FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” was issued by the FASB in January of 2003. FIN 46 provides guidance relating to the identification of, and financial reporting for, variable-interest entities, as defined in the Interpretation. FIN 46 is effective for all variable-interest entities created after January 31, 2003. For any variable-interest entities created prior to February 1, 2003, FIN 46 will become effective for Kroger on August 17, 2003. We are analyzing our structured financing arrangements, joint ventures and partnerships to determine the effect this Interpretation will have on our financial statements. If we are required to consolidate any entity, we anticipate that such consolidation will not have a material effect on our financial statements.
OUTLOOK
This analysis contains certain forward-looking statements about Kroger’s future performance. These statements are based on management’s assumptions and beliefs in light of the information currently available. Such statements relate to, among other things: projected growth in earnings per share (“EPS”); working capital reduction; our ability to generate operating cash flow; and our Strategic Growth Plan (“Plan”), and are indicated by words or phrases such as “comfortable,” “committed,” “expects,” “goal,” “target,” and similar words or phrases. These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially.
Statements elsewhere in this report and below regarding our expectations, projections, beliefs, intentions or strategies are forward-looking statements within the meaning of Section 21 E of the Securities Exchange Act of 1934. While we believe that the statements are accurate, uncertainties about the general economy, our labor relations, our ability to execute our plans on a timely basis and other uncertainties described below could cause actual results to differ materially from those statements.
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Our identical food store sales, including supermarket fuel centers, declined 0.1% in the first quarter of 2003 compared to the first quarter of 2002. We believe the effects of the weak economy and intense competition partially offset the benefits from of Kroger’s execution of the Plan in the first quarter of 2003. Our sales results are further described above in “Results of Operations.”
We believe the continued enhancement of the Plan will improve our competitive position. We have identified additional opportunities to reduce costs and operate more efficiently. For example, in March of 2003, we announced the combining of two retail divisions headquartered in Livonia, Michigan, and Columbus, Ohio.
In March of 2003, we estimated that earnings for 2003 would be $1.63 per diluted share. This guidance had included a projected gross profit margin increase of 20 to 30 basis points to cover a portion of our increases in health care benefit, pension and utility costs. Competitive conditions, thus far, have prevented us from increasing gross profit margin as we had anticipated. As a result, we now estimate that earnings will be $1.55 to $1.63 per diluted share. This estimate includes approximately $0.02 of expense per share for systems conversions and the consolidation of the Michigan and Columbus divisions. The effect of the proposed settlement agreement related to the four energy purchase commitments described above in “Other Income and Expense Items” is not considered in this EPS estimate because the agreement is still subject to FERC approval. We expect our identical food store sales, including fuel, to be positive for fiscal 2003. At this time, we are not providing sales or earnings guidance beyond fiscal 2003.
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At the end of the first quarter of 2003, comparative net operating working capital decreased $47 million compared to the end of the first quarter of 2002 but increased $28 million compared to year-end 2002. We expect to reduce net operating working capital by $100 million in 2003. A reconciliation of net operating working capital is shown below:
Less: current liabilities
Working capital
Addback (subtract):
LIFO reserve
Current portion of long-term debt, including capital leases
Net current accrued/deferred income tax (assets) liabilities
Property held for sale
Prefunded employee benefits
Net operating working capital
Item-cost comparative adjustment (1)
EITF 02-16 comparative adjustment (1)
Comparative net operating working capital
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Various uncertainties and other factors could cause us to fail to achieve our goals. These include:
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Other factors and assumptions not identified above could also cause actual results to differ materially from those set forth in the forward-looking information. Accordingly, actual events and results may vary significantly from those included in or contemplated or implied by forward-looking statements made by us or our representatives.
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ITEM 3. Quantitative and Qualitative Disclosures About Market Risk.
As described in Item 7A. Quantitative and Qualitative Disclosures About Market Risk on our Form 10-K filed with the SEC on May 2, 2003, we recorded a pre-tax loss of $81 million in the third quarter of 2001 to accrue liabilities for the estimated fair values of energy contracts that no longer qualified for the normal purchases and normal sales exception. As described in Note 4 to the Consolidated Financial Statements and in “Management’s Discussion of Financial Condition and Results of Operations—Other Income and Expense Items,” on July 3, 2003, we announced that we had reached an agreement to settle litigation and restructure supply arrangements with a supplier of electricity in California related to four power supply contracts. Under the terms of the proposed settlement agreement, which must be approved by the Federal Energy Regulatory Commission (“FERC”), Kroger will pay a net amount of $110 million to settle outstanding litigation at FERC related to prior over-payments, terminate two of the four contracts, and restructure the remaining two agreements. The FERC is expected to rule on the proposed settlement within 60 days of the date of the agreement. Kroger estimates that it will incur an after-tax charge of approximately $41 million, or approximately $0.05 per diluted share, in the second quarter of 2003 as a result of the settlement. Kroger also expects that earnings per diluted share will increase by approximately $0.01 in 2003 and by approximately $0.02 in 2004 as a result of the ability to purchase electricity less expensively after the settlement. The net effect for 2003 is a reduction in earnings per diluted share of approximately $0.05.
There have been no other significant changes in our exposure to market risk from the information provided in Item 7A. Quantitative and Qualitative Disclosures About Market Risk on our Form 10-K filed with the SEC on May 2, 2003.
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ITEM 4. Controls and Procedures.
As of July 1, 2003, the Chief Executive Officer and the Chief Financial Officer, together with a disclosure review committee appointed by the Chief Executive Officer, evaluated Kroger’s disclosure controls and procedures. Based on that evaluation, Kroger’s Chief Executive Officer and Chief Financial Officer concluded that Kroger’s disclosure controls and procedures were effective as of July 1, 2003.
There have been no significant changes in Kroger’s internal controls or in other factors that could significantly affect these controls subsequent to July 1, 2003.
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PART II—OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K.
EXHIBIT 4.1—Instruments defining the rights of holders of long-term debt of the Company and its subsidiaries are not filed as Exhibits because the amount of debt under each instrument is less than 10% of the consolidated assets of the Company. The Company undertakes to file these instruments with the Commission upon request.
EXHIBIT 99.1—Additional Exhibits—Statement of Computation of Ratio of Earnings to Fixed Charges.
EXHIBIT 99.2—Additional Exhibits—Section 906 Certification.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Dated: July 8, 2003
By:
/s/ DAVID B. DILLON
David B. Dillon
Chief Executive Officer
/s/ J. MICHAEL SCHLOTMAN
J. Michael Schlotman
Senior Vice President and
Chief Financial Officer
CERTIFICATIONS
I, David B. Dillon, certify that:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
Date: July 7, 2003
(David B. Dillon)
(principal executive officer)
I, J. Michael Schlotman, certify that:
(J. Michael Schlotman)
(principal financial officer)
Exhibit Index