UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended November 5, 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 725,483,410 shares of Common Stock ($1 par value) outstanding as of December 9, 2005.
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in millions, except per share amounts)
(unaudited)
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
November 5,
2005
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
Property held for sale
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
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: 926 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
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
Debt prepayment costs
Decrease in book overdrafts
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 cash 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
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 third quarter and three quarters ended November 5, 2005 and November 6, 2004 include the results of operations of the Company for the 12-week and 40-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 Third Quarter
In addition, the Company maintains a $54 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 $9 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 $1, after-tax, for the third quarters of 2005 and 2004, respectively. Restricted stock expense totaled $4 and $6, after-tax, for the first three 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. COMPREHENSIVE INCOME
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 third 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 three quarters of 2005 and 2004:
The Company contributed $300 to the Company-sponsored pension plans in the first three quarters of 2005 and may elect to make additional contributions during 2005 in order to maintain its desired funding status.
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 SFAS No. 87,Employers’ Accounting for Pensions.
6. INCOMETAXES
The effective income tax rate was 37.0% for the first three quarters of 2005 and 36.7% for the first three 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 and the third quarter effect of certain legal expenses that were not deductible for tax purposes.
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 net earnings and shares used in calculating earnings per basic common share to those used in calculating earnings per diluted common share:
Third Quarter Ended
November 5, 2005
November 6, 2004
Earnings per basic common share
Dilutive effect of stock options and warrants
Earnings per diluted common share
Three Quarters Ended
The Company had options outstanding for approximately 24 shares and 39 shares during the third 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 three quarters of 2005 and 2004, the Company had options outstanding for approximately 25 and 31 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 Financial Accounting Standards Board (“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 did not have a material effect on the Company’s Consolidated Financial Statements.
In October 2005, the FASB issued FASB Staff Position FAS 13-1, “Accounting for Rental Costs Incurred during a Construction Period” (“FSP FAS 13-1”). FSP FAS 13-1 requires rental costs associated with building or ground leases incurred during a construction period to be recognized as rental expense and is effective for the first reporting period beginning after December 15, 2005. In addition, FSP FAS 13-1 requires lessees to cease capitalizing rental costs as of December 15, 2005 for operating lease agreements entered into prior to December 15, 2005. Early adoption is permitted. The Company was already in compliance with the provisions of FSP FAS 13-1, therefore it will have no 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 November 5, 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 January 29, 2005 and for the third quarters ended, and the three quarters ended, November 5, 2005 and November 6, 2004:
Condensed Consolidating
Balance Sheets
As of November 5, 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 November 5, 2005
Merchandise costs, including warehousing and transportation
Operating profit (loss)
Equity in earnings of subsidiaries
Earnings (loss) before income tax expense
Income tax expense (benefit)
For the Quarter Ended November 6, 2004
For the Three Quarters Ended November 5, 2005
For the Three Quarters Ended November 6, 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 February 2, 2004, the Attorney General for the State of California filed an action in Los Angeles federal court (California, ex rel Lockyer v. Safeway, Inc. dba Vons, a Safeway Company; Albertson’s, Inc. and Ralphs Grocery Company, a division of The Kroger Co., United States District Court Central District of California, Case No. CV04-0687) alleging that the Mutual Strike Assistance Agreement (the “Agreement”) between the Company, Albertson’s, Inc. and Safeway Inc. (collectively, the “Retailers”), which was designed to prevent the union from placing disproportionate pressure on one or more of the Retailers by picketing such Retailer(s) but not the other Retailer(s) during the labor dispute in southern California, violated Section 1 of the Sherman Act. The lawsuit seeks declarative and injunctive relief. Under the Agreement, the Company paid approximately $147 to the other Retailers. The lawsuit raises claims that could question the validity of those payments, as well as claims that the retailers unlawfully restrained competition. On May 25, 2005, the Court denied a motion for a summary judgment filed by the defendants. Ralphs and the other defendants filed a notice of an interlocutory appeal to the United States Court of Appeals for the Ninth Circuit. On November 29, 2005, the appellate court dismissed the appeal. The Company continues to believe it has strong defenses against this lawsuit and is vigorously defending it. Although this lawsuit is subject to uncertainties inherent to the litigation process, based on the information presently available to the Company, management does not expect that the ultimate resolution of this action will have a material effect, favorable or adverse, on the Company’s financial condition, results of operations or cash flows.
The United States Attorney’s Office for the Central District of California is investigating the hiring practices of Ralphs Grocery Company (“Ralphs”), a wholly-owned subsidiary of The Kroger Co., during the labor dispute from October 2003 through February 2004. Among the matters under investigation is whether some locked-out employees were allowed or encouraged to work under false identities or false Social Security numbers, despite Company policy forbidding such conduct. A grand jury has convened to consider whether such acts violated federal criminal statutes. The Company expects that Ralphs will be indicted on charges that its conduct violated federal law. In addition, these alleged practices are the subject of claims that Ralphs’ conduct of the lockout was unlawful, and that Ralphs is liable under the National Labor Relations Act (“NLRA”). The Los Angeles Regional Office of the National Labor Relations Board (“NLRB”) has notified the charging parties that all charges alleging that Ralphs’ lockout violated the NLRA have been dismissed. That decision is being appealed by the charging parties to the General Counsel of the NLRB. The amounts potentially claimed in both the criminal and the NLRB matter are substantial, but based on the information presently available to the Company, management does not expect the ultimate resolution of this matter to have a material effect on the financial condition of the Company.
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. On December 1, 2005, Ralphs executed a civil consent judgment under which the misdemeanor complaint is to be dismissed and Ralphs will pay a civil penalty.
On November 24, 2004, the Company was notified by the office of the United States Attorney for the District of Colorado that the Drug Enforcement Agency (“DEA”) had referred a matter to it for investigation regarding alleged violation of the Controlled Substances Act by the Company’s King Soopers division. The government alleges that ineffective controls and procedures, as well as improper record keeping, permitted controlled substances to be diverted from pharmacies operated by King Soopers. As a result of these allegations, the Company has retained a consultant to assist it in reviewing its policies and procedures, record keeping and training in its pharmacies, and is taking corrective action, as warranted. On October 20, 2005, the Company resolved this matter by agreeing to pay a $7 civil penalty, agreeing to implement a comprehensive compliance program, and agreeing to an additional $3 payment if it fails to comply with the compliance program.
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 therefor. 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 November 5, 2005, the Company was a partner with 50% ownership in two real estate joint ventures for which it has guaranteed approximately $11 of debt incurred by the ventures. Based on the covenants underlying this indebtedness as of November 5, 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.
The Company contributed $300 to its Company-sponsored pension plans in the first three quarters of 2005. The Company expects these contributions to reduce its minimum required contributions in future years. 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. While the Company has no required contributions due in 2006, the Company expects to make voluntary contributions to Company-sponsored pension plans totaling approximately $100 - $150 during fiscal 2006.
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, other factors such as increased contributions, changes in benefits and improved investment performance 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 SFAS No. 87, Employers’ Accounting for Pensions.
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 November 5, 2005, the unamortized balances totaled approximately $67.
At the end of the third quarter of 2005, the Company maintained 10 interest rate swap agreements that are being accounted for as fair value hedges. As of November 5, 2005, liabilities totaling $42 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 November 17, 2005, the Company entered into three forward-starting interest rate swap agreements with an aggregate notional amount totaling $750. A forward-starting interest rate swap is an agreement that effectively hedges future benchmark interest rates, including general corporate spreads, on debt for an established period of time. The Company entered into the forward-starting interest rate swaps in order to lock in fixed interest rates on the Company’s forecasted issuance of debt in fiscal 2007 and 2008. The forward-starting interest rate swaps were designated as cash-flow hedges as defined by SFAS No. 133.
On December 9, 2005, the Company announced a set of corporate governance enhancements. The Company’s board of directors voted to recommend that shareholders approve at the next shareholder meeting in June 2006: the declassification of the board of directors in conjunction with the elimination of cumulative voting; the elimination of the supermajority necessary to engage in certain transactions with shareholders owning 10% or more of the Company’s shares; and opting out of the Ohio control share acquisition statute. The board of directors also will allow the Company’s warrant dividend plan, or poison pill, to expire March 19, 2006; adopted a policy requiring shareholder approval of new severance arrangements with senior executives that would exceed 2.99 times average W-2 earnings over the prior five years; and adopted a policy requiring a director receiving more “withheld” votes than “for” votes to tender his or her resignation, which resignation would be acted on by either the board’s Corporate Governance Committee or the remainder of the board.
On December 14, 2005, the Company disclosed on a Current Report on Form 8-K the adoption of the 2006 Long-Term Bonus Plan.
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
Third quarter total sales increased 9.1% and identical supermarket sales (as defined below) increased 6.6% with fuel and 3.7% without fuel. This continues a positive trend, as this was our ninth consecutive quarter of increased identical supermarket sales, excluding fuel, and our highest identical supermarket sales since the merger with Fred Meyer in 1999. Further, this growth was broad-based across all of the country and across all major categories. The strongest categories included produce, grocery, drug and general merchandise and fuel, in terms of both dollars and gallons. While our retail fuel margins for the quarter were strong, on a year-to-date basis they were more normalized. All but one of our divisions experienced another quarter of positive identical supermarket sales. Identical sales growth is a core part of our strategy.
Kroger’s business strategy is squarely aimed at consistently meeting the needs of our customers through service, selection and value. In the third quarter, our associates continued to focus on improving the shopping experience for our customers. This commitment to placing the “customer first” helped drive our growth in customer traffic and average transaction size.
During the third quarter, we continued to rebuild our business in southern California, which includes the Ralphs and Food 4 Less stores. Identical sales in that region, without fuel, grew 2.9% over the prior-year period. While the pace of our recovery in southern California has been slower than we would like, we see additional opportunities for growth in that market and our teams at Ralphs and Food 4 Less are clearly focused on seizing those opportunities.
Our results for the third quarter reflected a variety of items that together had little effect on earnings per share. These items include $0.02 of income resulting from the settlement of a previous class-action credit card suit and the reversal of an unrelated tax contingency. These benefits were offset by a combined $0.03 of expense resulting from: the effect of hurricanes Katrina and Rita; an increase in certain legal reserves, some of which are non-deductible for tax purposes; and a writedown to fair market value of assets held for sale.
On the strength of Kroger’s year-to-date financial performance, we are confident we will exceed our earnings estimate of $1.24 per fully diluted share for fiscal 2005. We expect this earnings growth to be driven by improved results in southern California and the balance of the Company, lower interest expense and fewer shares outstanding as a result of stock buybacks.
RESULTS OFOPERATIONS
Net Earnings
Net earnings totaled $185 million for the third quarter of 2005, an increase of 29.3% from net earnings of $143 million for the third quarter of 2004. Net earnings totaled $676 million for the first three quarters of 2005, an increase of 23.4% from net earnings of $548 million for the first three 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 of $0.25 per diluted share for the third quarter of 2005 represented an increase of 31.6% over net earnings of $0.19 per diluted share for the third quarter of 2004. Earnings of $0.92 per diluted share for the first three quarters of 2005 represented an increase of 26.0% over net earnings of $0.73 per diluted share for the first three 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 16 million shares of the Company’s stock for a total investment of $272 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 three 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 third 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 third 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 62 basis points to 24.48% for the third quarter of 2005 from 25.10% for the third quarter of 2004. Excluding the effect of retail fuel operations, our FIFO gross margin rate decreased six basis points for the third quarter of 2005 compared to the third quarter of 2004. The growth in our retail fuel sales lowers our FIFO gross margin rate due to the very low FIFO gross margin on retail fuel sales as compared to non-fuel sales. Improvements in shrink, advertising and warehousing costs helped offset higher energy costs and our investments in targeted retail price reductions for our customers. We estimate higher energy costs decreased our third quarter FIFO gross margin rate eight basis points.
Our FIFO gross margin rate declined 69 basis points to 24.78% for the first three quarters of 2005 from 25.47% for the first three quarters of 2004. Of this decline, the effect of retail fuel operations 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 69 basis points to 18.23% for the third quarter of 2005 from 18.92% for the third quarter of 2004. Of this decline, the effect of retail fuel operations accounted for a 66 basis point reduction in our OG&A rate. The growth in our retail fuel sales lowers our OG&A rate due to the very low OG&A rate on retail 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, lower health care costs, and $12.9 million of settlement income related to a previous class-action credit card lawsuit. These improvements were partially offset by increased pension costs, credit card fees and incentive plan expenses, as well as the effect of hurricanes Katrina and Rita, an increase in legal reserves for certain legal matters and a writedown to fair market value of assets held for sale. We estimate higher energy costs increased our third quarter OG&A rate nine basis points.
OG&A expenses, as a percent of sales, decreased 61 basis points to 18.28% for the first three quarters of 2005 from 18.89% for the first three quarters of 2004. Of this decline, retail fuel operations accounted for a 46 basis point reduction in our OG&A rate. In addition to the items affecting the third quarter 2005 rate, the year-to-date declining rate on non-fuel sales was negatively affected by increased loss contingencies for some outstanding legal matters.
Rent Expense
Rent expense was $166 million, or 1.19% of sales, for the third quarter of 2005, compared to $158 million, or 1.23% of sales, for the third quarter of 2004. The increase in rent expense resulted from increased store closing activities during the third quarter of 2005. For the year-to-date period, rent expense, as a percent of total sales, was 1.12% and 1.23% for 2005 and 2004, respectively. This decline in rent expense reflects our emphasis on the ownership of real estate combined with a continued focus on the closing of underperforming stores.
Depreciation Expense
Depreciation expense was $287 million, or 2.05% of total sales, for the third quarter of 2005 compared to $288 million, or 2.24% of total sales, for the third quarter of 2004. Depreciation expense was $969 million, or 2.12% of total sales, for the first three quarters of 2005 compared to $949 million, or 2.22% of total sales, for the first three quarters of 2004. The increase in depreciation expense for the year-to-date period reflects our continued emphasis on the ownership of real estate. 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 $114 million, or 0.81% of total sales, and $117 million, or 0.90% of total sales, in the third quarters of 2005 and 2004, respectively. For the year-to-date period, interest expense was $394 million, or 0.86% of total sales, in 2005 and $442 million, or 1.03% of total sales in 2004. The reduction in interest expense for 2005, when compared to 2004, reflects a $660 million reduction in total debt as well as 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.
Income Taxes
Our effective income tax rate was 38.4% for the third quarter of 2005 and 35.0% for the third quarter of 2004. For the year-to-date period, our effective income tax rate was 37.0% in 2005 and 36.7% 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 and the third quarter effect of certain legal expenses that were not deductible for tax purposes.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flow Information
We generated $2.0 billion of cash from operating activities during the first three quarters of both 2005 and 2004. The increase in cash generated by our net earnings was offset by a cash contribution of $300 million to our Company-sponsored pension plan in the first three quarters of 2005 compared to a $35 million cash contribution during the first three quarters of 2004.
Investing activities used $1.0 billion of cash during the first three quarters of 2005 compared to $1.2 billion during the first three quarters of 2004. The amount of cash used by investing activities decreased in 2005 versus 2004 due to decreased capital expenditures during the first three quarters of 2005.
Financing activities used $984 million of cash in the first three quarters of 2005 compared to $862 million in the first three quarters of 2004. The increase in the amount of cash used by financing activities was the result of increased debt reduction, partially offset by an increase in the amount of cash proceeds from the issuance of capital stock and a decrease in stock repurchase activity.
Debt Management
As of November 5, 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 November 5, 2005, our outstanding commercial paper borrowings under our credit agreement totaled $65 million. We had no borrowings under the money market line as of November 5, 2005. The outstanding letters of credit that reduced the funds available under our credit agreements totaled $313 million as of November 5, 2005.
Our bank credit facilities and the indentures underlying our publicly issued debt contain various restrictive covenants. As of November 5, 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 $560 million to $7.3 billion as of the end of the third quarter of 2005, from $7.8 billion as of the end of the third quarter of 2004. Total debt decreased $710 million as of the end of the third 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 third quarter of 2005, we invested $12 million to repurchase 0.6 million shares of Kroger stock at an average price of $19.97 per share. For the first three quarters of 2005, we invested $202 million to repurchase 12.3 million shares of Kroger stock at an average price of $16.51 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 three quarters of 2005, we purchased approximately 11.8 million shares, totaling $195 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 November 5, 2005, we had approximately $158 million remaining under the September 2004 repurchase program.
CAPITAL EXPENDITURES
Capital expenditures, excluding acquisitions, totaled $1.0 billion for the first three quarters of 2005 and $1.3 billion for the first three quarters of 2004. The decrease reflects our continued emphasis on the tightening of capital and our increasing focus on remodel, merchandising and productivity projects.
During the third quarter of 2005, we opened, acquired, expanded or relocated ten food stores and also completed 43 within-the-wall remodels. In total, we operated 2,510 supermarkets and multi-department stores at the end of the third quarter of 2005 versus 2,531 food stores in operation at the end of the third quarter of 2004. Total food store square footage increased 0.6% over the third quarter of 2004. Excluding acquisitions and operational closings, total food store square footage increased 2.0% over the third quarter of 2004.
CRITICAL ACCOUNTING POLICIES
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 ISSUEDACCOUNTING 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, 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 rather than 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 second fiscal quarter beginning August 14, 2005. The adoption of EITF No. 05-6 did not have a material effect on the Company’s Consolidated Financial Statements.
In October 2005, the FASB issued FASB Staff Position FAS 13-1, “Accounting for Rental Costs Incurred during a Construction Period” (“FSP FAS 13-1”). FSP FAS 13-1 requires rental costs associated with building or ground leases incurred during a construction period to be recognized as rental expense and is effective for the first reporting period beginning after December 15, 2005. In addition, FSP FAS 13-1 requires lessees to cease capitalizing rental costs as of December 15, 2005 for operating lease agreements entered into prior to December 15, 2005. Early adoption is permitted. We were already in compliance with the provisions of FSP FAS 13-1, therefore it will have no effect on our 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 “are confident,” “expect,” “will,” “plan,” “is focused on,” “intend,” “believe,” and “anticipate,” 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. 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 November 5, 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 November 5, 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.
Litigation — On February 2, 2004, the Attorney General for the State of California filed an action in Los Angeles federal court (California, ex rel Lockyer v. Safeway, Inc. dba Vons, a Safeway Company; Albertson’s, Inc. and Ralphs Grocery Company, a division of The Kroger Co., United States District Court Central District of California, Case No. CV04-0687) alleging that the Mutual Strike Assistance Agreement (the “Agreement”) between the Company, Albertson’s, Inc. and Safeway Inc. (collectively, the “Retailers”), which was designed to prevent the union from placing disproportionate pressure on one or more of the Retailers by picketing such Retailer(s) but not the other Retailer(s) during the labor dispute in southern California, violated Section 1 of the Sherman Act. The lawsuit seeks declarative and injunctive relief. Under the Agreement, the Company paid approximately $147 million to the other Retailers. The lawsuit raises claims that could question the validity of those payments, as well as claims that the retailers unlawfully restrained competition. On May 25, 2005, the Court denied a motion for a summary judgment filed by the defendants. Ralphs and the other defendants filed a notice of an interlocutory appeal to the United States Court of Appeals for the Ninth Circuit. On November 29, 2005, the appellate court dismissed the appeal. The Company continues to believe it has strong defenses against this lawsuit and is vigorously defending it. Although this lawsuit is subject to uncertainties inherent to the litigation process, based on the information presently available to the Company, management does not expect that the ultimate resolution of this action will have a material effect, favorable or adverse, on the Company’s financial condition, results of operations or cash flows.
On November 24, 2004, the Company was notified by the office of the United States Attorney for the District of Colorado that the Drug Enforcement Agency (“DEA”) had referred a matter to it for investigation regarding alleged violation of the Controlled Substances Act by the Company’s King Soopers division. The government alleges that ineffective controls and procedures, as well as improper record keeping, permitted controlled substances to be diverted from pharmacies operated by King Soopers. As a result of these allegations, the Company has retained a consultant to assist it in reviewing its policies and procedures, record keeping and training in its pharmacies, and is taking corrective action, as warranted. On October 20, 2005, the Company resolved this matter by agreeing to pay a $7 million civil penalty, agreeing to implement a comprehensive compliance program, and agreeing to an additional $3 million payment if it fails to comply with the compliance program.
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.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
(c)
Period (1)
First four weeks
August 14, 2005 to September 10, 2005
Second four weeks
September 11, 2005 to October 8, 2005
Third four weeks
October 9, 2005 to November 5, 2005
Total
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.
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