Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

90K characters. Original on sec.gov · Markdown

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

| --- | --- |

The following discussion and analysis of financial condition and results of operations of The Kroger Co. should be read in conjunction with the “Forward-looking Statements” section set forth in Part I and the “Risk Factors” section set forth in Item 1A of Part I. MD&A is provided as a supplement to, and should be read in conjunction with, our Consolidated Financial Statements and the accompanying notes thereto contained in Item 8 of this report, as well as Part II, Item 7 “Management's Discussion and Analysis of Financial Condition and Results of Operations” of our Form 10-K for the year ended February 2, 2019, which provides additional information on comparisons of fiscal years 2018 and 2017.

OUR BUSINESS

The Kroger Co. was founded in 1883 and incorporated in 1902. As of February 1, 2020, Kroger is one of the world’s largest retailers, as measured by revenue, operating 2,757 supermarkets under a variety of local banner names in 35 states and the District of Columbia. Of these stores, 2,270 have pharmacies and 1,567 have fuel centers. We offer Pickup (also referred to as ClickList®) and Harris Teeter ExpressLane™ — personalized, order online, pick up at the store services — at 1,989 of our supermarkets and provide home delivery service to 97% of Kroger households. We also operate an online retailer.

We operate 35 food production plants, primarily bakeries and dairies, which supply approximately 31% of Our Brands units and 42% of the grocery category Our Brands units sold in our supermarkets; the remaining Our Brands items are produced to our strict specifications by outside manufacturers.

Our revenues are predominately earned and cash is generated as consumer products are sold to customers in our stores, fuel centers and via our online platforms. We earn income predominately by selling products at price levels that produce revenues in excess of the costs we incur to make these products available to our customers. Such costs include procurement and distribution costs, facility occupancy and operational costs, and overhead expenses. Our retail operations, which represent 97% of our consolidated sales, is our only reportable segment.

On January 27, 2020, Lucky’s Market filed a voluntary petition in the Bankruptcy Court seeking relief under the Bankruptcy Code. Lucky’s Market is included in our Consolidated Balance Sheet for 2018 and our Consolidated Statements of Operations in all periods in 2017 and 2018 and through January 26, 2020. Refer to Note 17 to the Consolidated Financial Statements for additional information.

On April 26, 2019, we completed the sale of our Turkey Hill Dairy business for total proceeds of $225 million. Turkey Hill Dairy is included in our Consolidated Balance Sheet for 2018 and our Consolidated Statements of Operations in all periods in 2017 and 2018 and through April 25, 2019.

On March 13, 2019, we completed the sale of our You Technology business to Inmar for total consideration of $565 million, including $396 million of cash and $64 million of preferred equity received upon closing. We are also entitled to receive other cash payments of $105 million over five years. The transaction includes a long-term service agreement for Inmar to provide us digital coupon services. You Technology is included in our Consolidated Balance Sheet for 2018 and our Consolidated Statements of Operations in all periods in 2017 and 2018 and through March 12, 2019.

On June 22, 2018, we closed our merger with Home Chef by purchasing 100% of the ownership interest in Home Chef, for $197 million net of cash and cash equivalents of $30 million, in addition to future earnout payments of up to $500 million over five years that are contingent on achieving certain milestones. Home Chef is included in our ending Consolidated Balance Sheet for 2018 and 2019 and in our Consolidated Statements of Operations from June 22, 2018 through February 2, 2019 and all periods in 2019. See Note 2 to the Consolidated Financial Statements for more information related to our merger with Home Chef.

On April 20, 2018, we completed the sale of our convenience store business unit for $2.2 billion. The convenience store business is included in our Consolidated Statements of Operations in all periods in 2017 and through April 19, 2018.

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 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 for our net earnings and net earnings per diluted share because adjusted items are not the result of our normal operations. Net earnings for 2019 include the following, which we define as the “2019 Adjusted Items:”

	●	Charges to operating, general and administrative expenses (“OG&A”) of $135 million, $104 million net of tax, for obligations related to withdrawal liabilities for certain multi-employer pension funds; $80 million, $61 million net of tax, for a severance charge and related benefits; $412 million including $305 million attributable to The Kroger Co., $225 million net of tax, for impairment of Lucky’s Market; $52 million, $37 million net of tax, for transformation costs, primarily including 35 planned store closures; and a reduction to OG&A of $69 million, $49 million net of tax, for the revaluation of Home Chef contingent consideration (the “2019 OG&A Adjusted Items”).

	●	Gains in other income (expense) of $106 million, $80 million net of tax, related to the sale of Turkey Hill Dairy; $70 million, $52 million net of tax, related to the sale of You Technology; and $157 million, $119 million net of tax, for the mark to market gain on Ocado Group plc (“Ocado”) securities (the “2019 Other Income (Expense) Adjusted Items”).

Net earnings for 2018 include the following, which we define as the “2018 Adjusted Items:”

	●	Charges to OG&A of $155 million, $121 million net of tax, for obligations related to withdrawal liabilities for certain local unions of the Central States multi-employer pension fund; $33 million, $26 million net of tax, for the revaluation of Home Chef contingent consideration; and $42 million, $33 million net of tax, for an impairment of financial instrument (the “2018 OG&A Adjusted Items”). We had initially received the financial instrument in 2016 with no cash outlay as part of the consideration for entering into agreements with a third party.

	●	A reduction to depreciation and amortization expenses of $14 million, $11 million net of tax, related to held for sale assets (the “2018 Depreciation Adjusted Item”).

	●	Gains in other income (expense) of $1.8 billion, $1.4 billion net of tax, related to the sale of our convenience store business unit and $228 million, $174 million net of tax, for the mark to market gain on Ocado securities.

Net earnings for 2017 include the following, which we define as the “2017 Adjusted Items:”

	●	Charges to OG&A of $550 million, $360 million net of tax, for obligations related to withdrawing from and settlements of withdrawal liabilities for certain multi-employer pension funds; $184 million, $117 million net of tax, related to the voluntary retirement offering (“VRO”); and $110 million, $74 million net of tax, related to the Kroger Specialty Pharmacy goodwill impairment (the “2017 OG&A Adjusted Items”).

	●	A reduction to depreciation and amortization expenses of $19 million, $13 million net of tax, related to held for sale assets (the “2017 Depreciation Adjusted Item”).

	●	A reduction to income tax expense of $922 million primarily due to the re-measurement of deferred tax liabilities and the reduction of the statutory rate for the last five weeks of the fiscal year from the Tax Cuts and Jobs Act ("Tax Act") (the “2017 Tax Expense Adjusted Item”).

	●	A charge in other income (expense) of $502 million, $335 million net of tax, related to a company-sponsored pension plan termination.

In addition, net earnings for 2017 include $119 million, $79 million net of tax, due to a 53rd week in fiscal year 2017 (the “Extra Week”).

EXECUTIVE SUMMARY – OUR PATH TO DELIVERING CONSISTENT AND ATTRACTIVE TOTAL SHAREHOLDER RETURN

In 2019, we delivered on the total shareholder return model that we outlined at our Investor Day in November 2019 and are positioned to deliver on our total shareholder return model of the future. We also delivered on our guidance for identical sales without fuel, adjusted net earnings per diluted share and adjusted FIFO operating profit. We are using the power of Kroger’s stable and growing supermarket business to create meaningful incremental operating profit through the alternative profit stream businesses, positioning our business for long-term growth. By executing against the Restock Kroger framework, we are repositioning our business by widening and deepening our competitive moats. The four main areas of the Restock Kroger framework – Redefine the Customer Experience, Partner to Create Value, Develop Talent and Live Our Purpose – continue to be a top strategic priority for us. Our model is built upon a strong and durable base driven by our retail supermarket, fuel, and health and wellness businesses. We continue to generate strong free cash flow and are being disciplined in how we deploy it to deliver strong and attractive total shareholder returns.

Our financial strategy is to continue to use our strong free cash flow to invest in the business 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, improving productivity, and building 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 will continue to return excess cash to investors via share repurchases. 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%. Our full-year 2019 results demonstrated clear progress toward delivering on this model. Restock Kroger is the right strategic framework to deliver both our 2020 guidance and to position Kroger for sustainable growth and total shareholder return.

The following table provides highlights of our financial performance:

Financial Performance Data

($ in millions, except per share amounts)


				Percentage
	2019			Change		2018
Sales	$	122,286		0.4	%	$	121,852
Net earnings attributable to The Kroger Co.		1,659		(46.7)	%		3,110
Adjusted net earnings attributable to The Kroger Co.		1,786		2.3	%		1,745
Net earnings attributable to The Kroger Co. per diluted common share		2.04		(45.7)	%		3.76
Adjusted net earnings attributable to The Kroger Co. per diluted common share		2.19		3.8	%		2.11
Operating profit		2,251		(13.9)	%		2,614
Adjusted FIFO operating profit		2,995		4.0	%		2,880
Reduction in total debt, including obligations under finance leases		1,153		220.3	%		360
Share repurchases		465		(76.9)	%		2,010
Dividends paid		486		11.2	%		437
Dividends paid per common share		0.600		13.2	%		0.530
Identical sales excluding fuel		2.0	%	N/A			1.8	%
FIFO gross margin rate, excluding fuel and Adjusted Items, bps decrease		(0.23)		N/A			(0.55)
OG&A rate, excluding fuel and Adjusted Items, bps increase (decrease)		(0.29)		N/A			0.07

OVERVIEW

Notable items for 2019 are:

Shareholder Return

	●	Net earnings attributable to The Kroger Co. per diluted common share of $2.04.

	●	Adjusted net earnings attributable to The Kroger Co. per diluted common share of $2.19.

	●	We returned $951 million to shareholders from share repurchases and dividend payments.

	●	Over the last 12 months, we decreased total debt, including obligations under finance leases, by $1.2 billion.

Other Financial Results

	●	Identical sales, excluding fuel, increased 2.0% in 2019.

	●	Digital revenue grew 29% in 2019, driven by Pickup and Delivery sales growth. Digital revenue growth has moderated primarily due to cycling our merger with the Home Chef business. Digital revenue primarily includes revenue from all curbside pickup locations, online sales delivered to customer locations and products shipped to customer locations.

	●	Alternative profit streams grew over $100 million in 2019 compared to 2018, meeting our expectations. Kroger’s ecosystem fuels the growth of adjacent alternative profit streams like Kroger Personal Finance, customer data insights, and media businesses that are essential components of Restock Kroger. These businesses comprise a significant portion of Kroger’s overall alternative profit stream portfolio. They are dependent on a core supermarket business to deliver sustainable, long-term growth and profitability.

Significant Events

	●	During the fourth quarter of 2019, we recognized transformation costs of $52 million, $37 million net of tax, primarily including 35 planned store closures.

	●	During the third quarter of 2019, we approved and implemented a plan to reorganize certain portions of our division management structure, resulting in a charge for severance and related benefits of $80 million, $61 million net of tax. This reorganization is expected to increase operational effectiveness and reduce overhead costs while maintaining a high quality customer experience.

	●	As a result of a portfolio review, we decided to divest our interest in Lucky’s Market and we recognized a non-cash impairment charge of $238 million in the third quarter of 2019. The amount of the impairment charge attributable to The Kroger Co. is $131 million, $100 million net of tax. Subsequently, the decision was made by Lucky’s Market to file for bankruptcy in January 2020, which led us to fully write off the value of our investment and deconsolidate Lucky’s Market from our consolidated financial statements. This resulted in an additional non-cash charge of $174 million, $125 million net of tax, in the fourth quarter of 2019. The amount of the total 2019 charge attributable to The Kroger Co. is $305 million, $225 million net of tax. This impairment charge was a non-cash charge and reflects the write down of our initial investment in Lucky’s Market, as well as additional funding provided to operate and grow the business. Kroger maintains liabilities associated with certain property related guarantees that will result in Kroger making payments to settle these over time.

	●	During the first quarter of 2019, we sold our You Technology business to Inmar for total consideration of $565 million, including $396 million of cash and $64 million of preferred equity received upon closing. We are also entitled to receive other cash payments of $105 million over five years. The transaction includes a long-term service agreement for Inmar to provide us digital coupon services.

	●	During the first quarter of 2019, we sold our Turkey Hill Dairy business to an affiliate of Peak Rock Capital for $225 million.

	●	In 2019, we recorded charges to OG&A of $135 million, $104 million net of tax, for obligations related to withdrawal liabilities for certain multi-employer pension funds.

COVID-19

On March 11, 2020, the World Health Organization announced that infections of the coronavirus (COVID-19) had become a pandemic, and on March 13, the U.S. President announced a National Emergency relating to the disease. There is a possibility of widespread infection in the United States and abroad, with the potential for catastrophic impact. National, state and local authorities have recommended social distancing and imposed or are considering quarantine and isolation measures on large portions of the population, including mandatory business closures. These measures, while intended to protect human life, are expected to have serious adverse impacts on domestic and foreign economies of uncertain severity and duration. The effectiveness of economic stabilization efforts, including proposed government payments to affected citizens and industries, is uncertain. Some economists are predicting the United States may enter a recession as a result of the pandemic.

We expect the ultimate significance of the impact on our financial condition, results of operations, or cash flows will be dictated by the length of time that such circumstances continue, which will depend on the currently unknowable extent and duration of the COVID-19 pandemic and any governmental and public actions taken in response. COVID-19 also makes it more challenging for management to estimate future performance of our businesses, particularly over the near term.

On April 1, 2020, we issued a press release announcing business updates in response to the impact from novel coronavirus (COVID-19).

The following table provides a reconciliation of net earnings attributable to The Kroger Co. to adjusted net earnings attributable to The Kroger Co. and a reconciliation of net earnings attributable to The Kroger Co. per diluted common share to adjusted net earnings attributable to The Kroger Co. per diluted common share, excluding the 2019, 2018 and 2017 Adjusted Items.

Net Earnings per Diluted Share excluding the Adjusted Items

($ in millions, except per share amounts)


	2019		2018		2017
Net earnings attributable to The Kroger Co.	$	1,659	$	3,110	$	1,907
(Income) expense adjustments
Adjustments for pension plan withdrawal liabilities(1)(2)		104		121		360
Adjustment for voluntary retirement offering(1)(3)		—		—		117
Adjustment for Kroger Specialty Pharmacy goodwill impairment(1)(4)		—		—		74
Adjustment for company-sponsored pension plan termination(1)(5)		—		—		335
Adjustment for gain on sale of convenience store business(1)(6)		—		(1,360)		—
Adjustment for gain on sale of Turkey Hill Dairy(1)(7)		(80)		—		—
Adjustment for gain on sale of You Technology(1)(8)		(52)		—		—
Adjustment for mark to market gain on Ocado securities(1)(9)		(119)		(174)		—
Adjustment for depreciation related to held for sale assets(1)(10)		—		(11)		(13)
Adjustment for severance charge and related benefits(1)(11)		61		—		—
Adjustment for deconsolidation and impairment of Lucky's Market attributable to The Kroger Co.(1)(12)		225		—		—
Adjustment for Home Chef contingent consideration(1)(13)		(49)		26		—
Adjustment for impairment of financial instrument(1)(14)		—		33		—
Adjustment for transformation costs, primarily including 35 planned store closures(1)(15)		37		—		—
Adjustment for Tax Act(1)(16)		—		—		(922)
Total Adjusted Items		127		(1,365)		(49)

Net earnings attributable to The Kroger Co. excluding the Adjusted Items	$	1,786	$	1,745	$	1,858

Extra Week adjustment(1)(17)		—		—		(79)

Net earnings attributable to The Kroger Co. excluding the Adjusted Items and the Extra Week adjustment	$	1,786	$	1,745	$	1,779

Net earnings attributable to The Kroger Co. per diluted common share	$	2.04	$	3.76	$	2.09
(Income) expense adjustments
Adjustments for pension plan withdrawal liabilities(18)		0.13		0.15		0.40
Adjustment for voluntary retirement offering(18)		—		—		0.13
Adjustment for Kroger Specialty Pharmacy goodwill impairment(18)		—		—		0.08
Adjustment for company-sponsored pension plan termination(18)		—		—		0.37
Adjustment for gain on sale of convenience store business(18)		—		(1.65)		—
Adjustment for gain on sale of Turkey Hill Dairy(18)		(0.10)		—		—
Adjustment for gain on sale of You Technology(18)		(0.06)		—		—
Adjustment for mark to market gain on Ocado securities(18)		(0.15)		(0.21)		—
Adjustment for depreciation related to held for sale assets(18)		—		(0.01)		(0.01)
Adjustment for severance charge and related benefits(18)		0.08		—		—
Adjustment for deconsolidation and impairment of Lucky's Market attributable to The Kroger Co.(18)		0.28		—		—
Adjustment for Home Chef contingent consideration(18)		(0.07)		0.03		—
Adjustment for impairment of financial instrument(18)		—		0.04		—
Adjustment for transformation costs, primarily including 35 planned store closures(18)		0.04		—		—
Adjustment for Tax Act(18)		—		—		(1.02)
Total Adjusted Items		0.15		(1.65)		(0.05)

Net earnings attributable to The Kroger Co. per diluted common share excluding the Adjusted Items	$	2.19	$	2.11	$	2.04

Extra Week adjustment(18)		—		—		(0.09)

Net earnings attributable to The Kroger Co. per diluted common share excluding the Adjusted Items and the Extra Week adjustment	$	2.19	$	2.11	$	1.95

Average numbers of common shares used in diluted calculation		805		818		904

Net Earnings per Diluted Share excluding the Adjusted Items (continued)

($ in millions, except per share amounts)

(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 $135 in 2019, $155 in 2018 and $550 in 2017.

(3)	The pre-tax adjustment for the voluntary retirement offering was $184.

(4)	The pre-tax adjustment for Kroger Specialty Pharmacy goodwill impairment was $110.

(5)	The pre-tax adjustment for the company-sponsored pension plan termination was $502.

(6)	The pre-tax adjustment for gain on sale of convenience store business was ($1,782).

(7)	The pre-tax adjustment for gain on sale of Turkey Hill Dairy was ($106).

(8)	The pre-tax adjustment for gain on sale of You Technology was ($70).

(9)	The pre-tax adjustment for mark to market gain on Ocado securities was ($157) in 2019 and ($228) in 2018.

(10)	The pre-tax adjustment for depreciation related to held for sale assets was ($14) in 2018 and ($19) in 2017.

(11)	The pre-tax adjustment for severance charge and related benefits was $80.

(12)	The pre-tax adjustment for deconsolidation and impairment of Lucky’s Market was $412 including $305 attributable to The Kroger Co.

(13)	The pre-tax adjustment for Home Chef contingent consideration was ($69) in 2019 and $33 in 2018.

(14)	The pre-tax adjustment for impairment of financial instrument was $42.

(15)	The pre-tax adjustment for transformation costs, primarily including 35 planned store closures was $52.

(16)	Due to the re-measurement of deferred tax liabilities and the reduction of the statutory income tax rate for the last few weeks of the fiscal year.

(17)	The pre-tax Extra Week adjustment was ($119).

(18)	The amount presented represents the net earnings per diluted common share effect of each adjustment.

RESULTS OF OPERATIONS

Sales

Total Sales

($ in millions)



			Percentage				Percentage				2017
	2019		Change(1)		2018		Change(2)		2017		Adjusted(3)
Total sales to retail customers without fuel(4)	$	107,487	2.2	%	$	105,123	2.2	%	$	104,817	$	102,900
Supermarket fuel sales		14,052	(5.7)	%		14,903	15.5	%		13,177		12,906
Convenience stores(5)		—	—	%		944	(78.7)	%		4,515		4,434
Other sales(6)		747	(15.3)	%		882	15.9	%		771		761
Total sales	$	122,286	0.4	%	$	121,852	0.7	%	$	123,280	$	121,001

(1)	This column represents the percentage change in 2019 compared to 2018.

(2)	This column represents the percentage change in 2018 compared to 2017 adjusted sales, which removes the Extra Week.

(3)	The 2017 Adjusted column represents the items presented in the 2017 column adjusted to remove the Extra Week.

(4)	Digital sales, primarily including Pickup, Delivery, Ship and pharmacy e-commerce sales, grew approximately 29% in 2019, 58% in 2018 and 90% in 2017, adjusted to remove the Extra Week. These sales are included in the “total sales to retail customers without fuel” line above. Digital sales growth has moderated primarily due to cycling our merger with the Home Chef business.

(5)	We completed the sale of our convenience store business unit during the first quarter of 2018.

(6)	Other sales primarily relate to external sales at food production plants, data analytic services, third party media revenue and digital coupon services. The decrease in other sales in 2019, compared to 2018, is primarily due to the sale of You Technology and Turkey Hill Dairy during the first quarter of 2019, partially offset by an increase in data analytic services and third party media revenue.

Total sales increased in 2019, compared to 2018, by 0.4%. The increase was due to an increase in total sales to retail customers without fuel, partially offset by decreased supermarket fuel sales, a reduction in convenience store sales due to the sale of our convenience store business unit in the first quarter of 2018 and decreased sales due to the disposal of Turkey Hill Dairy and You Technology in the first quarter of 2019. Total sales, excluding fuel, dispositions and the merger with Home Chef increased 2.3% in 2019, compared to 2018. The increase in total sales to retail customers without fuel for 2019, compared to 2018, was primarily due to our merger with Home Chef and our identical sales increase, excluding fuel, of 2.0%. Identical sales, excluding fuel, for 2019, compared to 2018, increased primarily due to growth of loyal households, a higher customer basket value including retail inflation and Kroger Specialty Pharmacy sales growth, partially offset by continued investments in lower prices for our customers. Total supermarket fuel sales decreased 5.7% in 2019, compared to 2018, primarily due to a decrease in fuel gallons sold of 4.8% and a decrease in the average retail fuel price of 1.0%. The decrease in the average retail fuel price was caused by a decrease in the product cost of fuel.

Total sales decreased in 2018, compared to 2017, by 1.2%. The decrease in total sales in 2018, compared to 2017, is due to the Extra Week in 2017, partially offset by the increase in 2018 sales, compared to 2017 adjusted sales. Total sales increased in 2018, compared to 2017 adjusted sales, by 0.7%. This increase was primarily due to our increases in total sales to retail customers without fuel and supermarket fuel sales, partially offset by a reduction in convenience store sales due to the sale of our convenience store business unit in the first quarter of 2018. The increase in total sales to retail customers without fuel for 2018, compared to 2017 adjusted sales to retail customers without fuel, was primarily due to our merger with Home Chef and our identical sales increase, excluding fuel, of 1.8%. Identical sales, excluding fuel, for 2018, compared to 2017, increased primarily due to a higher customer basket value and Kroger Specialty Pharmacy sales growth, partially offset by our continued investments in lower prices for our customers. Total supermarket fuel sales increased 15.5% in 2018, compared to 2017 adjusted supermarket fuel sales, primarily due to an increase in the average retail fuel price of 13.6% and an increase in fuel gallons sold of 1.5%. The increase in the average retail fuel price was caused by an increase 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. Additionally, sales from all acquired businesses are treated as identical as if they were part of the Company in the prior year. Products and services related primarily to Kroger Personal Finance, which were historically accounted for as an offset to OG&A, are classified as a component of sales as of the beginning of fiscal year 2019. These prior-year amounts have been reclassified to conform to current-year presentation, which is consistent with our Restock Kroger initiative and our view of the products and services as part of our core business strategy. This is also more consistent with industry practice. These Kroger Personal Finance transactions represent sales to retail customers and, as such, are included in identical sales in 2019 and 2018. This change did not affect identical sales percentages for 2018. See “Supplemental Information” section below for more detail on the changes and the impact of the reclassification. 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 results are summarized in the following table. We used the identical sales dollar figures presented below to calculate percentage changes for 2019.

Identical Sales

($ in millions)


	2019			2018
Excluding fuel	$	106,037		$	103,946
Excluding fuel		2.0	%		1.8	%

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 rates, as a percentage of sales, were 22.07% in 2019 and 21.95% in 2018. The increase in 2019, compared to 2018, resulted primarily from a higher gross margin rate on fuel sales, decreased shrink, as a percentage of sales, growth in our alternative profit stream portfolio and effective negotiations to achieve savings on the cost of products sold, partially offset by industry-wide lower gross margin rates in pharmacy, continued investments in lower prices for our customers, a higher LIFO charge and continued growth in the specialty pharmacy business.

Our LIFO charge was $105 million in 2019 and $29 million in 2018. Our LIFO charge reflects an increase in our product cost inflation for 2019, driven by dry grocery, pharmacy and dairy.

Our FIFO gross margin rate, which excludes the LIFO charge, was 22.16% in 2019, compared to 21.98% for 2018. 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 23 basis points in 2019, compared to 2018. This decrease resulted primarily from industry-wide lower gross margin rates in pharmacy, continued investments in lower prices for our customers and continued growth in the specialty pharmacy business, partially offset by decreased shrink, as a percentage of sales, growth in our alternative profit stream portfolio and effective negotiations to achieve savings on the cost of products sold.

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 17.34% in 2019 and 17.06% in 2018. The increase in 2019, compared to 2018 resulted primarily from the 2019 OG&A Adjusted Items, the effect of decreased supermarket fuel and convenience store sales, which increases our OG&A rate, as a percentage of sales, investments in our digital strategy and increases in hourly associate labor costs. The increase in hourly associate labor costs is attributable to investing in higher wages and other comprehensive benefits to improve employee retention, engagement and customer experience. The increase was partially offset by the 2018 OG&A Adjusted Items, broad based improvement of Restock Kroger cost savings initiatives that drive administrative efficiencies, store productivity and sourcing cost reductions, decreased incentive plan and healthcare costs and planned real estate transactions during the first quarter of 2019.

Excluding the effect of fuel, the 2019 OG&A Adjusted Items and the 2018 OG&A Adjusted Items, our OG&A rate decreased 29 basis points in 2019, compared to 2018. This decrease resulted primarily from broad based improvement of Restock Kroger cost savings initiatives that drive administrative efficiencies, store productivity and sourcing cost reductions, decreased incentive plan and healthcare costs and planned real estate transactions during the first quarter of 2019. The decrease was partially offset by investments in our digital strategy and increases in hourly associate labor costs attributed to investing in higher wages and other comprehensive benefits to improve employee retention, engagement and customer experience.

During the second quarter of 2019, we accepted an offer to sell an unused warehouse that had been on the market for some time. We used this gain as an opportunity to contribute a similar amount into the United Food and Commercial Workers (“UFCW”) Consolidated Pension Plan, helping stabilize associates’ future benefits. The net impact of these transactions had no effect to OG&A for 2019.

Rent Expense

Rent expense, as a percentage of sales, remained relatively consistent in 2019, compared to 2018.

Depreciation and Amortization Expense

Depreciation and amortization expense increased, as a percentage of sales, in 2019, compared to 2018. This increase is primarily due to the 2018 Depreciation Adjusted Item, additional depreciation on capital investments, excluding mergers and lease buyouts, of $3.0 billion during 2019 and a decrease in the average useful life on these capital investments, as we are investing more in technology projects and our digital ecosystem.

Operating Profit and FIFO Operating Profit

Operating profit was $2.3 billion, or 1.84% of sales, for 2019, compared to $2.6 billion, or 2.15% of sales, for 2018. Operating profit, as a percentage of sales, decreased 31 basis points in 2019, compared to 2018, due to increased OG&A and depreciation and amortization expenses, as a percentage of sales, partially offset by a higher gross margin rate.

FIFO operating profit was $2.4 billion, or 1.93% of sales, for 2019, compared to $2.6 billion, or 2.17% of sales, for 2018. FIFO operating profit excluding the 2019 and 2018 Adjusted Items was $3.0 billion, or 2.45% of sales, for 2019, compared to $2.9 billion, or 2.36% of sales, for 2018. FIFO operating profit excluding the 2019 and 2018 Adjusted Items increased 9 basis points in 2019, compared to 2018, due to increased fuel earnings, improved sales to retail customers without fuel and decreased OG&A expenses, as a percentage of sales, partially offset by decreased pharmacy gross profit and increased depreciation and amortization 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.

The following table provides a reconciliation of operating profit to FIFO operating profit, excluding the 2019 and 2018 Adjusted Items.

Operating Profit excluding the Adjusted Items

($ in millions)


	2019		2018
Operating profit	$	2,251	$	2,614
LIFO charge		105		29

FIFO Operating profit		2,356		2,643

Adjustments for pension plan withdrawal liabilities		135		155
Adjustment for depreciation related to held for sale assets		—		(14)
Adjustment for Home Chef contingent consideration		(69)		33
Adjustment for severance charge and related benefits		80		—
Adjustment for impairment of financial instrument		—		42
Adjustment for transformation costs, primarily including 35 planned store closures		52		—
Adjustment for deconsolidation and impairment of Lucky's Market(1)		412		—
Other		29		21

2019 and 2018 Adjusted items		639		237

Adjusted FIFO operating profit excluding the adjustment items above	$	2,995	$	2,880

(1)	The adjustment for impairment of Lucky’s Market includes a $107 million net loss attributable to the minority interest of Lucky’s Market.

Interest Expense

Interest expense totaled $603 million in 2019 and $620 million in 2018. The decrease in interest expense in 2019, compared to 2018, resulted primarily from decreased borrowings and a lower weighted average interest rate. Over the last 12 months, we decreased total debt, including obligations under finance leases, by $1.2 billion.

Income Taxes

Our effective income tax rate was 23.7% in 2019 and 22.6% in 2018. The 2019 tax rate differed from the federal statutory rate primarily due to the effect of state income taxes and Lucky’s Market losses attributable to the noncontrolling interest which reduced pre-tax income but did not impact tax expense. These 2019 items were partially offset by the utilization of tax credits and deductions. The 2018 tax rate differed from the federal statutory rate primarily due to the effect of state income taxes and an IRS audit that resulted in a reduction of prior year tax deductions at pre-Tax Act rates and an increase in future tax deductions at post-Tax Act rates. These 2018 items were partially offset by the utilization of tax credits and deductions, the remeasurement of uncertain tax positions and adjustments to provisional amounts that increased prior year deductions at pre-Tax Act rates and decreased future deductions at post-Tax Act rates.

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 $2.04 per diluted share for 2019 compared to net earnings of $3.76 per diluted share for 2018. Adjusted net earnings of $2.19 per diluted share for 2019 represented an increase of 3.8% compared to adjusted net earnings of $2.11 per diluted share for 2018. The increase in adjusted net earnings per diluted share resulted primarily from increased fuel earnings, decreased interest expense and lower weighted average common shares outstanding due to common share repurchases, partially offset by increased tax expense and a higher LIFO charge.

COMMON SHARE REPURCHASE PROGRAMS

We maintain share repurchase programs that comply with Rule 10b5-1 of the Securities Exchange Act of 1934 and allow for the orderly repurchase of our common shares, from time to time. The share repurchase programs do not have an expiration date but may be suspended or terminated by our Board of Directors at any time. We made open market purchases of our common shares totaling $400 million in 2019 and $727 million in 2018. On April 20, 2018, we entered and funded a $1.2 billion ASR program to reacquire shares in privately negotiated transactions.

In addition to these repurchase programs, we also repurchase common shares to reduce dilution resulting from our employee stock option plans. This program is solely funded by proceeds from stock option exercises, and the tax benefit from these exercises. We repurchased approximately $65 million in 2019 and $83 million in 2018 of our common shares under the stock option program.

On March 15, 2018, our Board of Directors approved a $1.0 billion share repurchase program to reacquire shares via open market purchase or privately negotiated transactions, including accelerated stock repurchase transactions, block trades, or pursuant to trades intending to comply with rule 10b5-1 of the Securities Exchange Act of 1934 (the “March 2018 Repurchase Program”). On November 5, 2019, our Board of Directors approved a $1.0 billion share 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 of the Securities Exchange Act of 1934 (the “November 2019 Repurchase Program”). The November 2019 Repurchase Program authorization replaced the existing March 2018 Repurchase Program that had approximately $546 million remaining.

The shares repurchased in 2019 were reacquired under the following share repurchase programs:

	●	The November 2019 Repurchase program.

	●	A program announced on December 6, 1999 to repurchase common shares to reduce dilution resulting from our employee stock option and long-term incentive plans, under which repurchases are limited to proceeds received from exercises of stock options and the tax benefits associated therewith (“1999 Repurchase Program”).

As of February 1, 2020, there was $600 million remaining under the November 2019 Repurchase Program.

During the first quarter through March 25, 2020, we repurchased an additional $39 million of our common shares under the stock option program and $355 million additional shares under the November 2019 Repurchase Program. As of March 25, 2020, we have $245 million remaining under the November 2019 Repurchase Program. To maintain financial flexibility, we have decided to pause on additional share repurchases during the first quarter of 2020.

CAPITAL INVESTMENTS

Capital investments, including changes in construction-in-progress payables and excluding mergers and the purchase of leased facilities, totaled $3.0 billion in 2019 and 2018. Capital investments for mergers were $197 million in 2018 related to the merger with Home Chef. Refer to Note 2 to the Consolidated Financial Statements for more information on these mergers. Capital investments for the purchase of leased facilities totaled $82 million in 2019 and $5 million in 2018. The table below shows our supermarket storing activity and our total supermarket square footage:

Supermarket Storing Activity


	2019	2018	2017
Beginning of year	2,764	2,782	2,796
Opened	10	10	24
Opened (relocation)	9	4	15
Acquired	6	10	3
Closed (operational)	(19)	(38)	(41)
Closed (relocation)	(13)	(4)	(15)
End of year	2,757	2,764	2,782

Total supermarket square footage (in millions)	180	179	179

RETURN ON INVESTED CAPITAL

We calculate return on invested capital (“ROIC”) by dividing adjusted ROIC operating profit for the prior four quarters by the average invested capital. Adjusted operating profit for ROIC purposes is calculated by excluding certain items included in operating profit, and adding back our LIFO charge, depreciation and amortization and rent to our U.S. GAAP operating profit of the prior four quarters. Average invested capital is calculated as the sum of (i) the average of our total assets, (ii) the average LIFO reserve, (iii) the average accumulated depreciation and amortization, (iv) for 2018, a rent factor equal to total rent for the last four quarters multiplied by a factor of eight and (v) for 2019, an adjustment due to the adoption of ASU 2016-02, “Leases,” at the beginning of 2019 as further described in Notes 10 and 18 to the Consolidated Financial Statements; minus (i) the average taxes receivable, (ii) the average trade accounts payable, (iii) the average accrued salaries and wages, (iv) the average other current liabilities, excluding accrued income taxes, (v) the average liabilities held for sale and (vi) certain other adjustments. Averages are calculated for ROIC by adding the beginning balance of the first quarter and the ending balance of the fourth quarter, of the last four quarters, and dividing by two. For 2018, we used a factor of eight for our total rent as we believe this is a common factor used by our investors, analysts and rating agencies. ROIC is a non-GAAP financial measure of performance. ROIC should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. ROIC is an important measure used by management to evaluate our investment returns on capital. Management believes ROIC is a useful metric to investors and analysts because it measures how effectively we are deploying our assets.

Although ROIC is a relatively standard financial term, numerous methods exist for calculating a company’s ROIC. As a result, the method used by our management to calculate ROIC may differ from methods other companies use to calculate their ROIC. We urge you to understand the methods used by other companies to calculate their ROIC before comparing our ROIC to that of such other companies.

The following table provides a calculation of ROIC for 2019 and 2018 on a 52 week basis ($ in millions). The 2019 calculation of ROIC excludes the financial position and results of operations of You Technology and Turkey Hill Dairy, due to the sales in 2019, and Lucky’s Market, due to the deconsolidation in 2019. The 2018 calculation of ROIC excludes the financial position and results of operations of Home Chef, due to the merger in 2018, and the convenience store business, due to the sale in 2018.


	Fiscal Year Ended
	February 1,			February 2,
	2020			2019
Return on Invested Capital
Numerator
Operating profit	$	2,251		$	2,614
LIFO charge		105			29
Depreciation and amortization		2,649			2,465
Rent		884			884
Adjustment for merger with Home Chef		—			28
Adjustment for operating profit of convenience store business		—			(21)
Adjustment for Home Chef contingent consideration		(69)			33
Adjustment for impairment of financial instrument		—			42
Adjustments for pension plan withdrawal liabilities		135			155
Adjustment for depreciation related to held for sale assets		—			(14)
Adjustment for severance charge and related benefits		80			—
Adjustment for transformation costs, primarily including 35 planned store closures		52			—
Adjustment for deconsolidation and impairment of Lucky's Market		412			—
Adjustment for operating losses of Lucky's Market		75			—
Adjustment for disposal of You Technology		(49)			—
Adjusted ROIC operating profit	$	6,525		$	6,215

Denominator
Average total assets	$	41,687		$	37,658
Average taxes receivable(1)		(41)			(115)
Average LIFO reserve		1,329			1,263
Average accumulated depreciation and amortization		23,404			21,703
Average trade accounts payable		(6,204)			(5,959)
Average accrued salaries and wages		(1,198)			(1,163)
Average other current liabilities(2)		(3,942)			(3,571)
Average liabilities held for sale		(26)			(155)
Adjustment for merger with Home Chef		—			(145)
Adjustment for disposal of convenience store business		—			(198)
Adjustment for disposal of Turkey Hill Dairy		(45)			—
Adjustment for disposal of You Technology		(13)			—
Adjustment for deconsolidation of Lucky's Market		(25)			—
Rent x 8		—			7,072
Initial operating lease assets at adoption of ASU 2016-02, “Leases” (see Notes 10 and 18)		3,406			—
Average invested capital	$	58,332		$	56,390
Return on Invested Capital		11.19	%		11.02	%

(1)Taxes receivable were $82 as of February 1, 2020 and $229 as of February 3, 2018. We did not have any taxes receivable as of February 2, 2019.

(2)Other current liabilities included accrued income taxes of $60 as of February 2, 2019. We did not have any accrued income taxes as of February 1, 2020 or February 3, 2018. Accrued income taxes are removed from other current liabilities in the calculation of average invested capital.

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 significant accounting policies are summarized in Note 1 to the Consolidated Financial Statements.

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 differ from those estimates.

We believe the following accounting policies are the most critical in the preparation of our financial statements because they involve the most difficult, subjective or complex judgments about the effect of matters that are inherently uncertain.

Impairments of Long-Lived Assets

We monitor the carrying value of long-lived assets for potential impairment each quarter based on whether certain triggering events have occurred. These events include current period losses combined with a history of losses or a projection of continuing losses or a significant decrease in the market value of an asset. When a triggering event occurs, we perform an impairment calculation, comparing projected undiscounted cash flows, utilizing current cash flow information and expected growth rates related to specific stores, to the carrying value for those stores. If we identify impairment for long-lived assets to be held and used, we compare the assets’ current carrying value to the assets’ fair value. Fair value is determined based on market values or discounted future cash flows. We record impairment when the carrying value exceeds fair market value. With respect to owned property and equipment held for disposal, we adjust the value of the property and equipment to reflect recoverable values based on our previous efforts to dispose of similar assets and current economic conditions. We recognize impairment for the excess of the carrying value over the estimated fair market value, reduced by estimated direct costs of disposal.

As discussed previously in the Overview section, we recognized an impairment charge related to Lucky’s Market in the third quarter of 2019 totaling $238 million. The Lucky’s Market impairment charge consists of property, plant and equipment of $200 million; goodwill of $19 million; operating lease assets of $11 million; and other charges of $8 million. Additionally, we recorded asset impairments totaling $120 million in 2019, including $70 million of operating lease assets. This 2019 impairment charge includes the 35 planned store closures across our footprint in 2020 related to our Restock Kroger transformation efforts. We recorded asset impairments in the normal course of business totaling $56 million in 2018. We record costs to reduce the carrying value of long-lived assets in the Consolidated Statements of Operations as OG&A expense.

The factors that most significantly affect the impairment calculation are our estimates of future cash flows. Our cash flow projections look several years into the future and include assumptions on variables such as inflation, the economy and market competition. Application of alternative assumptions and definitions, such as reviewing long-lived assets for impairment at a different level, could produce significantly different results.

Business Combinations

We account for business combinations using the acquisition method of accounting. All the assets acquired, liabilities assumed and amounts attributable to noncontrolling interests are recorded at their respective fair values at the date of acquisition once we obtain control of an entity. The determination of fair values of identifiable assets and liabilities involves estimates and the use of valuation techniques when market value is not readily available. We use various techniques to determine fair value in such instances, including the income approach. Significant estimates used in determining fair value include, but are not limited to, the amount and timing of future cash flows, growth rates, discount rates and useful lives. The excess of the purchase price over fair values of identifiable assets and liabilities is recorded as goodwill. See Note 3 for further information about goodwill.

Goodwill

Our goodwill totaled $3.1 billion as of February 1, 2020. We review goodwill for impairment in the fourth quarter of each year, and also upon the occurrence of triggering events. We perform reviews of each of our operating divisions and other consolidated entities (collectively, “reporting units”) that have goodwill balances. Generally, fair value is determined using a multiple of earnings, or discounted projected future cash flows, and we compare fair value to the carrying value of a reporting unit for purposes of identifying potential impairment. We base projected future cash flows on management’s knowledge of the current operating environment and expectations for the future. We recognize goodwill impairment for any excess of a reporting unit's carrying value over its fair value, not to exceed the total amount of goodwill allocated to the reporting unit.

Our annual evaluation of goodwill is performed for our reporting units during the fourth quarter. In 2017, we recorded goodwill impairment for our Kroger Specialty Pharmacy (“KSP”) reporting unit totaling $110 million, $74 million net of tax, resulting in a remaining goodwill balance of $243 million. The 2019 fair value of our KSP reporting unit was estimated using multiple valuation techniques: a discounted cash flow model (income approach), a market multiple model and a comparable mergers and acquisition model (market approaches), with each method weighted in the calculation. The income approach relies on management’s projected future cash flows, estimates of revenue growth rates, margin assumptions and an appropriate discount rate. The market approaches require the determination of an appropriate peer group, which is utilized to derive estimated fair values based on selected market multiples. The annual evaluation of goodwill performed in 2019 and 2018 did not result in impairment for any of our reporting units. Based on current and future expected cash flows, we believe additional goodwill impairments are not reasonably likely. A 10% reduction in fair value of our reporting units would not indicate a potential for impairment of our goodwill balance.

For additional information relating to our results of the goodwill impairment reviews performed during 2019, 2018 and 2017, see Note 3 to the Consolidated Financial Statements.

The impairment review requires the extensive use of management judgment and financial estimates. Application of alternative estimates and assumptions could produce significantly different results. The cash flow projections embedded in our goodwill impairment reviews can be affected by several factors such as inflation, business valuations in the market, the economy, market competition and our ability to successfully integrate recently acquired businesses.

Multi-Employer Pension Plans

We contribute to various multi-employer pension plans based on obligations arising from collective bargaining agreements. These multi-employer pension 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.

We recognize expense in connection with these plans as contributions are funded or when commitments are probable and reasonably estimable, in accordance with GAAP. We made cash contributions to these plans of $461 million in 2019, $358 million in 2018 and $954 million in 2017. The increase in 2017, compared to 2019 and 2018 is due to the $467 million pre-tax payment we made in 2017 to satisfy withdrawal obligations for certain local unions of the Central States Pension Fund and the 2017 UFCW contribution.

We continue to evaluate and address our potential exposure to under-funded multi-employer pension plans as it relates to our associates who are beneficiaries of these plans. These under-fundings are not our liability. When an opportunity arises that is economically feasible and beneficial to us and our associates, we may negotiate the restructuring of under-funded multi-employer pension plan obligations to help stabilize associates’ future benefits and become the fiduciary of the restructured multi-employer pension plan. The commitments from these restructurings do not change our debt profile as it relates to our credit rating since these off-balance sheet commitments are typically considered in our investment grade debt rating. We are currently designated as the named fiduciary of the UFCW Consolidated Pension Plan and the International Brotherhood of Teamsters (“IBT”) Consolidated Pension Fund and have sole investment authority over these assets. We became the fiduciary of the IBT Consolidated Pension Fund in 2017 due to the ratification of a new labor contract with the IBT that provided for the withdrawal of certain local unions from the Central States Pension Fund. Significant effects of these restructuring agreements recorded in our Consolidated Financial Statements are:

	●	In 2019, we incurred a $135 million charge, $104 million net of tax, for obligations related to withdrawal liabilities for certain multi-employer pension funds.

	●	In 2018, we incurred a $155 million charge, $121 million net of tax, for obligations related to withdrawal liabilities for certain local unions of the Central States multi-employer pension fund.

	●	In 2017, we incurred a $550 million charge, $360 million net of tax, for obligations related to withdrawing from and settlements for withdrawal liabilities for certain multi-employer pension plan obligations, of which $467 million was contributed to the Central States Pension Fund in 2017.

	●	In 2017, we contributed an incremental $111 million, $71 million net of tax, to the UFCW Consolidated Pension Plan.

As we continue to work to find solutions to under-funded multi-employer pension plans, it is possible we could incur withdrawal liabilities for certain funds.

Based on the most recent information available to us, we believe that the present value of actuarially accrued liabilities in most of the multi-employer plans to which we contribute substantially exceeds the value of the assets held in trust to pay benefits. We have attempted to estimate the amount by which these liabilities exceed the assets, (i.e., the amount of underfunding), as of December 31, 2019. Because we are only one of a number of employers contributing to these plans, we also have attempted to estimate the ratio of our contributions to the total of all contributions to these plans in a year as a way of assessing our “share” of the underfunding. Nonetheless, the underfunding is not a direct obligation or liability of ours or of any employer.

As of December 31, 2019, we estimate our share of the underfunding of multi-employer pension plans to which we contribute was approximately $2.3 billion, $1.8 billion net of tax. This represents a decrease in the estimated amount of underfunding of approximately $800 million, $600 million net of tax, as of December 31, 2019, compared to December 31, 2018. The decrease in the amount of underfunding is primarily attributable to higher expected returns on assets in the funds during 2019. Our estimate is based on the most current information available to us including actuarial evaluations and other data (that include the estimates of others), and such information may be outdated or otherwise unreliable.

We have made and disclosed this estimate not because, except as noted above, this underfunding is a direct liability of ours. Rather, we believe the underfunding is likely to have important consequences. In the event we were to exit certain markets or otherwise cease making contributions to these plans, we 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 estimated, in accordance with GAAP.

The amount of underfunding described above is an estimate and could change based on contract negotiations, returns on the assets held in the multi-employer pension plans, benefit payments or future restructuring agreements. The amount could decline, and our future expense would be favorably affected, if the values of the assets held in the trust significantly increase or if further changes occur through collective bargaining, trustee action or favorable legislation. On the other hand, our share of the underfunding could increase and our future expense could be adversely affected if the asset values decline, if employers currently contributing to these funds cease participation or if changes occur through collective bargaining, trustee action or adverse legislation. We continue to evaluate our potential exposure to under-funded multi-employer pension plans. Although these liabilities are not a direct obligation or liability of ours, any commitments to fund certain multi-employer pension plans will be expensed when our commitment is probable and an estimate can be made.

See Note 16 to the Consolidated Financial Statements for more information relating to our participation in these multi-employer pension plans.

NEW ACCOUNTING STANDARDS

Refer to Note 18 and Note 19 to the Consolidated Financial Statements for recently adopted accounting standards and recently issued accounting standards not yet adopted as of February 1, 2020.

LIQUIDITY AND CAPITAL RESOURCES

Cash Flow Information

Net cash provided by operating activities

We generated $4.7 billion of cash from operations in 2019 compared to $4.2 billion in 2018. Net earnings including noncontrolling interests, adjusted for non-cash items and other impacts, generated approximately $4.9 billion of operating cash flow in 2019 compared to $3.8 billion in 2018. Cash provided (used) by operating activities for changes in working capital was ($259) million in 2019 compared to $395 million in 2018. The decrease in cash provided by operating activities for changes in working capital in 2019, compared to 2018, was primarily due to the following:

	●	The change in prepaid and other current assets decreased in 2019, compared to 2018, due to a decrease in the amount of prepaid medical benefit costs at the end of 2018 compared to the end of 2017;

	●	Cash flows from income taxes were favorable in 2018, compared to 2019, because of income tax overpayments made in 2017 that reduced payments made in 2018; and

	●	Payments on operating lease liabilities; partially offset by

	●	Proceeds from a contract associated with the sale of a business;

	●	Decreased contributions to the company-sponsored pension plan in 2019, compared to 2018; and

	●	Higher third-party payor receivables at the end of 2018 due to the timing of third-party payments, which resulted in a reduction in cash provided by operating activities in 2018. Receivable balances were similar in 2019 compared to 2018.

Cash paid for taxes increased in 2019, compared to 2018, primarily due to the payment of estimated taxes on the gain on sale of the You Technology and Turkey Hill Dairy businesses in 2019 and an overpayment of our fourth quarter 2017 estimated taxes that resulted in lower tax payments in 2018.

Cash paid for interest decreased in 2019, compared to 2018, primarily due to an increase in accrued interest related to certain semi-annual senior notes interest payments that were paid subsequent to February 1, 2020.

Net cash used by investing activities

Investing activities used cash of $2.6 billion in 2019 compared to $1.2 billion in 2018. The amount of cash used by investing activities increased in 2019, compared to 2018, primarily due to the following:

	●	A lower amount of net proceeds from the sale of businesses, since the proceeds from the sale of the convenience store business exceeded the proceeds from the sales of the Turkey Hill Dairy and You Technology businesses;

	●	A lower amount of net proceeds from the settlement of a financial instrument; partially offset by

	●	Increased proceeds from the sale of assets due to the sale of an unused warehouse and proceeds from sale leaseback transactions;

	●	No payments for purchases of Ocado securities in 2019; and

	●	No acquisitions in 2019.

Net cash used by financing activities

We used $2.1 billion of cash for financing activities in 2019 compared to $2.9 billion during 2018. The amount of cash used for financing activities for 2019, compared to 2018, decreased primarily due to decreased payments on commercial paper and share repurchases, partially offset by increased payments on long-term debt including obligations under finance leases and a reduction of proceeds from the issuance of long-term debt.

Debt Management

Total debt, including both the current and long-term portions of obligations under finance leases, decreased $1.2 billion to $14.1 billion as of year-end 2019 compared to 2018. The decrease in 2019, compared to 2018, resulted primarily from payment of $500 million of senior notes bearing an interest rate of 1.50%, payment of $750 million of senior notes bearing an interest rate of 6.15% and the repayment of our $1.0 billion term loan, partially offset by the issuance of $750 million of senior notes bearing an interest rate of 3.95% and an increase in outstanding commercial paper borrowings of $350 million at the end of 2019 compared to 2018.

Dividends

The following table provides dividend information ($ in millions, except per share amounts):


	2019		2018
Cash dividends paid	$	486	$	437
Cash dividends paid per common share	$	0.600	$	0.530

Liquidity Needs

We estimate our liquidity needs over the next twelve-month period to approximate $5.5 billion, which includes anticipated requirements for working capital, capital investments, interest payments and scheduled principal payments of debt and commercial paper, offset by cash and temporary cash investments on hand at the end of 2019. 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. 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. We have approximately $700 million of senior notes and $1.2 billion of commercial paper maturing in fiscal year 2020, which are included in the $5.5 billion of estimated liquidity needs. We expect to satisfy these obligations using cash generated from operations and through issuing 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.

Factors Affecting Liquidity

We can currently borrow on a daily basis approximately $2.75 billion under our commercial paper program. At February 1, 2020, we had $1.2 billion of commercial paper borrowings outstanding. Commercial paper borrowings are backed by our credit facility, and reduce the amount we can borrow under the credit facility. If our short-term credit ratings fall, the ability to borrow under our current commercial paper program could be adversely affected for a period of time and increase our interest cost on daily borrowings under our commercial paper program. This could require us to borrow additional funds under the credit facility, under which we believe we have sufficient capacity. However, in the event of a ratings decline, we do not anticipate that our borrowing capacity under our commercial paper program would be any lower than $500 million on a daily basis. Although our ability to borrow under the credit facility is not affected by our credit rating, the interest cost and applicable margin on borrowings under the credit facility could be affected by a downgrade in our Public Debt Rating. “Public Debt Rating” means, as of any date, the rating that has been most recently announced by either S&P or Moody’s, as the case may be, for any class of non-credit enhanced long-term senior unsecured debt issued by the Company. On March 18, 2020, we proactively borrowed $1 billion from our revolving credit facility. This was a precautionary measure in order to preserve financial flexibility, reduce reliance on the commercial paper market and maintain liquidity in response to the coronavirus pandemic. Cash and temporary cash investments immediately following the borrowing were approximately $2.3 billion. As of March 25, 2020, we had no commercial paper borrowings outstanding.

Our credit facility requires the maintenance of a Leverage Ratio and a Fixed Charge Coverage Ratio (our “financial covenants”). A failure to maintain our financial covenants would impair our ability to borrow under the credit facility. These financial covenants are described below:

	●	Our Leverage Ratio (the ratio of Net Debt to Adjusted EBITDA, as defined in the credit facility) was 2.30 to 1 as of February 1, 2020. If this ratio were to exceed 3.50 to 1, we would be in default of our credit facility and our ability to borrow under the facility would be impaired.

	●	Our Fixed Charge Coverage Ratio (the ratio of Adjusted EBITDA plus Consolidated Rental Expense to Consolidated Cash Interest Expense plus Consolidated Rental Expense, as defined in the credit facility) was 4.39 to 1 as of February 1, 2020. If this ratio fell below 1.70 to 1, we would be in default of our credit facility and our ability to borrow under the facility would be impaired.

Our credit facility is more fully described in Note 6 to the Consolidated Financial Statements. We were in compliance with our financial covenants at year-end 2019.

The tables below illustrate our significant contractual obligations and other commercial commitments, based on year of maturity or settlement, as of February 1, 2020 (in millions of dollars):


	2020		2021		2022		2023		2024		Thereafter		Total
Contractual Obligations(1)(2)
Long-term debt(3)	$	1,926	$	804	$	894	$	594	$	495	$	8,543	$	13,256
Interest on long-term debt(4)		488		489		442		421		410		5,301		7,551
Finance lease obligations		84		95		80		86		81		757		1,183
Operating lease obligations		932		884		772		758		637		6,353		10,336
Self-insurance liability(5)		216		141		99		66		41		126		689
Construction commitments(6)		670		—		—		—		—		—		670
Purchase obligations(7)		814		360		163		109		37		10		1,493
Total	$	5,130	$	2,773	$	2,450	$	2,034	$	1,701	$	21,090	$	35,178

Other Commercial Commitments
Standby letters of credit	$	347	$	—	$	—	$	—	$	—	$	—	$	347
Surety bonds		401		—		—		—		—		—		401
Total	$	748	$	—	$	—	$	—	$	—	$	—	$	748

(1)The contractual obligations table excludes funding of pension and other postretirement benefit obligations, which totaled approximately $34 million in 2019. This table also excludes contributions under various multi-employer pension plans, which totaled $461 million in 2019. This table also excludes the March 18, 2020 $1 billion borrowing under our revolving credit facility since the borrowing occurred subsequent to February 1, 2020.

(2)The liability related to unrecognized tax benefits has been excluded from the contractual obligations table because a reasonable estimate of the timing of future tax settlements cannot be determined.

(3)As of February 1, 2020, we had $1.2 billion of commercial paper and no borrowings under our credit facility.

(4)Amounts include contractual interest payments using the interest rate as of February 1, 2020, and stated fixed and swapped interest rates, if applicable, for all other debt instruments.

(5)The amounts included in the contractual obligations table for self-insurance liability related to workers’ compensation claims have been stated on a present value basis.

(6)Amounts include funds owed to third parties for projects currently under construction. These amounts are reflected in other current liabilities in our Consolidated Balance Sheets.

(7)Amounts include commitments, many of which are short-term in nature, to be utilized in the normal course of business, such as several contracts to purchase raw materials utilized in our food production plants and several contracts to purchase energy to be used in our stores and food production plants. Our obligations also include management fees for facilities operated by third parties and outside service contracts. Any upfront vendor allowances or incentives associated with outstanding purchase commitments are recorded as either current or long-term liabilities in our Consolidated Balance Sheets.

As of February 1, 2020, we maintained a $2.75 billion (with the ability to increase by $1 billion), unsecured revolving credit facility that, unless extended, terminates on August 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 of February 1, 2020, we had $1.2 billion of 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 $2 million as of February 1, 2020.

In addition to the available credit mentioned above, as of February 1, 2020, we had authorized for issuance $4.3 billion of securities remaining under a shelf registration statement filed with the SEC and effective on May 24, 2019.

We also maintain surety bonds related primarily to our self-insured workers’ compensation claims. These bonds are required by most states in which we are self-insured for workers’ compensation and are placed with predominately third-party insurance providers to insure payment of our obligations in the event we are unable to meet our claim payment obligations up to our self-insured retention levels. These bonds do not represent liabilities of ours, as we already have reserves on our books for the claims costs. Market changes may make the surety bonds more costly and, in some instances, availability of these bonds may become more limited, which could affect our costs of, or access to, such bonds. Although we do not believe increased costs or decreased availability would significantly affect our ability to access these surety bonds, if this does become an issue, we would issue letters of credit, in states where allowed, against our credit facility to meet the state bonding requirements. This could increase our cost and decrease the funds available under our credit facility.

We also are contingently liable for leases that have been assigned to various third parties in connection with facility closings and dispositions. We could be required to satisfy obligations under the leases if any of the assignees are unable to fulfill their lease obligations. Due to the wide distribution of our assignments among third parties, and various other remedies available to us, we believe the likelihood that we will be required to assume a material amount of these obligations is remote. We have agreed to indemnify certain third-party logistics operators for certain expenses, including multi-employer pension plan obligations and withdrawal liabilities.

In addition to the above, we enter into various indemnification agreements and take on indemnification obligations in the ordinary course of business. Such arrangements include indemnities against third party claims arising out of agreements to provide services to us; indemnities related to the sale of our securities; indemnities of directors, officers and employees in connection with the performance of their work; and indemnities of individuals serving as fiduciaries on benefit plans. While our aggregate indemnification obligation could result in a material liability, we are not aware of any current matter that could result in a material liability.

SUPPLEMENTAL INFORMATION

Sales Reclassification

Products and services related primarily to Kroger Personal Finance and Media, which were historically accounted for as an offset to OG&A, are classified as a component of sales as of the beginning of fiscal year 2019, except for certain amounts in Media, which are netted against merchandise costs. These prior-year amounts have been reclassified to conform to current-year presentation, which is consistent with our Restock Kroger initiative and our view of the products and services as part of our core business strategy. This is also more consistent with industry practice.

The following tables summarize the Company's 2018 sales reclassifications ($ in millions):


	Fiscal Year Ended
	Previously Stated		Reclassification		Reclassified
	February 2,				February 2,
	2019		2018		2019
Sales	$	121,162	$	690	$	121,852

Operating expenses
Merchandise costs, including advertising, warehousing, and transportation, excluding items shown separately below		94,894		209		95,103
Operating, general and administrative		20,305		481		20,786
Rent		884		—		884
Depreciation and amortization		2,465		—		2,465

Operating profit	$	2,614	$	—	$	2,614

The following tables summarize the Company's 2017 sales reclassifications ($ in millions):


	Fiscal Year Ended
	Previously Stated		Reclassification		Reclassified
	February 3,				February 3,
	2018		2017		2018
Sales	$	122,662	$	618	$	123,280

Operating expenses
Merchandise costs, including advertising, warehousing, and transportation, excluding items shown separately below		95,662		149		95,811
Operating, general and administrative		21,041		469		21,510
Rent		911		—		911
Depreciation and amortization		2,436		—		2,436

Operating profit	$	2,612	$	—	$	2,612

Previous: Item 6. SELECTED FINANCIAL DATA. · Next: Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.