Kroger Co (NYSE: KR) Q4 2020 earnings call dated Mar. 04, 2021.
Rebekah Manis — Director, Investor Relations
W. Rodney McMullen — Chairman and Chief Executive Officer
Gary Millerchip — Senior Vice President and Chief Financial Officer
John Heinbockel — Guggenheim Securities — Analyst
Karen Short — Barclays — Analyst
Michael Lasser — UBS — Analyst
Rupesh Parikh — Oppenheimer — Analyst
Robby Ohmes — Bank of America Global Research — Analyst
Spencer Hanus — Wolfe Research — Analyst
Matt Fishbein — Jefferies — Analyst
Paul Lejuez — Citigroup — Analyst
Good morning, and welcome to the Kroger Co. Fourth Quarter 2020 Earnings Conference Call. [Operator Instructions]
I would now like to turn the conference over to Rebekah Manis, Director, Investor Relations. Please go ahead.
Rebekah Manis — Director, Investor Relations
Thank you, Gary.
Good morning, and thank you for joining us.
Before we begin, I want to remind you that today’s discussions will include forward-looking statements. We want to caution you that such statements are predictions and actual events or results can differ materially. A detailed discussion of the many factors that we believe may have a material effect on our business on an ongoing basis is contained in our SEC filings. The Kroger Co. assumes no obligation to update that information.
Both our fourth quarter press release and our prepared remarks from this conference call will be available on our website at ir.kroger.com. After our prepared remarks, we look forward to taking your questions. In order to cover a broad range of topics from as many of you as we can, we ask that you please limit yourself to one question and one follow-up question, if necessary. I’d like to confirm that Kroger will host its annual virtual Investor Day event on Wednesday, March 31. Please hold the day, and we look forward to sharing more about our future growth plans at the event.
I will now turn the call over to Kroger’s Chairman and Chief Executive Officer, Rodney McMullen.
W. Rodney McMullen — Chairman and Chief Executive Officer
Thank you, Rebekah.
Good morning and thank you for joining us. With me today to review Kroger’s fourth quarter and full year 2020 results is Chief Financial Officer, Gary Millerchip.
This past year presented challenges that none of us could have predicted. I am so proud of how Team Kroger has risen to meet every challenge and to be there for our customers when they needed us the most. While we hope that the worst the pandemic is behind us and we are encouraged by the progress around the initial vaccine rollout, our priority remains the health and safety of our associates, customers and communities.
2020 was the final year of our three-year transformational plan, Restock Kroger, during which we made strategic investments and changes to our business model to better serve our customers. We focused on widening and deepening our competitive moats, which include Seamless, Personalization, Fresh and Our Brands. As a result, we generated strong momentum and successfully repositioned our company to serve our customers in new and exciting ways.
Let me now turn to our results. Kroger delivered strong results during our fourth quarter and for the full year 2020. We continued to gain market share, and full year results were above the guidance we shared with you last quarter. Identical sales without fuel grew 14.1% for the year as customers continued to consolidate trips and spend more per transaction. We grew digital sales triple digits in 2020, enabled by our team’s ability to pivot quickly and effectively in the first stage of the pandemic to ensure that we were meeting our customers’ demand for safe, low-touch and touchless shopping modalities. Our strong performance in digital is also a testament to the proactive investments we made over the last several years in our network which position Kroger to respond with agility during this crisis and critical time. Beyond the numbers, we have built substantial momentum within our business, and more importantly, we continue to deepen our personalized relationships with our customers who will remain at the center of everything we do.
When the pandemic started, no one knew what to expect. But what we did know was that our decisions and actions would be guided by our purpose and our values. Our purpose is to feed the human spirit, which means we are driven to do more and help make the lives of those around us better, especially during times of uncertainty. Since the beginning of the pandemic last March, our most urgent priority has been to safeguard our associates and customers. We’ve implemented dozens of new safety and cleanliness processes and procedures in our stores and all of our facilities, including safety partitions and physical distancing floor decals, implementation of customer capacity limits and providing PPE-like masks for our associates, all of which are described in our Blueprint for Businesses, an open source guide we created to help other companies navigate the complexities of safely operating during a pandemic.
Supported by our strong performance and cash position, we’ve committed more than $2.5 billion to safeguard the environment of our associates and customers where they work and shop in and to reward associates, including committing nearly $1 billion to better secure pensions for over 30,000 associates. This was in addition to paid emergency leaves, financial assistance through our Helping Hand Funds program and much more. We continue to provide support for our associates, including awards in November and February that included $100 cash and 1,000 fuel points placed on frontline associates’ shopper cards to help ease financial hardship from the pandemic and as a Thank You for their continued commitment to serving our customers so tirelessly.
We know the critical role that the COVID vaccine plays in creating a safe environment for our associates and customers. That’s why we’re encouraging everyone to receive the vaccine as soon as they are eligible to do so. During the quarter, we announced a $100 incentive for all associates who receive the manufacturer recommended dosage of the vaccine. We hope this offer, along with targeted education efforts, will help breakthrough vaccine hesitancy and further encourage the health and safety of our associates.
Kroger Health is proud to be a partner with the federal government and our state governments in distributing the vaccine. We continue to introduce initiatives to improve the vaccination process, including the recent launch of a new scheduling tool and enhancements to our website to make finding and scheduling vaccine appointments easier. To-date, Kroger Health has administrated more than 665,000 vaccines, including more than 38,000 for our own associates. Because vaccine availability and eligibility continues to vary by jurisdiction, we are advocating at the local, state and federal level and calling for our associates and frontline grocery workers broadly to be included in the earliest vaccine phase possible.
Inspired by purpose and guided by our values, 2020 taught us that we are capable of doing more, of moving faster and effectively prioritizing what matters most to our customers, associates and communities. In addition to changing how we work, COVID-19 has changed how our customers enjoy food. We continue to see people eat and work more from home and prioritize health and cleanliness. We believe that these trends will continue even as restrictions ease and vaccinations are distributed. We will share more of these trends with you at our Investor Day in a few weeks. What hasn’t changed is our fundamental commitment to putting our customers first. Our competitive moats, Seamless, Personalization, Fresh and Our Brands, are built upon this commitment and are stronger today than ever before, especially as customers eat more food at home. We will continue to invest in these critical competitive advantages as we work to win a larger share of the food-at-home market.
Let me provide some more detail on each of these competitive moats. Pickup and delivery continued to grow during the quarter, and we are seeing more and more new customers engaging in our seamless ecosystem. Our overall digital sales grew 118%, including delivery sales growth of 249% during the quarter. When customers engage in both our in-store and online modalities, we see a 98% retention rate within our ecosystem, highlighting how sticky our customer engagement is.
During the quarter, we also saw further improvement in digital profitability as we continued to improve cost efficiency, sales mix and retail media. Yesterday, we completed the inaugural order through our first Ocado shed in Monroe, Ohio. This marks the soft opening of the facility, and we look forward to our grand opening in early April. We continue to be excited about the elevated experience that this will bring to our customers in the tri-state area and across the country as we continue to open additional facilities. Our Data and Personalization allow us to deliver meaningful unique customer moments across channels to address specific customer needs while enhancing their relationship with Kroger. 60 million households shop with Kroger every year. The scale of our digital business has grown rapidly. In fact, during 2020, we had over 1.3 billion customer interactions across our digital modalities, a 30% increase over last year. Our significant reach allows us to meaningfully personalize the customer experience. In 2020, we presented nearly 11 million [Phonetic] personalized recommendations per week. That’s right. 11 billion recommendations, personalized, each week. When you look at that over the year, that’s more than a half a trillion offered personalized for customers during 2020.
We achieved several exciting milestones in Fresh this year. As more customers are spending more time at home, our produce and floral departments outperformed total Company. Customers are focused on eating healthier, as evidenced by the increased engagement in our Simple Truth brand, which grew 18% during the quarter. We also saw customers trading up and buying higher-quality premium products like Luxury wine and Murray’s Cheese which also outperformed the total Company. As customers look for food inspiration, we continue to develop innovative products to meet their needs, including ready-to-heat and ready-to-eat foods. We have seen significant growth in deli bakery and meals solution, and Home Chef finished the year with record sales, capturing additional share of stomach from restaurants and grocery retailers. Also this quarter, our Fresh for Everyone campaign celebrated its first anniversary. The marketing campaign is reaching new heights and add effectiveness and it’s resonating with our customers.
Our Brands achieved its best year ever in 2020, exceeding $26.2 billion in sales. Our Simple Truth brand achieved a major milestone exceeding $1 billion in annual sales for the first time, and this is a brand that was just — that was created from scratch a little over five years ago. We saw a 20% growth in our premium culinary brand, Private Selection, as more people continue cooking at home and elevating their meals. Our Simple Truth, plant-based platform launched 53 new items in 2020. One of the key launches for the year was Simple Truth oat milk ice cream. This line has brought new customers to the category, and sales are continuing to outpace projections. Over 1.4 million new households have purchased from the Simple Truth plant-based platform this year, as we hold high standards for the taste and experience of our plant-based products, just like the rest of Our Brands portfolio. Our trial rate has continued to grow and our repeat rate has continued to strengthen.
Kroger is committing to helping people and our planet. This is at the core of who we are as a company. During 2020, this work became even more critical as our communities experienced the pandemic and its economic impacts, social unrest and natural disasters. Let me provide some detail on two important areas under our broader ESG strategy: diversity, equity and inclusion and our Zero Hunger Zero Waste efforts to improve food access and food security. Diversity and inclusion are among Kroger’s longstanding core values.
In October, we introduced a 10-point framework for action to accelerate diversity, equity and inclusion and promote greater change in the workplace and in our communities. As part of this framework, we created an internal advisory council comprised of black leaders and associates across the Company to help set priorities and drive meaningful change. The Kroger Co. Foundation also established a $5 million Racial Equity Fund to align philanthropy to our extended commitment. So far, the foundation has directed $3 million in grants to four organizations with innovative approaches to building stronger, more equitable communities.
COVID-19 and its impact also shined a light on the intersection of food security, health and nutrition and racial equity. Given the increased need in 2020, Kroger nearly doubled our charitable giving to the Feeding America network of food banks and support key partners like No Kid Hungry to direct meals where needed most. We are pleased to note that our associates continued to rescue surplus food throughout the year despite heavy stockpiling up periods early in the year. Zero Hunger Zero Waste is the centerpiece of our ESG strategy, and it’s how our associates live our purpose every day.
I would now like to turn it over to Gary to take you through our quarter four and full year 2020 financial results. Gary?
Gary Millerchip — Senior Vice President and Chief Financial Officer
Thanks, Rodney, and good morning, everyone.
We are extremely proud of our results in 2020 and the balance achieved in delivering for all our key stakeholders: our associates, customers, communities and shareholders. Strong execution by our team and accelerated investments in our competitive moats during the pandemic allowed us to create significant value to shareholders and strengthen our balance sheet. The momentum we see in our business, which started pre-pandemic and accelerated during the pandemic places us in an even better position to grow sales and profitability in the future and deliver on our TSR commitments. Three points of the accelerated momentum in our model achieved during 2020 include significant market share gains, accelerated investments in Fresh and digital experience, over $1 billion of cost savings, $150 million of incremental alternative profit and improved digital profitability. Let me share additional color on each of these points.
The change in customer behavior caused by COVID was of course a major factor in our results last year. This brought to the forefront the importance to the customer fresh and digital. We continued to invest and aggressively grew our capabilities in these areas of strength for Kroger, leading to significant gains in both digital and total food at home market share. Consistent with our value creation model, we were disciplined in balancing investments in our customers and associates with cost savings.
For the third year in a row, our operations and sourcing teams delivered over $1 billion in incremental cost savings. These savings continue to be focused in areas that take complexity out of the business and allow our associates to provide a better customer experience. Alternative profit continues to be a significant growth driver in our model and contributed $150 million of incremental operating profit on top of the $100 million of incremental profit in 2019. Retail media fueled this acceleration, and we continue to see significant opportunity for additional growth in the future. Importantly, this progress with cost savings and growth of retail media also allowed us to improve the profitability of our digital model in 2019 as we reduced the cost to fulfill a digital order and grew media revenue from digital sales.
I’ll now provide more color on our full year results. We delivered adjusted EPS of $3.47 per diluted share, up 58% compared to last year and the head of the range we shared during quarter three. Identical sales excluding fuel grew 14.1%, in with expectations, and our adjusted FIFO operating profit also came in at the top end of our increased guidance. Gross margin was 23.3% of sales for 2020. The FIFO gross margin rate excluding fuel increased 14 basis points, reflecting sales leverage, continued growth in alternative profit streams and sourcing benefits, offset by continued investments in price and value for customers. Our OG&A rate without fuel and adjustment items decreased 6 basis points, reflecting increased sales leverage and execution of cost savings, offset by COVID-related investments to reward associates and to protect the health and safety of associates, customers and our communities.
Turning now to our fourth quarter results. We delivered adjusted EPS of $0.81 per diluted share, up 42% compared to the same quarter last year. Kroger reported identical sales without fuel of 10.6%, driven by continued strength in grocery, produce and meat. Digital sales grew 118% during the quarter, outpacing the full year rate, as customers continued to rely heavily on our digital modalities. Digital contributed approximately 5.5% to total identical sales without fuel, and as a result of productivity improvements in the cost to fulfill a digital order and accelerated retail media revenue, we improved pass-through profitability on digital sales by over 20% in the fourth quarter.
FIFO gross margin rate decreased 6 basis points, with continued price investments, offset by growth in alternative profit streams and sourcing benefits. Our OG&A rate without fuel and adjustment items decreased 7 basis points, which reflects increased sales leverage and execution of cost savings, offset by continued COVID related investments to reward our associates and to protect the health and safety of associates, customers and our communities. During the fourth quarter, the incremental COVID related investments were approximately $275 million. LIFO was a credit for the quarter of $84 million. The LIFO credit was primarily driven by fourth quarter working capital improvements in pharmacy inventory and dairy deflation. The income tax rate of 30.8% was a benefit for the fourth quarter as a result of the UFCW pension restructure charge. Fuel was a headwind of approximately $50 million to net operating profit during quarter four. Like the broader industry, we experienced a year-over-year decline in fuel gallons, and the average retail price of fuel was also lower at $2.20 this quarter versus $2.58 in the same quarter last year.
As Rodney touched on earlier, our associates have been nothing short of amazing over the past year, and we continued to invest in and reward our associates for their incredible work. We invested approximately $300 million in increased hourly rates during 2020 as part of the $800 million incremental investment in associate wages previously announced as part of Restock Kroger. Our average hourly rate is now $15.50, up from $15 last year, and with comprehensive benefits factored in, our average hourly rate is over $20. In 2021, we expect to invest an incremental $350 million in continued average hourly wage increases for our associates.
Looking ahead, we have several major labor negotiations in 2021, including contracts with the UFCW for store associates in Atlanta, Houston, Little Rock, Michigan, Memphis, Mid-Atlantic, Cincinnati and Portland. Our objective in every negotiation is to find a fair and reasonable balance between competitive costs and compensation packages that provide solid wages, good-quality affordable healthcare and retirement benefits for our associates. We strive to make our overall benefit package relevant to today’s associates.
Our financial results continue to be pressured by healthcare and pension costs which most of our competitors do not face. We continue to communicate with our local unions and the international unions, which represent many of our associates, on the importance of growing our business in a profitable way, which will help us create more jobs and career opportunities and enhance job security for our associates.
Turning now to our financial strategy. As a result of our strong operating performance, Kroger generated tremendous free cash flow in 2020, which resulted in a significant strengthening of our balance sheet and liquidity. We’ve reduced net total debt by $2 billion over the last four quarters, and Kroger’s net total debt to adjusted EBITDA ratio is now 1.75 compared to our target range of 2.3 to 2.5. Our financial strategy remains unchanged, and we will continue to evaluate how to deploy excess cash in ways that would accelerate our value creation model by sustainably growing earnings and delivering on our TSR commitments of 8% to 11%.
Looking towards 2021, we are providing specific guidance to help you better understand how we see the business today. Due to the uncertainty surrounding trends in the food at home market as COVID vaccines roll out, we are sharing a wider range than we typically would, and we will be transparent in sharing more as the year unfolds. Our insight suggests there are a number of consumer changes that have occurred during the pandemic that will prove to be more structural and lasting, which, combined with our strong execution and flexible financial model, give us confidence we will be able to manage through the current unknowns. As we cycle the tough comparisons from 2020, we expect our sales will turn negative in 2021 and are guiding to a range of negative 3% to negative 5% identical sales excluding fuel and adjusted FIFO operating profit of $3.3 billion to $3.5 billion in 2021.
Evaluating our performance using a two-year period will more accurately measure our underlying momentum. We expect our two-year stacked identical sales without fuel to be in the range of 9% and 11%. In addition, we expect our adjusted net earnings per diluted share and adjusted FIFO operating profit to have compounded annual growth rates of between 12% and 16% and 5.4% and 8.5% respectively. Over the two years, this would result in total shareholder returns significantly above our previously communicated target of 8% to 11%. We expect our free cash flow to be at least $1.6 billion in 2021, which includes a payment of $300 million for payroll taxes deferred from 2020.
Over the course of 2020 and 2021, average annual free cash flow is forecast to be between $2.9 billion and $3 billion. This excludes the sale of strategic assets, Company-sponsored pension contributions and pension payments related to the restructuring of multi-employer pension plans. These two-year expectations are ahead of our TSR growth algorithm, and we believe the momentum in our business places us in an even better position to grow profitably in the future. We remain committed to delivering strong and attractive shareholder — total shareholder return over the long term and expect our 2021 operating profit guidance to represent a new higher baseline from which we will deliver future TSR of 8% to 11%.
Finally, we look forward to sharing more about our strategy for growth and delivering on our TSR commitments at our upcoming Investor Day.
And with that, I’ll turn it back over to Rodney.
W. Rodney McMullen — Chairman and Chief Executive Officer
Thank you, Gary.
I’m incredibly proud of our associates. During this past year, our team was amazingly agile and always led with our purpose and values, especially in dealing with all the unknowns of navigating a global pandemic. We are a different company today because of the events of the past year. We are more resilient than we’ve ever been. We are more confident in our ability to continue to deliver for our customers, associates, communities and our shareholders.
Now we look forward to your questions.
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