UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended August 13, 2005
OR
For the transition period from to
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)
(I.R.S. Employer
Identification No.)
1014 Vine Street, Cincinnati, OH 45202
(Address of principal executive offices)
(Zip Code)
(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 ¨.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x.
There were 724,866,659 shares of Common Stock ($1 par value) outstanding as of September 16, 2005.
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in millions, except per share amounts)
(unaudited)
August 13,
2005
2004
August 14,
Sales
Merchandise costs, including advertising, warehousing, and transportation, excluding items shown separately below
Operating, general and administrative
Rent
Depreciation and amortization
Operating Profit
Interest expense
Earnings before income tax expense
Income tax expense
Net earnings
Net earnings per basic common share
Average number of common shares used in basic calculation
Net earnings per diluted common share
Average number of common shares used in diluted calculation
The accompanying notes are an integral part of the Consolidated Financial Statements.
CONSOLIDATED BALANCE SHEETS
ASSETS
Current assets
Cash – In stores
Cash – Temporary cash investments
Total Cash
Deposits in-transit
Receivables
Receivables - Taxes
FIFO Inventory
LIFO Credit
Prefunded employee benefits
Prepaid and other current assets
Total current assets
Property, plant and equipment, net
Goodwill
Other assets and investments
Total Assets
LIABILITIES
Current liabilities
Current portion of long-term debt, at face value, including obligations under capital leases and financing obligations
Accounts payable
Accrued salaries and wages
Deferred income taxes
Other current liabilities
Total current liabilities
Long-term debt including obligations under capital leases and financing obligations:
Long-term debt, at face value, including obligations under capital leases and financing obligations
Adjustment to reflect fair value interest rate hedges (Note 11)
Long-term debt including obligations under capital leases and financing obligations
Other long-term liabilities
Total Liabilities
Commitments and Contingencies (Note 10)
SHAREOWNERS’ EQUITY
Preferred stock, $100 par, 5 shares authorized and unissued
Common stock, $1 par, 1,000 shares authorized: 924 shares issued in 2005 and 918 shares issued in 2004
Additional paid-in capital
Accumulated other comprehensive loss
Accumulated earnings
Common stock in treasury, at cost, 201 shares in 2005 and 190 shares in 2004
Total Shareowners’ Equity
Total Liabilities and Shareowners’ Equity
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions and unaudited)
Cash Flows From Operating Activities:
Adjustments to reconcile net earnings to net cash provided by operating activities:
LIFO charge
Other
Changes in operating assets and liabilities net of effects from acquisitions of businesses:
Inventories
Prepaid expenses
Accrued expenses
Accrued income taxes
Contribution to company-sponsored pension plans
Long-term liabilities
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
Payments on long-term debt
Borrowings (payments) on bank revolver
Financing charges incurred
Increase (decrease) in book overdrafts
Proceeds from issuance of capital stock
Treasury stock purchases
Net cash used by financing activities
Net decrease in cash and temporary cash investments
Cash and temporary cash investments:
Beginning of year
End of quarter
Supplemental disclosure of cash flow information:
Cash paid during the year for interest
Cash paid (refunded) during the year for income taxes
Non-cash changes related to purchase acquisitions:
Fair value of assets acquired
Goodwill recorded
Liabilities assumed
NOTES TO CONSOLIDATED FINANCIALSTATEMENTS
All amounts are in millions except per share amounts.
Certain prior-year amounts have been reclassified to conform to current-year presentation.
1. ACCOUNTINGPOLICIES
Basis of Presentation and Principles of Consolidation
The accompanying financial statements include the consolidated accounts of The Kroger Co. and its subsidiaries. The January 29, 2005 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 2004 Annual Report on Form 10-K of The Kroger Co. filed with the SEC on April 15, 2005, as amended.
The unaudited information included in the Consolidated Financial Statements for the second quarter and two quarters ended August 13, 2005 and August 14, 2004 include the results of operations of the Company for the 12-week and 28-week periods then ended.
Vendor Allowances
The Company recognizes all vendor allowances as a reduction in merchandise costs when the related product is sold. In most cases, vendor allowances are applied to the related product by item, and therefore reduce the carrying value of inventory by item. When it is not practicable to allocate vendor allowances to the product by item, vendor allowances are recognized as a reduction in merchandise costs based on inventory turns and recognized as the product is sold.
Store Closing and Other Expense Allowances
All closed store liabilities related to exit or disposal activities initiated after December 31, 2002, are accounted for in accordance with Statement on Financial Accounting Standards (“SFAS”) No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The Company provides for closed store liabilities relating to the present value of the estimated remaining noncancellable lease payments after the closing date, net of estimated subtenant income. The Company estimates the net lease liabilities using a discount rate to calculate the present value of the remaining net rent payments on closed stores. The closed store lease liabilities usually are paid over the lease terms associated with the closed stores, which generally have remaining terms ranging from one to 20 years. Adjustments to closed store liabilities primarily relate to changes in subtenant income and lease buyouts. Adjustments are made for changes in estimates in the period in which the change becomes known. Store closing liabilities are reviewed quarterly to ensure that any accrued amount that is not a sufficient estimate of future costs, or that no longer is needed for its originally intended purpose, is adjusted to income in the proper period.
Owned stores held for disposal are reduced to their estimated net realizable value. Costs to reduce the carrying values of property, equipment and leasehold improvements are accounted for in accordance with the Company’s policy on impairment of long-lived assets. Inventory write-downs, if any, in connection with store closings, are classified in “Merchandise costs.” Costs to transfer inventory and equipment from closed stores are expensed as incurred.
The following table summarizes accrual activity for future lease obligations of stores closed in the normal course of business.
Balance at beginning of year
Additions
Payments
Adjustments
Balance at end of Second Quarter
In addition, the Company also maintains a $56 liability for facility closure costs for locations closed in California prior to the Fred Meyer merger, a $14 liability relating to a charitable contribution required as a result of the Fred Meyer merger and a $11 liability for store closing costs related to two distinct, formalized plans that coordinated the closing of several locations over relatively short periods of time in 2000 and 2001.
2. 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 $1 and $2, after-tax, for the second quarter of 2005 and 2004, respectively. Restricted stock expense totaled $3 and $5, after-tax, for the first two quarters of 2005 and 2004, respectively. The Company’s stock option plans are more fully described in the Company’s fiscal 2004 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 SFAS No. 123, “Accounting for Stock-Based Compensation.”
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
Net earnings per diluted common share, as reported
Pro forma earnings per diluted common share
To calculate pro forma stock-based compensation, the Company estimated the fair value of each option grant, on the date of the grant, using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 2005 and 2004.
Weighted average expected volatility (based on historical volatility)
Weighted average risk-free interest rate
Expected term (based on historical results)
The weighted average fair value of options granted during 2005 and 2004 was $7.64 per share granted and $7.91 per share granted, respectively. The Company uses a risk-free interest rate based upon the yield of a treasury note maturing at a date that approximates the option’s expected term.
3. DEBT OBLIGATIONS
Long-term debt consists of:
January 29,
Credit Facility and Commercial Paper borrowings
4.95% to 8.92% Senior Notes and Debentures due through 2031
5.00% to 10.23% mortgages due in varying amounts through 2017
Total debt, excluding capital leases and financing obligations
Less current portion
Total long-term debt, excluding capital leases and financing obligations
4. COMPREHENSIVEINCOME
Comprehensive income is as follows:
Unrealized gain (loss) on hedging activities, net of tax(1)
Comprehensive income
During 2005, 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.
5. BENEFIT PLANS
The following table provides the components of net periodic benefit costs for the Company-sponsored pension plans and other post-retirement benefits for the second quarter of 2005 and 2004.
Components of net periodic benefit cost:
Service cost
Interest cost
Expected return on plan assets
Amortization of:
Transition asset
Prior service cost
Actuarial (gain) loss
Net periodic benefit cost
The following table provides the components of net periodic benefit costs for the Company-sponsored pension plans and other post-retirement benefits for the first two quarters of 2005 and 2004:
In addition to the $107 contributed to the Company-sponsored pension plans in the first two quarters of 2005, the Company is required to make cash contributions totaling $36 during the balance of fiscal 2005. The Company may elect to make additional contributions during 2005 in order to maintain its desired funding status, as described in Note 12, Subsequent Events.
The Company also contributes to various multi-employer pension plans based on obligations arising from most of its collective bargaining agreements. These plans provide retirement benefits to participants based on their service to contributing employers. The Company recognizes expense in connection with these plans as contributions are funded, in accordance with GAAP.
6. INCOME TAXES
The effective income tax rate was 36.5% for the first two quarters of 2005 and 37.3% for the first two quarters of 2004. In addition to the effect of state taxes, the effective income tax rate differed from the federal statutory rate due to a reduction of previously recorded tax contingency allowances resulting from a revision of the required allowances based on resolutions with tax authorities during the quarters.
7. EARNINGS PER COMMON SHARE
Earnings per basic common share equals net earnings divided by the weighted average number of common shares outstanding. Earnings per diluted common share equals net earnings divided by the weighted average number of common shares outstanding, after giving effect to dilutive stock options, restricted stock and warrants.
The following table provides a reconciliation of earnings before the cumulative effect of an accounting change and shares used in calculating earnings per basic common share to those used in calculating earnings per diluted common share:
Second Quarter Ended
August 13, 2005
August 14, 2004
Shares
(Denominator)
Earnings per basic common share
Dilutive effect of stock options and warrants
Earnings per diluted common share
Two Quarters Ended
The Company had options outstanding for approximately 24 shares and 33 shares during the second quarters of 2005 and 2004, respectively, that were excluded from the computations of earnings per diluted common share because their inclusion would have had an anti-dilutive effect on earnings per share. For the first two quarters of 2005 and 2004, the Company had options outstanding for approximately 26 and 30 shares, 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.
8. RECENTLY ISSUED ACCOUNTING STANDARDS
In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS No. 123R”), which replaces SFAS No. 123, supersedes APB No. 25 and related interpretations and amends SFAS No. 95 “Statement of Cash Flows.” The provisions of SFAS No. 123R are similar to those of SFAS No. 123; however, SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements as compensation cost based on their fair value on the date of grant. Fair value of share-based awards will be determined using option pricing models (e.g. Black-Scholes or binomial models) and assumptions that appropriately reflect the specific circumstances of the awards.
Prior to the adoption of SFAS No. 123R, the Company is accounting for share-based compensation expense under the recognition and measurement provisions of APB No. 25, “Accounting for Stock Issued to Employees” and is following the accepted practice of recognizing share-based compensation expense over the explicit vesting period. SFAS No. 123R will require the immediate recognition at the grant date of the full share-based compensation expense for grants to retirement eligible employees, as the explicit vesting period is non-substantive. The estimated effect of applying the explicit vesting period approach versus the non-substantive approach is not material to any period presented. The Company expects to adopt SFAS No. 123R in the first quarter of fiscal 2006 and expects the adoption to reduce net earnings by $0.04-$0.06 per diluted share during fiscal 2006.
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43 Chapter 4” which clarifies that inventory costs that are “abnormal” are required to be charged to expense as incurred as opposed to being capitalized into inventory as a product cost. SFAS No. 151 provides examples of “abnormal” costs to include costs of idle facilities, excess freight and handling costs and spoilage. SFAS No. 151 will become effective for the Company’s fiscal year beginning January 29, 2006. The adoption of SFAS No. 151 is not expected to have a material effect on the Company’s Consolidated Financial Statements.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 requires retrospective application to prior periods financial statements for changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 also requires that retrospective application of a change in accounting principle be limited to the direct effects of the change. Indirect effects of a change in accounting principle should be recognized in the period of the accounting change. SFAS No. 154 further requires a change in depreciation, amortization or depletion method for long-lived, non-financial assets to be accounted for as a change in accounting estimate effected by a change in accounting principle. SFAS No. 154 will become effective for the Company’s fiscal year beginning January 29, 2006.
FASB Interpretation No. 47 (“FIN 47”) “Accounting for Conditional Asset Retirement Obligations” was issued by the FASB in March 2005. FIN 47 provides guidance relating to the identification of and financial reporting for legal obligations to perform an asset retirement activity. The Interpretation requires recognition of a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. FIN 47 is effective no later than the end of fiscal years ending after December 15, 2005. The adoption of FIN 47 is not expected to have a material effect on the Company’s Consolidated Financial Statements.
In June 2005, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 05-6, “Determining the Amortization Period for Leasehold Improvements Purchased After Lease Inception or Acquired in a Business Combination.” EITF No. 05-6 requires that leasehold improvements acquired in a business combination be amortized over the shorter of the useful life of the assets or a term that includes required lease periods and renewals deemed to be reasonably assured at the date of acquisition. EITF No. 05-6 further requires that leasehold improvements that are placed into service significantly after and not contemplated at or near the beginning of the lease term shall be amortized over the shorter of the useful life of the assets or a term that includes the required lease periods and renewals deemed to be reasonably assured at the date of acquisition. EITF No. 05-6 became effective for the Company’s fiscal quarter beginning August 14, 2005. The adoption of EITF No. 05-6 is not expected to have a material effect on the Company’s Consolidated Financial Statements.
9. GUARANTOR SUBSIDIARIES
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 August 13, 2005, a total of approximately $6.3 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 represented less than 3% on an individual and aggregate basis of consolidated assets, pre-tax 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.
The following tables present summarized financial information as of August 13, 2005, and January 29, 2005, and for the second quarters ended, and the two quarters ended, August 13, 2005 and August 14, 2004:
Condensed Consolidating
Balance Sheets
As of August 13, 2005
Cash, including temporary cash investments
Accounts receivable
Net inventories
Investment in and advances to subsidiaries
Total assets
Current portion of long-term debt including obligations under capital leases and financing obligations
Face value long-term debt including obligations under capital leases and financing obligations
Adjustment to reflect fair value interest rate hedges
Total liabilities
Shareowners’ Equity
Total liabilities and shareowners’ equity
As of January 29, 2005
Statements of Operations
For the Quarter Ended August 13, 2005
Merchandise costs, including warehousing and transportation
Operating profit
Equity in earnings of subsidiaries
Earnings (loss) before income tax expense
Income tax expense (benefit)
For the Quarter Ended August 14, 2004
Operating profit (loss)
For the Two Quarters Ended August 13, 2005
For the Two Quarters Ended August 14, 2004
Statements of Cash Flows
Cash flows from investing activities:
Cash flows from financing activities:
Payments on bank revolver
Net change in advances to subsidiaries
Net increase (decrease) in cash
Cash:
Borrowings on bank revolver
Net decrease in cash
10. COMMITMENTS AND CONTINGENCIES
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. The liability for general liability risks is not present-valued. Actual claim settlements and expenses incident thereto may differ from the provisions for loss.
Litigation — On September 8, 2005, the Los Angeles City Attorney’s office filed a misdemeanor complaint against a subsidiary of the Company, Ralphs Grocery Company (People v. Ralphs Grocery Company, Superior Court of California, County of Los Angeles, Case No. 5CR02616) regarding alleged violations of the California Water Code. Ralphs operates a system at one store location to treat groundwater within an underground basement because of the presence of naturally occurring petroleum associated with the nearby La Brea tar pits, which system is subject to a discharge permit issued by the California Regional Water Quality Control Board (“Board”). The misdemeanor complaint alleges that Ralphs violated California Water Code Section 13387(a)(2) in connection with its obligations under the permit. Ralphs Grocery Company has been advised that the Los Angeles City Attorney’s office also intends to file a civil complaint against Ralphs in the Superior Court of California, City of Los Angeles, under California Business and Professions Code Section 17200, alleging other violations of the same discharge permit. The Company does not expect that the ultimate resolution of these matters by either settlement or litigation will have a material effect on the Company’s financial condition, results of operations or cash flows.
On March 30, 2005, the United States District Court for the Northern District of Illinois rendered a decision in an action (Central States, Southeast and Southwest Areas Pension Fund et al. v. The Kroger Co.) alleging that the Company has failed to make contributions to a multi-employer pension fund in connection with certain employees the Company had viewed as exempt from the contribution requirement. The Court’s decision was adverse to the Company’s position, resulting in an order that would require payments of approximately $13 million. A related decision, also adverse to the Company, was appealed to the United States Court of Appeals for the Seventh Circuit. On July 26, 2005, the Company resolved both of these actions through execution of a settlement agreement.
Various claims and lawsuits arising in the normal course of business, including suits charging violations of certain antitrust and civil rights laws, are pending against the Company. Some of these purport or have been determined to be class actions and/or seek substantial damages. Any damages that may be awarded in an antitrust case will be automatically trebled. Although it is not possible at this time to evaluate the merits of all these claims and lawsuits, nor their likelihood of success, the Company is of the belief that any resulting liability will not have a material adverse effect on the Company’s financial position.
The Company continually evaluates its exposure to loss contingencies arising from pending or threatened litigation and believes it has made adequate provisions therefore. Nonetheless, assessing and predicting the outcomes of these matters involves substantial uncertainties. It remains possible that despite management’s current belief, material differences in actual outcomes or changes in management’s evaluation or predictions could arise that could have a material adverse effect on the Company’s financial condition or results of operation.
Guarantees – The Company periodically enters into real estate joint ventures in connection with the development of certain properties. The Company usually sells its interest in such partnerships upon completion of the projects. As of August 13, 2005, the Company was a partner with 50% ownership in two real estate joint ventures for which it has guaranteed approximately $7 of debt incurred by the ventures. Based on the covenants underlying this indebtedness as of August 13, 2005, it is unlikely that the Company will be responsible for repayment of these obligations.
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 satisfy obligations under 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 satisfy 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 an evaluation of the assets and liabilities of each plan.
In addition to providing pension benefits, the Company provides certain health care benefits for retired employees. Funding for the retiree health care benefits occurs as claims or premiums are paid.
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 2004 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 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.
In addition to the $107 contributed to Company-sponsored pension plans in the first two quarters of 2005, the Company is required to make cash contributions totaling $36 during the balance of fiscal 2005. The Company may elect to make additional contributions during 2005 in order to maintain its desired funding levels, as described in Note 12, Subsequent Events. Among other things, investment performance of plan assets, the interest rates required to be used to calculate pension obligations and future changes in legislation will determine the amounts of any additional contributions.
The Company also contributes to various multi-employer pension plans based on obligations arising from most of its collective bargaining agreements. These plans provide retirement benefits to participants based on their service to contributing employers. The benefits are paid from assets held in trust for that purpose. Trustees are appointed in equal number by employers and unions. The trustees typically are responsible for determining the level of benefits to be provided to participants as well as for such matters as the investment of the assets and the administration of the plans.
Based on the most recent information available to it, the Company believes that the present value of actuarial accrued liabilities in most or all of these multi-employer plans substantially exceeds the value of the assets held in trust to pay benefits. Because the Company is only one of a number of employers contributing to these plans, it is difficult to ascertain what the Company’s “share” of the underfunding would be, although we anticipate the Company’s contributions to these plans will increase each year. Although underfunding can result in the imposition of excise taxes on contributing employers, increased contributions can reduce underfunding so that excise taxes are not triggered. Moreover, if the Company were to exit certain markets or otherwise cease making contributions to these funds, the Company could trigger a substantial withdrawal liability. Any adjustment for withdrawal liability will be recorded when it is probable that a liability exists and can be reasonably determined, in accordance with GAAP.
11. FAIR VALUE INTEREST RATE HEDGES
In 2003, the Company reconfigured a portion of its interest derivative portfolio by terminating six interest rate swap agreements that 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. As of August 13, 2005, the unamortized balances totaled approximately $71.
At the end of the second quarter of 2005, the Company maintained 10 interest rate swap agreements that are being accounted for as fair value hedges. As of August 13, 2005, liabilities totaling $25 have been recorded to reflect the fair value of these new agreements, offset by reductions in the fair value of the underlying debt.
12. SUBSEQUENT EVENTS
On September 14, 2005, the Company made a cash contribution totaling $140 to its Company-sponsored pension plans, of which $36 was required. The Company expects the additional $104 contribution will reduce its minimum required contributions in future years.
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.
OVERVIEW
Second quarter total sales increased 6.8% and identical supermarket sales (as defined below) increased 5.1% with fuel and 3.4% without fuel. This growth continues a very good trend and was broad-based across all of the country and all major categories of products. The strongest categories included grocery, produce, drug and general merchandise and fuel, including both dollars and gallons. Identical sales growth is a core part of Kroger’s strategy.
Kroger’s business strategy is squarely aimed at consistently meeting the needs of our customers through service, selection and value. In the second quarter, our associates continued to focus on improving the shopping experience for our customers. This commitment to placing the “customer first” helped drive growth in customer traffic and average transaction size.
Our business in southern California, which includes Ralphs and Food 4 Less stores, continued to improve in the second quarter. Identical supermarket sales in that region, without fuel, continued to grow with a 2.9% increase over the prior-year period. Our recovery in southern California remains on track.
On the strength of Kroger’s year-to-date financial performance, we are affirming our earnings estimate for fiscal 2005. We expect earnings for the full year to exceed $1.24 per fully diluted share. We expect this earnings growth to be driven by continued progress in southern California, improved results from the balance of the Company, lower interest expense, and fewer shares outstanding as a result of buybacks. In addition, we expect identical supermarket sales for the second half of 2005, including southern California and excluding fuel, to exceed 3.0%.
The estimates above do not include the effect of Hurricane Katrina, as it is too early to fully understand the effect, whether favorable or unfavorable, that the storm and its aftermath will have on our results for the balance of the year.
RESULTS OF OPERATIONS
Net Earnings
Net earnings totaled $196 million for the second quarter of 2005, an increase of 38.0% from net earnings of $142 million for the second quarter of 2004. Net earnings totaled $490 million for the first two quarters of 2005, an increase of 21.0% from net earnings of $405 million for the first two quarters of 2004. The increase in our net earnings was the result of improvement in southern California and the leveraging of fixed costs by strong identical sales growth.
Earnings per share of $0.27 per diluted share for the second quarter of 2005 represented an increase of 42.1% over net earnings of $0.19 per diluted share for the second quarter of 2004. Earnings per share of $0.67 per diluted share for the first two quarters of 2005 represented an increase of 24.1% over net earnings of $0.54 per diluted share for the first two quarters of 2004. Earnings per share growth resulted from increased net earnings and the repurchase of Company stock. Over the past four quarters, we have repurchased 21 million shares of the Company’s stock for a total investment of $342 million.
Total Sales
(In millions)
Total supermarket sales without fuel
Total supermarket fuel sales
Total supermarket sales
Other sales (1)
Total sales
The change in our total sales was primarily the result of identical store sales increases, square footage growth, and increased fuel gallons, as well as inflation in fuel and other commodities. Increased customer count and average transaction size in the first two quarters of 2005 were primarily responsible for our increases in identical supermarket sales, excluding fuel.
We define a supermarket as identical when it has been in operation without expansion or relocation for five full quarters. Differences between total supermarket sales and identical supermarket sales primarily relate to changes in supermarket square footage. Our identical supermarket sales results are summarized in the table below. The identical supermarket dollar figures presented were used to calculate second quarter 2005 percent changes.
Identical Supermarket Sales
Including fuel centers
Excluding fuel centers
We define a supermarket as comparable when it has been in operation for five full quarters, including expansions and relocations. Our comparable supermarket sales results are summarized in the table below. The comparable supermarket dollar figures presented were used to calculate the first quarter 2005 percent changes.
Comparable Supermarket Sales
FIFO Gross Margin
We calculate First-In, First-Out (“FIFO”) Gross Margin as follows: Sales minus merchandise costs plus Last-In, First-Out (“LIFO”) charge. Merchandise costs include advertising, warehousing and transportation, but exclude depreciation expenses and rent expense. FIFO gross margin is an important measure used by management to evaluate merchandising and operational effectiveness.
Our FIFO gross margin rate declined 59 basis points to 24.59% for the second quarter of 2005 from 25.18% for the second quarter of 2004. Excluding the effect of fuel sales, our FIFO gross margin rate increased 10 basis points for the second quarter of 2005 compared to the second quarter of 2004. The growth in our fuel sales lowers our FIFO gross margin rate due to the very low FIFO gross margin rate on fuel sales as compared to non-fuel sales. Our FIFO gross margin rate for the second quarter, excluding the effect of fuel sales, reflects our continued investment in targeted retail price reductions that were positively offset by good expense control and shrink (i.e., product losses due to theft and spoilage) improvements in the grocery and drug and general merchandise categories.
Our FIFO gross margin rate declined 72 basis points to 24.91% for the first two quarters of 2005 from 25.63% for the first two quarters of 2004. Of this decline, the effect of fuel sales accounted for a 54 basis point reduction in our FIFO gross margin rate.
Operating, General and Administrative Expenses
Operating, general and administrative (“OG&A”) expenses consist primarily of employee-related costs such as wages, health care benefit costs and retirement plan costs. Among other items, rent expense, depreciation and amortization expense, and interest expense are not included in OG&A. OG&A expenses, as a percent of sales, decreased 52 basis points to 18.23% for the second quarter of 2005 from 18.75% for the second quarter of 2004. Of this decline, the effect of fuel sales accounted for a 30 basis point reduction in our OG&A rate. The growth in our fuel sales lowers our OG&A rate due to the very low OG&A rate on fuel sales as compared to non-fuel sales. The declining rate on non-fuel sales was primarily the result of our continued recovery in southern California, strong sales, labor productivity improvements and lower health care costs. These improvements were partially offset by increased pension costs, credit card fees and incentive plan expenses.
OG&A expenses, as a percent of sales, decreased 57 basis points to 18.31% for the first two quarters of 2005 from 18.88% for the first two quarters of 2004. Of this decline, fuel sales accounted for a 31 basis point reduction in our OG&A rate. In addition to the items affecting the second quarter 2005 rate, the year-to-date declining rate on non-fuel sales was negatively affected by increased loss contingencies for various outstanding legal matters.
Rent Expense
Rent expense was $145 million, or 1.04% of sales, for the second quarter of 2005, compared to $154 million, or 1.19% of sales, for the second quarter of 2004. For the year-to-date period, rent expense, as a percent of total sales, was 1.09% and 1.23% for 2005 and 2004, respectively. The decline in rent expense reflects our emphasis on ownership of real estate combined with continued focus on the closing of underperforming stores.
Depreciation Expense
Depreciation expense was $294 million, or 2.12% of total sales, for the second quarter of 2005 compared to $290 million, or 2.23% of total sales, for the second quarter of 2004. Depreciation expense was $682 million, or 2.15% of total sales, for the first two quarters of 2005 compared to $662 million, or 2.21% of total sales, for the first two quarters of 2004. The decrease in depreciation expense, as a percent of sales, was the result of sales leverage obtained from strong identical supermarket sales growth and improved efficiency in capital investment.
Interest Expense
Interest expense was $121 million, or 0.87% of total sales, and $152 million, or 1.17% of total sales, in the second quarters of 2005 and 2004, respectively. For the year-to-date period, interest expense was $280 million, or 0.88% of total sales, in 2005 and $325 million, or 1.09% of total sales in 2004, respectively. The reduction in interest expense for 2005, when compared to 2004, reflects a $24.7 million prepayment premium paid in the second quarter of 2004 as the result of the call of our $750 million, 7.375% bonds and a $333 million reduction of total debt.
Income Taxes
Our effective income tax rate was 37.4% for the second quarter of 2005 and 37.9% for the second quarter of 2004. For the year-to-date period, our effective income tax rate was 36.5% in 2005 and 37.3% in 2004, respectively. In addition to the effect of state taxes, the effective income tax rate differed from the federal statutory rate due to a reduction of previously recorded tax contingency allowances resulting from a revision of the required allowances based on resolutions with tax authorities during the quarters.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flow Information
We generated $1.8 billion of cash from operating activities during the first two quarters of 2005 and 2004. Although we generated more cash in 2005, the increase in cash generated by our net earnings was offset by a cash contribution of $107 million to our Company-sponsored pension plan in the first two quarters of 2005 compared to a $14 million cash contribution during the first two quarters of 2004.
Investing activities used $646 million of cash during the first two quarters of 2005 compared to $817 million during the first two quarters of 2004. The amount of cash used by investing activities decreased in 2005 versus 2004 due to decreased capital expenditures during the first two quarters of 2005.
Financing activities used $911 million of cash in the first two quarters of 2005 compared to $1,019 million in the first two quarters of 2004. The decrease in the amount of cash used by financing activities was the result of decreased debt reduction and an increase in the amount of cash proceeds from the issuance of capital stock, partially offset by increases in treasury stock repurchases.
Debt Management
As of August 13, 2005, we maintained a $1.8 billion, five-year revolving credit facility that terminates in 2009 and a $700 million five-year credit facility that terminates in 2007. Outstanding borrowings under the credit agreements and commercial paper borrowings, and some outstanding letters of credit, reduce funds available under the credit agreements. In addition to the credit agreements, we maintain a $75 million money market line, borrowings under which also reduce the amount of funds available under our credit agreements. The money market line borrowings allow us to borrow from banks at mutually agreed upon rates, usually at rates below the rates offered under the credit agreements. As of August 13, 2005, we had no commercial paper borrowings under our credit agreement. In addition, we had no borrowings under the money market line as of August 13, 2005. The outstanding letters of credit that reduced the funds available under our credit agreements totaled $289 million as of August 13, 2005.
At August 13, 2005, we also had a $100 million pharmacy receivable securitization facility that provided capacity incremental to the $2.5 billion credit agreements described above. Funds received under this facility do not reduce funds available under the credit agreements. Collection rights to some of our pharmacy accounts receivable balances are sold to initiate the drawing of funds under the facility. As of August 13, 2005, we had no borrowings under this $100 million facility.
Our bank credit facilities and the indentures underlying our publicly issued debt contain various restrictive covenants. As of August 13, 2005, 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.
Total debt, including both the current and long-term portions of capital leases, decreased $333 million to $7.2 billion as of the end of the second quarter of 2005, from $7.6 billion as of the end of the second quarter of 2004. Total debt decreased $750 million as of the end of the second quarter of 2005 from $8.0 billion as of year-end 2004. The decreases in 2005 resulted from the use of cash flow from operations to reduce outstanding debt and lower mark-to-market adjustments.
Common Stock Repurchase Program
During the second quarter of 2005, we invested $38 million to repurchase 2.2 million shares of Kroger stock at an average price of $17.53 per share. For the first two quarters of 2005, we invested $191 million to repurchase 11.7 million shares of Kroger stock at an average price of $16.33 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 September 2004. 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. During the first two quarters of 2005, we purchased approximately 11.2 million shares, totaling $184 million, under our $500 million stock repurchase program and we purchased an additional 0.5 million shares, totaling $7 million, under our program to repurchase common stock funded by the proceeds and tax benefits from stock option exercises. As of August 13, 2005, we had approximately $170 million remaining under the September 2004 repurchase program.
CAPITAL EXPENDITURES
Capital expenditures, excluding acquisitions, totaled $272 million for the second quarter of 2005 compared to $395 million for the second quarter of 2004. Year-to-date, capital expenditures, excluding acquisitions, totaled $672 million in 2005 and $848 million in 2004. The decrease reflects our continued emphasis on the tightening of capital and our increasing focus on remodel, merchandising and productivity projects.
During the second quarter of 2005, we opened, acquired, expanded or relocated 14 food stores and also completed 21 within-the-wall remodels. In total, we operated 2,515 supermarkets and multi-department stores at the end of the second quarter of 2005 versus 2,530 food stores in operation at the end of the second quarter of 2004. Total food store square footage increased 0.9% over the second quarter of 2004. Excluding acquisitions and operational closings, total food store square footage increased 2.2% over the second quarter of 2004.
CRITICAL ACCOUNTINGPOLICIES
We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a consistent manner. Our critical accounting policies are summarized in the Company’s 2004 Annual Report on Form 10-K, as amended.
The preparation of financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. We base our estimates on historical experience and other factors we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could vary from those estimates.
RECENTLY ISSUED ACCOUNTING STANDARDS
Prior to the adoption of SFAS No. 123R, we are accounting for share-based compensation expense under the recognition and measurement provisions of APB No. 25, “Accounting for Stock Issued to Employees” and are following the accepted practice of recognizing share-based compensation expense over the explicit vesting period. SFAS No. 123R will require the immediate recognition at the grant date of the full share-based compensation expense for grants to retirement eligible employees, as the explicit vesting period is non-substantive. The estimated effect of applying the explicit vesting period approach versus the non-substantive approach is not material to any period presented. We expect to adopt SFAS No. 123R in the first quarter of fiscal 2006 and expect the adoption to reduce net earnings by $0.04-$0.06 per diluted share during fiscal 2006.
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43 Chapter 4” which clarifies that inventory costs that are “abnormal” are required to be charged to expense as incurred as opposed to being capitalized into inventory as a product cost. SFAS No. 151 provides examples of “abnormal” costs to include costs of idle facilities, excess freight and handling costs and spoilage. SFAS No. 151 will become effective for our fiscal year beginning January 29, 2006. The adoption of SFAS No. 151 is not expected to have a material effect on our Consolidated Financial Statements.
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 requires retrospective application to prior periods financial statements for changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 also requires that retrospective application of a change in accounting principle be limited to the direct effects of the change. Indirect effects of a change in accounting principle should be recognized in the period of the accounting change. SFAS No. 154 further requires a change in depreciation, amortization or depletion method for long-lived, non-financial assets to be accounted for as a change in accounting estimate effected by a change in accounting principle. SFAS No. 154 will become effective for our fiscal year beginning January 29, 2006.
FASB Interpretation No. 47 (“FIN 47”) “Accounting for Conditional Asset Retirement Obligations” was issued by the FASB in March 2005. FIN 47 provides guidance relating to the identification of and financial reporting for legal obligations to perform an asset retirement activity. The Interpretation requires recognition of a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. FIN 47 is effective no later than the end of fiscal years ending after December 15, 2005. The adoption of FIN 47 is not expected to have a material effect on our Consolidated Financial Statements.
In June 2005, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 05-6, “Determining the Amortization Period for Leasehold Improvements Purchased After Lease Inception or Acquired in a Business Combination.” EITF No. 05-6 requires that leasehold improvements acquired in a business combination be amortized over the shorter of the useful life of the assets or a term that includes required lease periods and renewals deemed to be reasonably assured at the date of acquisition. EITF No. 05-6 further requires that leasehold improvements that are placed into service significantly after and not contemplated at or near the beginning of the lease term shall be amortized over the shorter of the useful life of the assets or a term that includes the required lease periods and renewals deemed to be reasonably assured at the date of acquisition. EITF No. 05-6 became effective for our fiscal quarter beginning August 14, 2005. We do not expect the adoption of EITF No. 05-6 to have a material effect on the Company’s Consolidated Financial Statements.
OUTLOOK
This discussion and 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 change in net earnings; identical sales growth; expected pension plan contributions; our ability to generate operating cash flow; projected capital expenditures; square footage growth; opportunities to reduce costs; cash flow requirements; and our operating plan for the future; and are indicated by words such as “comfortable,” “committed,” “expect,” “goal,” “should,” “intend,” “target,” “believe,” “anticipate,” “will,” 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.
Various uncertainties and other factors could cause us to fail to achieve our goals. These include:
We cannot fully foresee the effects of changes in economic conditions on Kroger’s business. We have assumed economic and competitive situations will not change significantly for 2005. 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, contemplated or implied by forward-looking statements made by us or our representatives.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
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 April 15, 2005, as amended.
Item 4. Controls and Procedures.
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 as of the quarter ended August 13, 2005. 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 the end of the period covered by this report.
In connection with the evaluation described above, there was no change in Kroger’s internal control over financial reporting during the quarter ended August 13, 2005, that has materially affected, or is reasonably likely to materially affect, Kroger’s internal control over financial reporting.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(c)
Period (1)
MaximumDollar Value ofShares that MayYet BePurchasedUnder the Plansor Programs (3)
(in millions)
First four weeks
May 22, 2005 to June 18, 2005
Second four weeks
June 19, 2005 to July 16, 2005
Third four weeks
July 17, 2005 to August 13, 2005
Total
Item 4. Submission of Matters to a Vote of Security Holders
To Serve Until 2008
Robert D. Beyer
John T. LaMacchia
Edward M. Liddy
Katherine D. Ortega
Bobby S. Shackouls
PricewaterhouseCoopers LLP
2005 Long-Term Incentive Plan
Shareholder proposal (amend Company’s Regulations)
Shareholder proposal (chicken supplier requirements)
Shareholder proposal (shareholder approval of executive severance agreements)
Item 6. Exhibits.
EXHIBIT 3.1 - Amended Articles of Incorporation of the Company are hereby incorporated by reference to Exhibit 3.1 of the Company’s Quarterly Report on Form 10-Q for the quarter ended October 3, 1998. The Company’s Regulations are incorporated by reference to Exhibit 4.2 of the Company’s Registration Statement on Form S-3 as filed with the Securities and Exchange Commission on January 28, 1993, and bearing Registration No. 33-57552.
EXHIBIT 4.1 - Instruments defining the rights of holders of long-term debt of the Company and its subsidiaries are not filed as Exhibits because the amount of debt under each instrument is less than 10% of the consolidated assets of the Company. The Company undertakes to file these instruments with the Commission upon request.
EXHIBIT 10.1 – Material Contracts – 2005 Deferred Compensation Plan for Independent Directors
EXHIBIT 10.2 – 2005 Executive Deferred Compensation Plan
EXHIBIT 31.1 – Rule 13a–14(a) / 15d–14(a) Certifications – Chief Executive Officer
EXHIBIT 31.2 – Rule 13a–14(a) / 15d–14(a) Certifications – Chief Financial Officer
EXHIBIT 32.1 – Section 1350 Certifications
EXHIBIT 99.1 - Additional Exhibits - Statement of Computation of Ratio of Earnings to Fixed Charges.
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.
/s/ David B. Dillon
/s/ J. Michael Schlotman
Exhibit Index