KROGER CO. (THE) The following analysis should be read in conjunction with the Consolidated Financial Statements.
USE OF NON-GAAP FINANCIAL MEASURES
The accompanying Consolidated Financial Statements, including the related notes,
are presented in accordance with generally accepted accounting principles
("GAAP"). We provide non-GAAP measures, including First-In, First-Out ("FIFO")
gross margin, FIFO operating profit, adjusted net earnings and adjusted net
earnings per diluted share because management believes these metrics are useful
to investors and analysts. These non-GAAP financial measures should not be
considered as an alternative to gross margin, operating profit, net earnings and
net earnings per diluted share or any other GAAP measure of performance. These
measures should not be reviewed in isolation or considered as a substitute for
our financial results as reported in accordance with GAAP.
We calculate FIFO gross margin as FIFO gross profit divided by sales. FIFO gross
profit is calculated as sales less merchandise costs, including advertising,
warehousing, and transportation expenses, but excluding the Last-In, First-Out
("LIFO") charge. Merchandise costs exclude depreciation and rent expenses. FIFO
gross margin is an important measure used by management as management believes
FIFO gross margin is a useful metric to investors and analysts because it
measures our day-to-day merchandising and operational effectiveness.
We calculate FIFO operating profit as operating profit excluding the LIFO charge. FIFO operating profit is an important measure used by management as management believes FIFO operating profit is a useful metric to investors and analysts because it measures our day-to-day operational effectiveness.
The adjusted net earnings and adjusted net earnings per diluted share metrics are important measures used by management to compare the performance of core operating results between periods. We believe adjusted net earnings and adjusted net earnings per diluted share are useful metrics to investors and analysts because they present more accurate year-over-year comparisons of our net earnings and net earnings per diluted share because adjusted items are not the result of our normal operations. Net earnings for the first three quarters of 2020 include the following, which we define as the "2020 Adjusted Items":
Charges to operating, general and administrative expenses ("OG&A") of
? million,
consideration and
costs (the "2020 OG&A Adjusted Items").
? Gains in other income (expense) of
the gain on investments (the "2020 Other Income (Expense) Adjusted Item").
Net earnings for the third quarter of 2020 include the following, which we define as the "2020 Third Quarter Adjusted Items":
Charges to OG&A of
? Home Chef contingent consideration and
transformation costs (the "2020 Third Quarter OG&A Adjusted Items").
Gains in other income (expense) of
? the gain on investments (the "2020 Third Quarter Other Income (Expense)
Adjusted Item").
Net earnings for the first three quarters of 2019 include the following, which we define as the "2019 Adjusted Items":
Charges to OG&A of
related to withdrawal liabilities for certain multi-employer pension funds;
million,
?
million net of tax, for impairment of Lucky's Market; and a reduction to OG&A
of$18 million ,$13 million net of tax, for the revaluation of Home Chef contingent consideration (the "2019 OG&A Adjusted Items"). 15 Gains in other income (expense) of$106 million ,$80 million net of tax,
related to the sale of
? related to the sale of You Technology; and
tax, for the gain on investments (the "2019 Other Income (Expense) Adjusted
Items").
Net earnings for the third quarter of 2019 include the following, which we define as the "2019 Third Quarter Adjusted Items":
Charges to OG&A of
to withdrawal liabilities for a certain multi-employer pension fund;
million,
?
million net of tax, for impairment of Lucky's Market; and
million net of tax, for the revaluation of Home Chef contingent consideration
(the "2019 Third Quarter OG&A Adjusted Items").
A gain in other income (expense) of
? the gain on investments (the "2019 Third Quarter Other Income (Expense)
Adjusted Item").
Please refer to the "Net Earnings per Diluted Share excluding the Adjusted Items" table below for reconciliations of certain non-GAAP financial measures reported in this Quarterly Report on Form 10-Q to the most comparable GAAP financial measure and related disclosure.
CAUTIONARY STATEMENT This discussion and analysis contains certain forward-looking statements about our future performance. These statements are based on management's assumptions and beliefs in light of the information currently available to it. Such statements are indicated by words such as "achieve," "affect," "anticipate," "believe," "committed," "continue," "could," "estimate," "expect," "future," "guidance," "maintain," "may," "strategy," "trend," "will," and "would," and similar words or phrases. These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially. These include the specific risk factors identified in "Risk Factors" and "Outlook" in our Annual Report on Form 10-K for our last fiscal year and any subsequent filings, as well as those identified in this Form 10-Q.
Various uncertainties and other factors could cause actual results to differ materially from those contained in the forward-looking statements. These include:
The extent to which our sources of liquidity are sufficient to meet our
requirements may be affected by the state of the financial markets and the
effect that such condition has on our ability to issue commercial paper at
acceptable rates. Our ability to borrow under our committed lines of credit,
? including our bank credit facilities, could be impaired if one or more of our
lenders under those lines is unwilling or unable to honor its contractual
obligation to lend to us, or in the event that global pandemics, including the
novel coronavirus, natural disasters or weather conditions interfere with the
ability of our lenders to lend to us. Our ability to refinance maturing debt
may be affected by the state of the financial markets.
16
Our ability to achieve sales, earnings and incremental FIFO operating profit
goals may be affected by: COVID-19 related factors, risks and challenges,
including among others, the length of time that the pandemic continues, the
temporary inability of customers to shop due to illness, quarantine, or other
travel restrictions or financial hardship, shifts in demand away from
discretionary or higher priced products to lower priced products, or
stockpiling or similar pantry-filling activities, product shortages due to
potential constraints in plants and distribution facilities, increases in the
costs to operate our business, reduced workforces which may be caused by, but
not limited to, the temporary inability of the workforce to work due to
illness, quarantine, or government mandates, temporary store closures due to
reduced workforces or government mandates, or the availability and efficacy of
a vaccine; labor negotiations or disputes; changes in the types and numbers of
businesses that compete with us; pricing and promotional activities of existing
and new competitors, including non-traditional competitors, and the
aggressiveness of that competition; our response to these actions; the state of
? the economy, including interest rates, the inflationary and deflationary trends
in certain commodities, changes in tariffs, and the unemployment rate; the
effect that fuel costs have on consumer spending; volatility of fuel margins;
changes in government-funded benefit programs and the extent and effectiveness
of any COVID-19 stimulus packages; manufacturing commodity costs; diesel fuel
costs related to our logistics operations; trends in consumer spending; the
extent to which our customers exercise caution in their purchasing in response
to economic conditions; the uncertainty of economic growth or recession;
changes in inflation or deflation in product and operating costs; stock
repurchases; our ability to retain pharmacy sales from third party payors;
consolidation in the healthcare industry, including pharmacy benefit managers;
our ability to negotiate modifications to multi-employer pension plans; natural
disasters or adverse weather conditions; the effect of public health crises or
other significant catastrophic events, including the coronavirus; the potential
costs and risks associated with potential or actual cyber-attacks or data
security breaches; the success of our future growth plans; the ability to
execute on Restock
and new partnerships.
Our ability to achieve these goals may also be affected by our ability to
? manage the factors identified above. Our ability to execute our financial
strategy may be affected by our ability to generate cash flow.
Our effective tax rate may differ from the expected rate due to changes in
? laws, the status of pending items with various taxing authorities, and the
deductibility of certain expenses. Statements elsewhere in this report and below regarding our expectations, projections, beliefs, intentions or strategies are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. 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 in this report and other reports that we file with theSecurities and Exchange Commission could cause actual results to differ materially.
EXECUTIVE SUMMARY - OUR PATH TO DELIVERING CONSISTENT AND ATTRACTIVE TOTAL SHAREHOLDER RETURN
We delivered strong results in the third quarter and first three quarters of 2020. Customers are at the center of everything we do and sales remain elevated as a result of higher food at home consumption because of the COVID-19 pandemic, and as we continue to enhance our competitive moats - Fresh, Our Brands, Data & Personalization and Seamless. We are executing against our strategy through the pandemic and continue to grow market share. Our results continue to show thatKroger is a trusted brand and our customers choose to shop with us because they value the product quality and freshness, convenience, and digital offerings that we provide, even more during these unprecedented times. The underlying momentum in our core supermarket business and acceleration in the growth of our alternative profit business demonstrates we are successfully transforming our business model to deliver consistently strong and attractive total shareholder return in 2020 and beyond. As a result of our continued strong performance, market share growth and the expectation of sustained trends in food at home consumption for the remainder of our fiscal year, we raised our full year 2020 guidance. We believe our 2021 business results will be stronger than we would have expected prior to the COVID-19 pandemic when viewed as a two-year stacked result for identical sales without fuel growth and as a compounded growth rate over 2020 and 2021 for adjusted net earnings per diluted share growth. 17 Our financial model is driven by our retail supermarket, fuel, and health and wellness businesses, in addition to our growing alternative profit businesses. Our financial strategy is to continue to use the strong free cash flow generated by the business and deploy it in the business in a disciplined way to drive long-term sustainable growth through the identification of high-return projects that support our strategy. We will allocate capital toward driving profitable sales growth in stores and digital, improve productivity, and build a seamless digital ecosystem and supply chain. At the same time, we are committed to maintaining our net debt to adjusted EBITDA range of 2.30 to 2.50 in order to keep our current investment-grade debt rating. We also expect to continue to grow our dividend over time, reflecting the confidence we have in our free cash flow, and expect to continue to return excess cash to investors via share repurchases. Our financial model has proven to be resilient throughout the economic cycle. We expect our model to deliver improved operating results over time and continued strong free cash flow, which will translate into a consistently strong and attractive total shareholder return over the long-term of 8% to 11%.
The following table provides highlights of our financial performance:
Financial Performance Data
($ in millions, except per share amounts)
Third Quarter Ended Three Quarters Ended
November 7, Percentage November 9, November 7, Percentage November 9,
2020 Change 2019 2020 Change 2019
Sales $ 29,723 6.3 % $ 27,974 $ 101,761 9.0 % $ 93,393 Sales without fuel 27,414 10.8 % 24,732 94,479 14.7 % 82,350 Net earnings attributable to TheKroger Co. 631 139.9 % 263 2,662 99.8 % 1,332 Adjusted net earnings attributable to TheKroger Co. 557 46.2 % 381 2,110 59.4 % 1,324 Net earnings attributable to TheKroger Co. per diluted common share 0.80 150.0 % 0.32 3.35 104.3 % 1.64 Adjusted net earnings attributable toThe Kroger Co. per diluted common share 0.71 51.1 % 0.47 2.66 64.2 % 1.62 Operating profit 792 211.8 % 254 2,938 71.4 % 1,714 Adjusted FIFO operating profit 871 33.4 % 653 3,218 43.9 % 2,237 Dividends paid 141 8.5 % 130 395 11.0 % 356 Dividends paid per common share 0.18 12.5 % 0.16 0.50 13.6 % 0.44 Identical sales excluding fuel 10.9 % N/A 2.5 % 15.3 % N/A 2.0 % FIFO gross margin rate, excluding fuel, bps increase (decrease) (0.02) N/A (0.24) 0.20 N/A (0.32) OG&A rate, excluding fuel and Adjusted Items, bps decrease (0.30) N/A (0.15) (0.06) N/A (0.14) Reduction in total debt, including obligations under finance leases compared to prior fiscal year end 556 N/A
1,585 556 N/A 1,585
Share repurchases 321 N/A 11 989 N/A 34
18
OVERVIEW
Notable items for the third quarter and first three quarters of 2020 are:
Shareholder Return
? Net earnings attributable to
for the third quarter and
? Adjusted net earnings attributable to
of$0.71 for the third quarter and$2.66 for the first three quarters.
? Achieved operating profit of
billion for the first three quarters.
? Achieved adjusted FIFO operating profit of
and
? During the first three quarters of 2020, we generated cash from operations of
$5.9 billion .
During the first three quarters of 2020, we increased cash and temporary cash
investments by
? significant improvements in working capital and deferred tax payments as a
result of the Coronavirus Aid, Relief, and Economic Security Act (the "CARES
Act") which was enacted in the first quarter of 2020.
? During the first three quarters of 2020, we returned
shareholders through share repurchases and dividend payments.
? During the first three quarters of 2020, we decreased total debt, including
obligations under finance leases, by$556 million . Other Financial Results
? Identical sales, excluding fuel, increased 10.9% for the third quarter and
15.3% for the first three quarters of 2020.
Digital revenue grew 108% in the third quarter and 115% in the first three
? quarters of 2020. Digital revenue primarily includes Pickup, Delivery, Ship and
pharmacy e-commerce sales.
Alternative profit streams grew in the third quarter and first three quarters
? of 2020 fueled by our digital media business -
("KPM"). KPM revenue increased 192% in the third quarter and 135% in the first
three quarters of 2020. Significant Events
During the first three quarters of 2020, we invested nearly
support and safeguard associates, customers and communities during the COVID-19
? pandemic. These investments primarily relate to items within OG&A such as
associate appreciation awards, expanded sick and emergency leave pay and
investments in associate and customer safety during the pandemic (collectively,
the "COVID-19 Investments").
During the first quarter of 2020, in addition to the recurring multi-employer
pension contributions we make in the normal course of business, we contributed
? an incremental
plans, helping stabilize future associate benefits (the "2020 Multi-Employer
Pension Contribution").
19
The following table provides a reconciliation of net earnings attributable toThe Kroger Co. to adjusted net earnings attributable toThe Kroger Co. and a reconciliation of net earnings attributable toThe Kroger Co. per diluted common share to adjusted net earnings attributable toThe Kroger Co. per diluted common share, excluding the 2020 and 2019 Adjusted Items. Net Earnings per Diluted Share excluding the Adjusted Items ($ in millions, except per share amounts) Third Quarter Ended Three Quarters Ended November 7, November 9, Percentage November 7, November 9, Percentage 2020 2019 Change 2020 2019 Change Net earnings attributable to TheKroger Co. $ 631 $ 263$ 2,662 $ 1,332 (Income) expense adjustments Adjustment for pension plan withdrawal liabilities(1)(2) - 35 - 101 Adjustment for gain on sale ofTurkey Hill Dairy(1)(3) - - - (80) Adjustment for gain on sale of You Technology(1)(4) - - - (52) Adjustment for gain on investments(1)(5) (115) (81) (705) (125) Adjustment for severance charge and related benefits(1)(6) - 61 - 61 Adjustment for impairment of Lucky's Market attributable to TheKroger Co. (1)(7) - 100 - 100 Adjustment for Home Chef contingent consideration(1)(8) 17 3 80 (13) Adjustment for transformation costs(1)(9) 24 - 73 - 2020 and 2019 Adjusted Items (74) 118 (552) (8) Net earnings attributable toThe Kroger Co. excluding the Adjusted Items $ 557 $ 381
46.2 %
Net earnings attributable to TheKroger Co. per diluted common share$ 0.80 $ 0.32 $ 3.35 $ 1.64 (Income) expense adjustments Adjustment for pension plan withdrawal liabilities(10) - 0.04 - 0.12 Adjustment for gain on sale ofTurkey Hill Dairy(10) - - - (0.10) Adjustment for gain on sale of You Technology(10) - - - (0.06) Adjustment for gain on investments(10) (0.15) (0.10) (0.90) (0.16) Adjustment for severance charge and related benefits(10) - 0.08 - 0.08 Adjustment for impairment of Lucky's Market attributable to TheKroger Co. (10) - 0.12 - 0.12 Adjustment for Home Chef contingent consideration(10) 0.02 0.01 0.10 (0.02) Adjustment for transformation costs(10) 0.04 - 0.11 - 2020 and 2019 Adjusted Items (0.09) 0.15 (0.69) (0.02) Adjusted net earnings attributable toThe Kroger Co. per diluted common share$ 0.71 $ 0.47
51.1 %
Average number of common shares used
in diluted calculation 780 807 785 805
20
(1) The amounts presented represent the after-tax effect of each adjustment,
which was calculated using discrete tax rates.
(2) The pre-tax adjustment for pension plan withdrawal liabilities was
third quarter of 2019 and $131 in the first three quarters of 2019.
(3) The pre-tax adjustment for gain on sale of
(4) The pre-tax adjustment for gain on sale of You Technology was (
The pre-tax adjustment for gain on investments was (
(
(6) The pre-tax adjustment for severance charge and related benefits was
(7) The pre-tax adjustment for impairment of Lucky's Market was
The pre-tax adjustment for Home Chef contingent consideration was
was $109 and ($18 ) in the first three quarters of 2020 and 2019,
respectively.
The pre-tax adjustment for transformation costs was
of 2020 and
party professional consulting fees associated with business transformation
and cost saving initiatives.
(10) The amount presented represents the net earnings per diluted common share
effect of each adjustment.
RESULTS OF OPERATIONS
Sales
Total Sales
($ in millions)
Third Quarter Ended Three Quarters Ended
November 7, Percentage November 9, Percentage November 7, Percentage November 9, Percentage
2020 Change(1) 2019 Change(2) 2020 Change(3) 2019 Change(4)
Total sales to retail
customers without
fuel (5) $ 27,179 10.6 % $ 24,575 2.6 % $ 93,830 14.8 % $ 81,766 2.3 %
Supermarket fuel sales 2,309 (28.8) % 3,242 (11.3) % 7,282 (34.1) % 11,043 (8.0) %
Other sales(6) 235 49.7 % 157 (27.3) % 649 11.1 % 584 (14.7) %
Total sales $ 29,723 6.3 % $ 27,974 0.5 % $ 101,761 9.0 % $ 93,393 (0.2) %
(1) This column represents the percentage change in the third quarter of 2020,
compared to the third quarter of 2019.
(2) This column represents the percentage change in the third quarter of 2019,
compared to the third quarter of 2018.
(3) This column represents the percentage change in the first three quarters of
2020, compared to the first three quarters of 2019.
(4) This column represents the percentage change in the first three quarters of
2019, compared to the first three quarters of 2018.
Digital sales, primarily including Pickup, Delivery, Ship and pharmacye-commerce sales, grew approximately 108% and 21% in the third quarter of (5) 2020 and 2019, respectively. Digital sales grew approximately 115% and 31% in
the first three quarters of 2020 and 2019, respectively. These sales are
included in the "total sales to retail customers without fuel" line above.
(6) Other sales primarily relate to external sales at food production plants,
data analytic services and third party media revenue.
21
Total sales were $29.7 billion in the third quarter of 2020, compared to $28.0
billion in the third quarter of 2019. This increase was due to an increase in
total sales to retail customers without fuel, partially offset by a reduction in
supermarket fuel sales. Total sales to retail customers without fuel increased
10.6% in the third quarter of 2020, compared to the third quarter of 2019. This
increase was primarily due to our identical sales increase, excluding fuel, of
10.9%, partially offset by decreased sales due to the deconsolidation of Lucky's
Market in the fourth quarter of 2019. Total sales excluding fuel and the
disposition increased 11.3% in the third quarter of 2020, compared to the third
quarter of 2019. The significant increase in identical sales, excluding fuel,
was caused by unprecedented demand due to the COVID-19 pandemic and growth in
market share. Market share growth contributed to our identical sales increase,
excluding fuel, as our sales outpaced the general growth in the food retail
industry during the third quarter of 2020. The increase in identical sales,
excluding fuel, was broad based across all retail divisions and all product
categories. Meat and produce departments led the way, continuing to underscore
the importance of Fresh and how we differentiate in quality and assortment for
our customers. During the pandemic, customers reduced trips while significantly
increasing basket value.
Total supermarket fuel sales decreased 28.8% in the third quarter of 2020, compared to the third quarter of 2019, primarily due to a decrease in fuel gallons sold of 13.3% and a decrease in the average retail fuel price of 17.8%. The decrease in fuel gallons sold was slightly better than the national trend, which decreased due to the COVID-19 pandemic. The decrease in the average retail fuel price was caused by a decrease in the product cost of fuel. Total sales were$101.8 billion in the first three quarters of 2020, compared to$93.4 billion in the first three quarters of 2019. This increase was due to an increase in total sales to retail customers without fuel, partially offset by a reduction in supermarket fuel sales and decreased sales due to the disposal ofTurkey Hill Dairy and You Technology in the first quarter of 2019. Total sales to retail customers without fuel increased 14.8% in the first three quarters of 2020, compared to the first three quarters of 2019. This increase was primarily due to our identical sales increase, excluding fuel, of 15.3%, partially offset by decreased sales due to the deconsolidation of Lucky's Market in the fourth quarter of 2019. The significant increase in identical sales, excluding fuel, was caused by unprecedented demand due to the COVID-19 pandemic and growth in market share. Market share growth contributed to our identical sales increase, excluding fuel, as our sales outpaced the general growth in the food retail industry during the first three quarters of 2020. The increase in identical sales, excluding fuel, was broad based across all retail divisions and remained heightened throughout the first three quarters of 2020. During the pandemic, customers reduced trips while significantly increasing basket value. Total supermarket fuel sales decreased 34.1% in the first three quarters of 2020, compared to the first three quarters of 2019, primarily due to a decrease in fuel gallons sold of 18.4% and a decrease in the average retail fuel price of 19.2%. The decrease in fuel gallons sold was reflective of the national trend, which decreased due to the COVID-19 pandemic. The decrease in the average retail fuel price was caused by a decrease in the product cost of fuel. We calculate identical sales, excluding fuel, as sales to retail customers, including sales from all departments at identical supermarket locations,Kroger Specialty Pharmacy businesses and ship-to-home solutions. We define a supermarket as identical when it has been in operation without expansion or relocation for five full quarters. Although identical sales is a relatively standard term, numerous methods exist for calculating identical sales growth. As a result, the method used by our management to calculate identical sales may differ from methods other companies use to calculate identical sales. We urge you to understand the methods used by other companies to calculate identical sales before comparing our identical sales to those of other such companies. Our identical sales, excluding fuel, results are summarized in the following table. We used the identical sales, excluding fuel, dollar figures presented below to calculate percentage changes for the third quarter and first three quarters
of
2020.
22
Identical Sales
($ in millions)
Third Quarter Ended
November 7, Percentage November 9, Percentage
2020 Change(1) 2019 Change(2)
Excluding fuel centers $ 26,860 10.9 % $ 24,212 2.5 %
(1) This column represents the percentage change in identical sales in the third
quarter of 2020, compared to the third quarter of 2019.
(2) This column represents the percentage change in identical sales in the third
quarter of 2019, compared to the third quarter of 2018.
Three Quarters Ended
November 7, Percentage November 9, Percentage
2020 Change(1) 2019 Change(2)
Excluding fuel centers $ 92,759 15.3 % $ 80,485 2.0 %
(1) This column represents the percentage change in identical sales in the first
three quarters of 2020, compared to the first three quarters of 2019.
(2) This column represents the percentage change in identical sales in the first
three quarters of 2019, compared to the first three quarters of 2018.
Gross Margin, LIFO and FIFO Gross Margin
We define gross margin as sales minus merchandise costs, including advertising, warehousing, and transportation. Rent expense, depreciation and amortization expense, and interest expense are not included in gross margin. Our gross margin rate, as a percentage of sales, was 22.95% for the third quarter of 2020, compared to 22.08% for the third quarter of 2019. The increase in rate in the third quarter of 2020, compared to the third quarter of 2019, resulted primarily from decreased fuel sales, which have a lower gross margin rate, an increase in our fuel gross margin, growth in our alternative profit stream portfolio, effective negotiations to achieve savings on the cost of products sold and decreased shrink and transportation costs, as a percentage of sales, reflecting the significant increase in sales volumes, partially offset by continued investments in lower prices for our customers and a change in our product sales mix, including lower relative sales in higher gross margin categories such as deli/bakery. Our gross margin rate, as a percentage of sales, was 23.44% for the first three quarters of 2020, compared to 22.06% for the first three quarters of 2019. The increase in rate in the first three quarters of 2020, compared to the first three quarters of 2019, resulted primarily from decreased fuel sales, which have a lower gross margin rate, an increase in our fuel gross margin, growth in our alternative profit stream portfolio, effective negotiations to achieve savings on the cost of products sold and decreased shrink, transportation and advertising costs, as a percentage of sales, reflecting the significant increase in sales volumes, partially offset by continued investments in lower prices for our customers and a change in our product sales mix, including lower relative sales in higher gross margin categories such as deli/bakery. Our LIFO charge was$23 million for both the third quarters of 2020 and 2019. Our LIFO charge was$77 million for the first three quarters of 2020 compared to$69 million for the first three quarters of 2019. Our LIFO charge reflects an increase in our expected annualized product cost inflation for 2020, primarily driven by grocery, meat and pharmacy. Our FIFO gross margin rate, which excludes the third quarter LIFO charge, was 23.03% for the third quarter of 2020, compared to 22.16% for the third quarter of 2019. Our fuel sales lower our FIFO gross margin rate due to the very low FIFO gross margin rate, as a percentage of sales, of fuel sales compared to non-fuel sales. Excluding the effect of fuel, our FIFO gross margin rate decreased 2 basis points in the third quarter of 2020, compared to the third quarter of 2019. This decrease resulted primarily from continued investments in lower prices for our customers and a change in our product sales mix, including lower relative sales in higher gross margin categories such as deli/bakery, partially offset by growth in our alternative profit stream portfolio, effective negotiations to achieve savings on the cost of products sold and decreased shrink and transportation costs, as a percentage of sales, reflecting the significant increase in sales volumes. 23 Our FIFO gross margin rate, which excludes the first three quarters LIFO charge, was 23.52% for the first three quarters of 2020, compared to 22.14% for the first three quarters of 2019. Excluding the effect of fuel, our FIFO gross margin rate increased 20 basis points in the first three quarters of 2020, compared to the first three quarters of 2019. This increase resulted primarily from growth in our alternative profit stream portfolio, effective negotiations to achieve savings on the cost of products sold and decreased shrink, transportation and advertising costs, as a percentage of sales, reflecting the significant increase in sales volumes, partially offset by continued investments in lower prices for our customers and a change in our product sales mix, including lower relative sales in higher gross margin categories such as deli/bakery.
Operating, General and Administrative Expenses
OG&A expenses consist primarily of employee-related costs such as wages, healthcare benefit costs, retirement plan costs, utilities, and credit card fees. Rent expense, depreciation and amortization expense, and interest expense are not included in OG&A.
OG&A expenses, as a percentage of sales, were 17.48% for the third quarter of 2020, compared to 18.23% for the third quarter of 2019. The decrease in the third quarter of 2020, compared to the third quarter of 2019 resulted primarily from the effect of increased sales due to the pandemic which decreases our OG&A rate, as a percentage of sales, the 2019 Third Quarter OG&A Adjusted Items and broad based improvement of RestockKroger cost savings initiatives that drive administrative efficiencies, store productivity and sourcing cost reductions, partially offset by the 2020 Third Quarter OG&A Adjusted Items, the COVID-19 Investments, growth in our digital channel as a result of heightened demand during the pandemic, increased incentive plan costs and the effect of decreased fuel sales, which increases our OG&A rate, as a percentage of sales. Our fuel sales lower our OG&A rate, as a percentage of sales, due to the very low OG&A rate, as a percentage of sales, of fuel sales compared to non-fuel sales. Excluding the effect of fuel, the 2020 Third Quarter OG&A Adjusted Items and the 2019 Third Quarter OG&A Adjusted Items, our OG&A rate decreased 30 basis points in the third quarter of 2020, compared to the third quarter of 2019. This decrease resulted primarily from the effect of increased sales due to the pandemic which decreases our OG&A rate, as a percentage of sales, and broad based improvement of RestockKroger cost savings initiatives that drive administrative efficiencies, store productivity and sourcing cost reductions, partially offset by the COVID-19 Investments, growth in our digital channel as a result of heightened demand during the pandemic and increased incentive plan costs. OG&A expenses, as a percentage of sales, were 17.85% for the first three quarters of 2020, compared to 17.37% for the first three quarters of 2019. The increase in the first three quarters of 2020, compared to the first three quarters of 2019 resulted primarily from the 2020 Multi-Employer Pension Contribution, the 2020 OG&A Adjusted Items, the COVID-19 Investments, growth in our digital channel as a result of heightened demand during the pandemic, increased incentive plan costs and the effect of decreased fuel sales, which increases our OG&A rate, as a percentage of sales, partially offset by the effect of increased sales due to the pandemic which decreases our OG&A rate, as a percentage of sales, the 2019 OG&A Adjusted Items and broad based improvement of RestockKroger cost savings initiatives that drive administrative efficiencies, store productivity and sourcing cost reductions. Excluding the effect of fuel, the 2020 OG&A Adjusted Items and the 2019 OG&A Adjusted Items, our OG&A rate decreased 6 basis points in the first three quarters of 2020, compared to the first three quarters of 2019. This decrease resulted primarily from the effect of increased sales due to the pandemic which decreases our OG&A rate, as a percentage of sales and broad based improvement of RestockKroger cost savings initiatives that drive administrative efficiencies, store productivity and sourcing cost reductions, partially offset by the 2020 Multi-Employer Pension Contribution, the COVID-19 Investments, growth in our digital channel as a result of heightened demand during the pandemic and increased incentive plan costs. Excluding the effect of fuel, the 2020 OG&A Adjusted Items, the 2019 OG&A Adjusted Items and the 2020 Multi-Employer Pension Contribution, our OG&A rate improved 31 basis points. Rent Expense
Rent expense decreased, as a percentage of sales, in both the third quarter and first three quarters of 2020, compared to the same periods in 2019. This decrease resulted primarily from the effect of increased sales due to the pandemic which decreases our rent expense, as a percentage of sales.
24
Depreciation and Amortization Expense
Depreciation and amortization expense decreased, as a percentage of sales, in both the third quarter and first three quarters of 2020, compared to the same periods in 2019. This decrease resulted primarily from the effect of increased sales due to the pandemic which decreases our depreciation expense, as a percentage of sales, partially offset by decreased fuel sales, which increases our depreciation expense, as a percentage of sales, additional depreciation on capital investments, excluding mergers and lease buyouts during the rolling four quarter period ending with the third quarter of 2020 of$2.9 billion and a decrease in the average useful life on these capital investments. Our strategy under RestockKroger includes initiatives to enhance the customer experience in stores, improve our process efficiency and integrate our digital shopping experience through technology developments. As such, the percentage of capital investments related to digital and technology has grown compared to the prior year, which has caused a decrease in the average depreciable life of our capital portfolio.
Operating Profit and FIFO Operating Profit
Operating profit was$792 million , or 2.67% of sales, for the third quarter of 2020, compared to$254 million , or 0.91% of sales, for the third quarter of 2019. Operating profit, as a percentage of sales, increased 176 basis points in the third quarter of 2020, compared to the third quarter of 2019, due to improved sales to retail customers without fuel, a higher gross margin rate, decreased OG&A, rent and depreciation and amortization expenses, as a percentage of sales, and increased fuel earnings. Operating profit was$2.9 billion , or 2.89% of sales, for the first three quarters of 2020, compared to$1.7 billion , or 1.83% of sales, for the first three quarters of 2019. Operating profit, as a percentage of sales, increased 106 basis points in the first three quarters of 2020, compared to the first three quarters of 2019, due to improved sales to retail customers without fuel, a higher gross margin rate, decreased rent and depreciation and amortization expenses, as a percentage of sales, and increased fuel earnings, partially offset by increased OG&A expense, as a percentage of sales. FIFO operating profit was$815 million , or 2.74% of sales, for the third quarter of 2020, compared to$277 million , or 0.99% of sales, for the third quarter of 2019. FIFO operating profit, excluding the 2020 and 2019 Third Quarter Adjusted Items, increased 64 basis points in the third quarter of 2020, compared to the third quarter of 2019, due to improved sales to retail customers without fuel, a higher gross margin rate, decreased rent and depreciation and amortization expenses, as a percentage of sales, and increased fuel earnings, partially offset by increased OG&A expense, as a percentage of sales. FIFO operating profit was$3.0 billion , or 2.96% of sales, for the first three quarters of 2020, compared to$1.8 billion , or 1.91% of sales, for the first three quarters of 2019. FIFO operating profit, excluding the 2020 and 2019 Adjusted Items, increased 80 basis points in the first three quarters of 2020, compared to the first three quarters of 2019, due to improved sales to retail customers without fuel, a higher gross margin rate, decreased rent and depreciation and amortization expenses, as a percentage of sales, and increased fuel earnings, partially offset by increased OG&A expense, as a percentage
of sales.
Specific factors contributing to the operating trends for operating profit and FIFO operating profit above are discussed earlier in this section.
25
The following table provides a reconciliation of operating profit to FIFO operating profit, and to Adjusted FIFO operating profit, excluding the 2020 and 2019 Adjusted Items.
Operating Profit excluding the Adjusted Items
($ in millions)
Third Quarter Ended Three Quarters Ended
November 7, November 9, November 7, November 9,
2020 2019 2020 2019
Operating profit $ 792 $ 254 $ 2,938 $ 1,714
LIFO charge 23 23 77 69
FIFO Operating profit 815 277 3,015 1,783
Adjustment for pension plan withdrawal
liabilities - 45 - 131
Adjustment for Home Chef contingent
consideration 24 4 109 (18)
Adjustment for severance charge and
related benefits - 80 - 80
Adjustment for transformation costs 33 - 100 -
Adjustment for impairment of Lucky's
Market(1) - 238 - 238
Other (1) 9 (6) 23
2020 and 2019 Adjusted items 56 376 203 454 Adjusted FIFO operating profit excluding the adjusted items above $ 871 $
653
(1) The adjustment for impairment of Lucky's Market includes a
attributable to the minority interest of Lucky's Market.
Income Taxes
The effective income tax rate was 24.2% in the third quarter of 2020, compared
to 35.6% in the third quarter of 2019. The effective income tax rate was 23.4%
for the first three quarters of 2020, compared to 25.0% for the first three
quarters of 2019. The effective income tax rate for the third quarter and the
first three quarters of 2020 differed from the federal statutory rate due to the
effect of state income taxes, partially offset by the utilization of tax credits
and deductions and the benefit from share-based payments. The effective income
tax rate for the third quarter and the first three quarters of 2019 differed
from the federal statutory rate primarily due to the portion of the impairment
of Lucky's Market attributable to the minority interest, which reduces pre-tax
income, but does not impact tax expense. The impact of this item on the
effective income tax rate is approximately 12% for the third quarter and 2% for
the first three quarters of 2019. The difference from the statutory rate is also
impacted by the effect of state income taxes, partially offset by the
utilization of tax credits and deductions.
Net Earnings and Net Earnings Per Diluted Share
Our net earnings are based on the factors discussed in the Results of Operations section.
Net earnings were$0.80 per diluted share for the third quarter of 2020 compared to net earnings of$0.32 per diluted share for the third quarter of 2019. Adjusted net earnings of$0.71 per diluted share for the third quarter of 2020 represented an increase of 51.1% compared to adjusted net earnings of$0.47 per diluted share for the third quarter of 2019. The increase in adjusted net earnings per diluted share resulted primarily from increased FIFO operating profit without fuel, increased fuel earnings and lower weighted average common shares outstanding due to common share repurchases, partially offset by a higher income tax expense. 26 Net earnings were$3.35 per diluted share for the first three quarters of 2020 compared to net earnings of$1.64 per diluted share for the first three quarters of 2019. Adjusted net earnings of$2.66 per diluted share for the first three quarters of 2020 represented an increase of 64.2% compared to adjusted net earnings of$1.62 per diluted share for the first three quarters of 2019. The increase in adjusted net earnings per diluted share resulted primarily from increased FIFO operating profit without fuel, increased fuel earnings and lower weighted average common shares outstanding due to common share repurchases, partially offset by a higher income tax expense.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flow Information
Net cash provided by operating activities
We generated$5.9 billion of cash from operations in the first three quarters of 2020 compared to$4.0 billion in the first three quarters of 2019. Net earnings including noncontrolling interests, adjusted for non-cash items and other impacts, generated approximately$5.2 billion of operating cash flow in the first three quarters of 2020 compared to$3.6 billion in the first three quarters of 2019. Cash provided by operating activities for changes in working capital was$692 million in the first three quarters of 2020 compared to$451 million in the first three quarters of 2019. The increase in cash provided by operating activities for changes in working capital in the first three quarters of 2020, compared to the first three quarters of 2019, was primarily due to
the following:
Increased trade accounts payable at the end of the third quarter of 2020,
? primarily related to inventory purchases to meet elevated demand during the
pandemic and improved vendor terms;
An increase in accrued salaries and wages at the end of the third quarter of
? 2020, primarily related to an increase in employee headcount in response to the
pandemic; and
Cash flows from income taxes were favorable in the first three quarters of 2020
? compared to the first three quarters of 2019, primarily due to favorable
changes in the timing of certain deductions including changes enacted under the
CARES Act;
? Partially offset by proceeds from a contract associated with the sale of a
business that benefited the first three quarters of 2019.
Cash paid for interest increased in the first three quarters of 2020, compared to the first three quarters of 2019, primarily due to the timing of certain semi-annual senior notes interest payments that were paid during the first quarter of 2020 which were accrued as of the end of fiscal year 2019.
Net cash used by investing activities
Investing activities used cash of$2.0 billion in the first three quarters of 2020 compared to$1.8 billion in the first three quarters of 2019. The amount of cash used by investing activities increased in the first three quarters of 2020 compared to the first three quarters of 2019, primarily due to the following:
? Decreased proceeds from the sale of assets in the first three quarters of 2020
compared to the first three quarters of 2019; and
? Proceeds from the sale of businesses that benefited the first three quarters of
2019, partially offset by
? Payments for property and equipment continued at a slower pace in the first
three quarters of 2020 due to disruptions from the pandemic.
Net cash used by financing activities
We used$2.1 billion of cash for financing activities in both the first three quarters of 2020 and 2019. The amount of cash used for financing activities for the first three quarters of 2020, compared to the first three quarters of 2019, remained consistent due to increased proceeds from the issuance of long-term debt and decreased payments on long-term debt being offset by increased payments on commercial paper and share repurchases. 27 Debt Management
As ofNovember 7, 2020 , we maintained a$2.75 billion (with the ability to increase by$1 billion ), unsecured revolving credit facility that, unless extended, terminates onAugust 29, 2022 . Outstanding borrowings under the credit facility, commercial paper borrowings, and some outstanding letters of credit reduce funds available under the credit facility. As ofNovember 7, 2020 , we had no outstanding commercial paper and no borrowings under our revolving credit facility. The outstanding letters of credit that reduce funds available under our credit facility totaled$1 million as ofNovember 7, 2020 . Our bank credit facility and the indentures underlying our publicly issued debt contain various financial covenants. As ofNovember 7, 2020 , we were in compliance with the financial covenants. Furthermore, management believes it is not reasonably likely that we will fail to comply with these financial covenants in the foreseeable future. Total debt, including both the current and long-term portions of obligations under finance leases, decreased$556 million as ofNovember 7, 2020 compared to our fiscal year end 2019 debt of$14.1 billion . This decrease resulted primarily from net payments on commercial paper borrowings of$1.2 billion partially offset by the issuance of$500 million of senior notes bearing an interest rate of 2.20% and a net increase in obligations under finance leases of$72 million .
Common Share Repurchase Program
During the third quarter of 2020, we invested$321 million to repurchase 9.6 millionKroger common shares at an average price of$33.53 per share. For the first three quarters of 2020, we invested$989 million to repurchase 31.1 millionKroger common shares at an average price of$31.77 per share. The shares repurchased in the first three quarters of 2020 were reacquired under the following share repurchase programs:
On
repurchase program to reacquire shares via open market purchase or privately
? negotiated transactions, block trades, or pursuant to trades intending to
comply with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended
(the "November 2019 Repurchase Program");
On
repurchase program to reacquire shares via open market purchase or privately
? negotiated transactions, block trades, or pursuant to trades intending to
comply with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended
(the "September 2020 Repurchase Program"); and
A program that uses the cash proceeds from the exercises of stock options by
? participants in
associated tax benefits.
The
Dividends
The following table provides dividend information ($ in millions, except per
share amounts):
Third Quarter Ended Three Quarters Ended
November 7, November 9, November 7, November 9,
2020 2019 2020 2019Cash dividends paid $ 141 $ 130$ 395 $ 356 Cash dividends paid per common share$ 0.18 $ 0.16
$ 0.50 $ 0.44 28 Liquidity Needs Based on current operating trends, we believe that cash flows from operating activities and other sources of liquidity, including borrowings under our commercial paper program and bank credit facility, will be adequate to meet our liquidity needs for the next twelve months and for the foreseeable future beyond the next twelve months. Our liquidity needs include anticipated requirements for working capital, capital investments, pension plan withdrawal liabilities, interest payments and scheduled principal payments of debt and commercial paper, offset by cash and temporary cash investments on hand at the end of the third quarter of 2020. We generally operate with a working capital deficit due to our efficient use of cash in funding operations and because we have consistent access to the capital markets. We have approximately$1.5 billion of senior notes maturing in the next twelve months and expect to pay approximately$220 million in the fourth quarter of 2020 and$280 million in the first half of 2021 to satisfy a portion of theUFCW National Fund withdrawal liability. We expect to satisfy these obligations using cash generated from operations, temporary cash investments on hand, or through the issuance of additional senior notes or commercial paper. We believe we have adequate coverage of our debt covenants to continue to maintain our current investment grade debt ratings and to respond effectively to competitive conditions. We held cash and temporary cash investments of$2.2 billion as of the end of the third quarter of 2020 which reflects our elevated operating performance and significant improvements in working capital. This improvement in working capital includes the impact of a temporary increase in warehousing and build-up of inventory during the third quarter of 2020, which we implemented to minimize supply disruptions as a result of higher forecasted COVID-19 cases over the winter months. We expect working capital to improve for the 2020 fiscal year. We remain committed to our dividend and share repurchase program and we will evaluate the optimal use of any excess free cash flow, consistent with our previously stated capital allocation strategy. The CARES Act, which was enacted onMarch 27, 2020 , includes measures to assist companies in response to the COVID-19 pandemic. These measures include deferring the due dates of tax payments and other changes to income and non-income-based tax laws. As permitted under the CARES Act, we are deferring the remittance of the employer portion of the social security tax. The social security tax provision requires that the deferred employment tax be paid over two years, with half of the amount required to be paid byDecember 31, 2021 and the other half byDecember 31, 2022 . During the first three quarters of 2020, we deferred the employer portion of social security tax of$505 million which is included in "Other long-term liabilities" in our Consolidated Balance Sheets. We expect to defer a total of approximately$600 to$650 million of payments related to the employer's portion of social security tax in 2020. For additional information about our debt activity in the first three quarters of 2020, including the drawdown and repayments under our revolving credit facility, forward-starting interest rate swap agreements and our senior notes issuance, see Note 2 to the Consolidated Financial Statements. CAPITAL INVESTMENTS Capital investments, excluding mergers, acquisitions and the purchase of leased facilities, totaled$624 million for the third quarter of 2020 compared to$691 million for the third quarter of 2019. Capital investments, excluding mergers, acquisitions and the purchase of leased facilities, totaled$2.1 billion in the first three quarters of 2020 and$2.2 billion in the first three quarters of 2019. During the rolling four quarter period ended with the third quarter of 2020, we opened, expanded, relocated or acquired 21 supermarkets and also completed 97 major within-the-wall remodels. Total supermarket square footage at the end of the third quarter of 2020 increased 0.1% from the end of the third quarter of 2019. Excluding mergers, acquisitions and operational closings, total supermarket square footage at the end of the third quarter of 2020 increased 0.6% over the end of the third quarter of 2019. 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 our Annual Report on Form 10-K for the fiscal year endedFebruary 1, 2020 . 29
The preparation of financial statements in conformity with GAAP 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. NEW ACCOUNTING STANDARDS Refer to Note 5 and Note 6 to the Consolidated Financial Statements for recently adopted accounting standards and recently issued accounting standards not yet adopted as ofNovember 7, 2020 . 30
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