Form 10-K

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Fiscal year ended January 29, 2005.

 

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                      to                     

 

Commission file number 1-303

 

THE KROGER CO.

(Exact name of registrant as specified in its charter)

 

Ohio   31-0345740
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
1014 Vine Street, Cincinnati, OH 45202   45202
(Address of principal executive offices)   (Zip Code)

 

Registrant’s telephone number, including area code (513) 762-4000

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class


 

Name of each exchange on which registered


Common Stock $1 par value   New York Stock Exchange
728,772,101 shares outstanding on April 8, 2005    

 

Securities registered pursuant to section 12(g) of the Act:

 

NONE

(Title of class)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No ¨.

 

Indicate by check mark if disclosure of delinquent filer pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10K or any amendment to this Form 10-K. ¨

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

Yes x No ¨.

 

The aggregate market value of the Common Stock of The Kroger Co. held by non-affiliates as of April 8, 2005: $11,616,627,274

 

Documents Incorporated by Reference:

 

Proxy statement to be filed pursuant to Regulation 14A of the Exchange Act on or before May 31, 2005, incorporated by reference into Parts II and III of Form 10-K.

 



 

PART I

 

ITEM 1. BUSINESS

 

The Kroger Co. was founded in 1883 and incorporated in 1902. As of January 29, 2005, the Company was one of the largest retailers in the United States based on annual sales. The Company also manufactures and processes some of the food for sale in its supermarkets. The Company’s principal executive offices are located at 1014 Vine Street, Cincinnati, Ohio 45202 and its telephone number is (513) 762-4000. The Company maintains a web site (www.kroger.com) that includes additional information about the Company. The Company makes available through its web site, free of charge, its annual reports on Form 10-K, its quarterly reports on Form 10-Q and its current reports on Form 8-K, including amendments thereto. These forms are available as soon as reasonably practicable after the Company has filed them electronically with the SEC.

 

The Company’s revenues are earned and cash is generated as consumer products are sold to customers in its stores. The Company earns income predominantly by selling products at price levels that produce revenues in excess of its costs to make these products available to its customers. Such costs include procurement and distribution costs, facility occupancy and operational costs, and overhead expenses.

 

EMPLOYEES

 

The Company employs approximately 289,000 full and part-time employees. Approximately 71% of the Company’s employees are covered by collective bargaining agreements negotiated with local unions affiliated with one of several different international unions. There are approximately 350 such agreements, usually with terms of three to five years.

 

During fiscal 2004, major collective bargaining agreements were ratified in Memphis, southern California, central Indiana, Houston, Arizona, Detroit, Nashville, Louisville, Seattle, Cincinnati and Las Vegas. In February 2005, a contract covering Denver employees in the Company’s King Soopers and City Market divisions was ratified.

 

During fiscal 2005, the Company has major labor contracts expiring in Roanoke, Atlanta, Portland (non-food), Columbus and Dallas. In addition, the Company has various Teamsters contracts expiring in 2005, including southern California and one that covers several facilities in the Midwest.

 

STORES

 

As of January 29, 2005, the Company operated, either directly or through its subsidiaries, 2,532 supermarkets, 536 of which had fuel centers. Approximately 35% of these supermarkets were operated in company-owned facilities, including some Company-owned buildings on leased land. The Company’s current strategy emphasizes self-development and ownership of store real estate. The Company’s stores operate under several banners that have strong local ties and brand equity. Supermarkets are generally operated under one of the following formats: combination food and drug stores (“combo stores”); multi-department stores; or price impact warehouses.

 

The combo stores are the primary food store format. They are typically able to earn a return above the Company’s cost of capital by drawing customers from a 2 – 2½ mile radius. The Company believes this format is successful because the stores are large enough to offer the specialty departments that customers desire for one-stop shopping, including “whole health” sections, pharmacies, general merchandise, pet centers and high-quality perishables such as fresh seafood and organic produce. Many combo stores include a fuel center.

 

Multi-department stores are significantly larger in size than combo stores. In addition to the departments offered at a typical combo store, multi-department stores sell a wide selection of general merchandise items such as apparel, home fashion and furnishings, electronics, automotive, toys and fine jewelry. Many multi-department stores include a fuel center.

 

Price impact warehouse stores offer a “no-frills, low cost” warehouse format and feature everyday low prices plus promotions for a wide selection of grocery and health and beauty care items. Quality meat, dairy, baked goods and fresh produce items provide a competitive advantage. The average size of a price impact warehouse store is similar to that of a combo store.

 

In addition to supermarkets, the Company operates, either directly or through subsidiaries, 795 convenience stores and 436 fine jewelry stores. Subsidiaries operated 699 of the convenience stores, while 96 were operated through franchise agreements. Approximately 44% of the convenience stores operated by subsidiaries were operated in company-owned facilities. The convenience stores offer a limited assortment of staple food items and general merchandise and, in most cases, sell gasoline.

 


SEGMENTS

 

The Company operates retail food and drug stores, multi-department stores, jewelry stores, and convenience stores throughout the United States. The Company’s retail operations, which represent approximately 99% of consolidated sales, are its only reportable segment. All of the Company’s operations are domestic.

 

MERCHANDISING AND MANUFACTURING

 

Corporate brand products play an important role in the Company’s merchandising strategy. Supermarket divisions typically stock approximately 8,000 private label items. The Company’s corporate brand products are produced and sold in three quality “tiers.” Private Selection is the premium quality brand designed to meet or beat the “gourmet” or “upscale” brands. The “banner brand” (Kroger, Ralphs, King Soopers, etc.), which represents the majority of the Company’s private label items, is designed to be equal to or better than the national brand and carries the “Try It, Like It, or Get the National Brand Free” guarantee. FMV (For Maximum Value) is the value brand, designed to deliver good quality at a very affordable price.

 

Approximately 55% of the corporate brand units sold are produced in the Company’s manufacturing plants; the remaining corporate brand items are produced to the Company’s strict specifications by outside manufacturers. The Company performs a “make or buy” analysis on corporate brand products and decisions are based upon a comparison of market-based transfer prices versus open market purchases. As of January 29, 2005, the Company operated 42 manufacturing plants. These plants consisted of 18 dairies, 11 deli or bakery plants, five grocery product plants, three beverage plants, three meat plants and two cheese plants.

 

EXECUTIVE OFFICERS OF THE REGISTRANT

 

The disclosure regarding executive officers is set forth in Item 10 of Part III of this Form 10-K under the heading “Executive Officers of the Company,” and is incorporated herein by reference.

 


ITEM 2. PROPERTIES

 

As of January 29, 2005, the Company operated more than 3,600 owned or leased supermarkets, convenience stores, fine jewelry stores, distribution warehouses and food processing facilities through divisions, subsidiaries or affiliates. These facilities are located throughout the United States. A majority of the properties used to conduct the Company’s business are leased.

 

The Company generally owns store equipment, fixtures and leasehold improvements, as well as processing and manufacturing equipment. The total cost of the Company’s owned assets and capitalized leases at January 29, 2005, was $19,203 million while the accumulated depreciation was $7,706 million.

 

Leased premises generally have base terms ranging from ten-to-twenty years with renewal options for additional periods. Some options provide the right to purchase the property after conclusion of the lease term. Store rentals are normally payable monthly at a stated amount or at a guaranteed minimum amount plus a percentage of sales over a stated dollar volume. Rentals for the distribution, processing and miscellaneous facilities generally are payable monthly at stated amounts. For additional information on leased premises, see Note 11 to the Consolidated Financial Statements.

 

ITEM 3. LEGAL PROCEEDINGS

 

The United States Attorney’s Office for the Central District of California is investigating the hiring practices of Ralphs Grocery Company (“Ralphs”), a wholly-owned subsidiary of The Kroger Co., during the labor dispute from October 2003 through February 2004. Among matters under investigation is the extent to which some locked-out employees were allowed to work under false identities or false Social Security numbers, despite Company policy forbidding such conduct. A grand jury has convened to consider whether such acts violated federal criminal statutes. The Company is cooperating with the investigation. Although the Company expects some adverse action to be taken, management is not able to estimate the dollar amount of penalties or liability Ralphs may incur. In addition, these alleged practices are the subject of claims that Ralphs’ conduct of the lockout was unlawful, and that Ralphs is liable under the National Labor Relations Act (“NLRA”). The Los Angeles Regional Office of the National Labor Relations Board (“NLRB”) has notified the charging parties that all charges alleging that Ralphs’ lockout violated the NLRA have been dismissed. That decision is being appealed to the General Counsel of the NLRB. The amounts potentially claimed in this matter are material, but based on the information presently available to the Company, management does not expect the ultimate resolution of this matter to have a material effect on the financial condition of the Company.

 

On February 2, 2004, the Attorney General for the State of California filed an action in Los Angeles federal court (California, ex rel Lockyer v. Safeway, Inc. dba Vons, a Safeway Company; Albertson’s, Inc. and Ralphs Grocery Company, a division of The Kroger Co., United States District Court Central District of California, Case No. CV04-0687) alleging that certain provisions of the Mutual Strike Assistance Agreement (the “Agreement”) between the Company, Albertson’s, Inc. and Safeway Inc. (collectively, the “Retailers”) which contained a provision designed to prevent the union from placing disproportionate pressure on one or more of the Retailers by picketing such Retailer(s) but not the other Retailer(s) during the labor dispute in southern California violated Section 1 of the Sherman Act. The lawsuit seeks declarative and injunctive relief. Under the Agreement, the Company paid approximately $147 million to the other Retailers. The lawsuit raises claims that could question the validity of those payments, as well as claims that the retailers unlawfully restrained competition. The Company continues to believe it has strong defenses against this lawsuit and is vigorously defending it. Although this lawsuit is subject to uncertainties inherent to the litigation process, based on the information presently available to the Company, management does not expect that the ultimate resolution of this action will have a material effect, favorable or adverse, on the Company’s financial condition, results of operations or cash flows.

 

On November 24, 2004, the Company was notified by the office of the United States Attorney for the District of Colorado that the Drug Enforcement Agency (“DEA”) had referred a matter to it for investigation regarding alleged violations of the Controlled Substances Act by the Company’s King Soopers division. The government alleges that ineffective controls and procedures, as well as improper record keeping, permitted controlled substances to be diverted from pharmacies operated by King Soopers. As a result of these allegations, the Company has retained a consultant to assist it in reviewing its policies and procedures, record keeping and training in its pharmacies, and is taking corrective action, as warranted. The Company is cooperating with the Assistant U.S. Attorney and the DEA, and expects to resolve this matter in the near future. Management does not expect that the ultimate resolution of this investigation will have a material effect on the Company’s financial condition, results of operations or cash flows.

 

On March 30, 2005, the United States District Court for the Northern District of Illinois rendered a decision in an action (Central States, Southeast and Southwest Areas Pension Fund et al. v. The Kroger Co.) alleging that the Company has failed to make contributions to a multi-employer pension fund in connection with certain employees the Company had viewed as exempt from the contribution requirement. The Court’s decision was adverse to the Company’s position, resulting in an order that would require payments of approximately $13 million. The Company has not yet decided whether to appeal. A related decision, also adverse to the Company, has been appealed to the United States Court of Appeals for the Seventh Circuit and is awaiting decision. The ultimate resolution is not expected to have a material effect on the results of operations as the Company believes it has recorded adequate allowances related to these contingencies.

 

Various claims and lawsuits arising in the normal course of business, including suits charging violations of certain antitrust and civil rights laws, are pending against the Company. Some of these suits purport or have been determined to be class actions and/or seek substantial damages. Any damages that may be awarded in antitrust cases will be automatically trebled. Although it is not possible at this time to evaluate the merits of all of these claims and lawsuits, nor their likelihood of success, the Company is of the belief that any resulting liability will not have a material adverse effect on the Company’s financial position.

 

The Company continually evaluates its exposure to loss contingencies arising from pending or threatened litigation and believes it has made adequate provisions therefor. Nonetheless, assessing and predicting the outcomes of these matters involves substantial

 


uncertainties. It remains possible that despite management’s current belief, material differences in actual outcomes or changes in management’s evaluation or predications could arise that could have a material adverse impact on the Company’s financial condition or results of operation.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

None.

 


 

PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

COMMON STOCK PRICE RANGE

 

     2004

   2003

Quarter


   High

   Low

   High

   Low

1st

   $ 19.67    $ 15.95    $ 15.52    $ 12.05

2nd

   $ 18.36    $ 14.70    $ 18.41    $ 15.14

3rd

   $ 17.31    $ 14.65    $ 19.70    $ 17.00

4th

   $ 17.75    $ 15.53    $ 19.03    $ 16.80

 

Main trading market: New York Stock Exchange (Symbol KR)

 

Number of shareholders of record at year-end 2004:        49,817

 

Number of shareholders of record at April 8, 2005:         49,517

 

Determined by number of shareholders of record

 

The Company has not paid dividends on its Common Stock for the past three fiscal years.

 

On January 17, 2005, the Company issued 21,761 shares of Common Stock to Robert I. Bernstein (the “Warrant Holder”). The shares were issued to the Warrant Holder upon conversion of warrants issued pursuant to a Warrant Agreement dated May 23, 1996. The original warrants were issued in a private placement transaction not involving a public offering pursuant to Section 4(2) of the Securities Act of 1933, as amended. The conversion of the warrants into common stock was an exempt exchange under Section 3(a)(9) of the Securities Act. The Company received no proceeds from the issuance of the common stock.

 

The information regarding equity compensation plans will be set forth in the section entitled “Equity Compensations Plan Information” in the definitive proxy statement to be filed by the Company with the SEC, and is incorporated by reference into this Form 10-K.

 


(c)

   ISSUER PURCHASES OF EQUITY SECURITIES     

 

Period (1)


   Total Number
of Shares
Repurchased


   Average
Price Paid
Per Share


   Total Number of
Shares
Purchased as
Part of Publicly
Announced
Plans or
Programs (2)


  

Maximum Dollar
Value of Shares
that May Yet Be
Purchased Under
the Plans or
Programs (3)

(in millions)


First four weeks

                       

November 7, 2004 to December 4, 2004

   1,737,590    $ 16.11    1,600,000    $ 395

Second four weeks

                       

December 5, 2004 to January 1, 2005

   1,361,400    $ 16.65    1,361,400    $ 373

Third four weeks

                       

January 2, 2005 to January 29, 2005

   1,239,905    $ 16.87    1,225,000    $ 353
    
         
      

Total

   4,338,895    $ 16.50    4,186,400    $ 353

 

(1) The reported periods conform to the Company’s fiscal calendar composed of thirteen 28-day periods. The fourth quarter of 2004 contains three 28-day periods.

 

(2) Shares were repurchased under (i) a $500 million stock repurchase program, authorized by the Board of Directors on September 16, 2004, and (ii) a program authorized in December 1999 to repurchase common stock to reduce dilution resulting from our employee stock option plans, a program that is limited based on proceeds received from exercises of stock options and the tax benefits associated therewith. The programs have no expiration date but may be terminated by the Board of Directors at any time. No shares were purchased other than through publicly announced programs during the periods shown.

 

(3) Amounts shown in this column reflect amounts remaining under the $500 million stock repurchase program referenced in Note 2 above. Amounts to be invested under the program utilizing option exercise proceeds are dependent upon option exercise activity.

 


ITEM 6. SELECTED FINANCIAL DATA

 

     Fiscal Years Ended

     January 29,
2005
(52 weeks)


    January 31,
2004
(52 weeks)


   February 1,
2003
(52 weeks)


    February 2,
2002
(52 weeks)


   February 3,
2001
(53 weeks)


     (In millions, except per share amounts)

Sales

   $ 56,434     $ 53,791    $ 51,760     $ 50,098    $ 49,000

Earnings (loss) before cumulative effect of accounting change

     (100 )     312      1,218       1,040      874

Cumulative effect of accounting change (A)

     —         —        (16 )     —        —  

Net earnings (loss)

     (100 )     312      1,202       1,040      874

Diluted earnings (loss) per share:

                                    

Earnings (loss) before cumulative Effect of accounting change

     (0.14 )     0.41      1.54       1.26      1.03

Cumulative effect of accounting change (A)

     —         —        (.02 )     —        —  

Net earnings (loss)

     (0.14 )     0.41      1.52       1.26      1.03

Total assets

     20,491       20,763      20,318       19,069      18,472

Long-term obligations, including obligations under capital leases

     10,635       10,613      10,667       10,103      9,727

Shareowners’ equity

     3,540       3,985      3,827       3,482      3,072

Cash dividends per common share (B)

     —         —        —         —        —  

 

(A) Amounts are net of tax. Refer to Note 5 of the Consolidated Financial Statements.

 

(B) During the fiscal years ended February 2, 2002, and prior, the Company was prohibited from paying cash dividends under the terms of its previous Credit Agreement. On May 22, 2002, the Company entered into a new Credit Agreement, at which time the restriction on payment of cash dividends was eliminated. However, no cash dividends were declared or paid in any of the periods presented.

 


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

 

OUR BUSINESS

 

The Kroger Co. was founded in 1883 and incorporated in 1902. It is one of the nation’s largest retailers, operating 2,532 stores under two dozen banners including Kroger, Ralphs, Fred Meyer, Food 4 Less, King Soopers, Smith’s, Fry’s, Fry’s Marketplace, Dillons, QFC and City Market. The Company also operates 795 convenience stores, 436 fine jewelry stores, and 536 supermarket fuel centers.

 

Kroger operates 42 manufacturing plants, primarily bakeries and dairies, which supply about two-thirds of the private label grocery products sold in the Company’s retail outlets.

 

Our revenues are earned and cash is generated as consumer products are sold to customers in our stores. We earn income predominately by selling products at price levels that produce revenues in excess of our costs to make these products available to our customers. Such costs include procurement and distribution costs, facility occupancy and operational costs, and overhead expenses. The Company’s operations are reported as a single operating segment: the retail sale of merchandise to individual customers.

 

OUR 2004 PERFORMANCE

 

The operating environment of the food retailing industry continues to be characterized by intense price competition, aggressive supercenter expansion, increasing fragmentation of retail formats, and market consolidation. Over the past several years, many traditional supermarket operators, including Kroger, have experienced declining profit margins. In an effort to maintain market share, we have lowered retail prices at a rate faster than we were able to reduce costs.

 

Kroger recognized the major changes in the operating environment and in 2001 we implemented a plan to transition to a lower gross margin environment. During 2002 and 2003 our identical food store sales without fuel declined. In 2004 we were pleased with the progress of our identical sales, excluding the effect of fuel and the southern California labor dispute, which has now shown sequential improvement for seven of the past eight quarters. Identical food store sales on this same basis increased 1.2% in 2004. This nearly met the 1.3% target we established at the beginning of the year. This was accomplished by focusing on our customers’ needs of high-quality perishable products and lowering selected prices.

 

Our internal analysis shows that we hold the #1 or #2 position in 40 of our 52 major markets. We define a major market as one in which we operate nine or more stores. According to our internal market share estimates, which include all retail outlets including supercenters and other non-traditional retail formats, Kroger’s market share increased in 23 of our 52 major markets in 2004, declined in 27 and remained unchanged in two. Six of the 27 markets in which our market share declined are in California, including five markets that were significantly affected by the southern California labor dispute. On a volume-weighted basis, Kroger’s overall market share declined slightly in our 52 major markets.

 

Our 2003 and 2004 financial results were affected by asset and goodwill impairment charges and two labor disputes that occurred in southern California and West Virginia. In West Virginia, we closed 44 stores starting October 13, 2003 when a strike was conducted by a local union of the United Food and Commercial Workers International Union (“UFCW”). These stores were reopened on December 11, 2003 after ratification of a new contract. In southern California, our Ralphs stores, as well as stores operated by Safeway, Inc. and Albertson’s, Inc. were subject to a labor dispute that started on October 12, 2003 and ended 141 days later on February 29, 2004. We are working hard to rebuild our business in this region. The recovery from the labor dispute has been slower than we expected. We continue to emphasize store conditions, associate training, associate engagement and competitive pricing. We are making progress and have a plan in place to return sales to pre-strike levels.

 

Excluding the impairment charges and the effect of the strikes, our net earnings still declined in 2004. Our increased sales did not translate to increased bottom line earnings. The competitive environment’s pressure on retail prices combined with increased inflation in product costs and increasingly price-conscience consumers have resulted in lower gross profit. Additionally, increases in operating and administrative costs, especially employee health care costs and pension costs have been increasing at a higher rate than sales.

 

FUTURE EXPECTATIONS

 

We believe that Kroger is now positioned, despite intense price competition, to increase total sales, identical store sales, and earnings. Kroger’s plan starts with the customer. We are listening to our customers through research and focus groups. Our plan centers around those areas that our customers have told us are important. Our focus is on differentiating our stores, being competitive on price, and providing our customers a superior shopping experience as compared to our competitors, in terms of service, product quality, and variety.

 


The plan should allow us to build a stronger relationship with our customers, position Kroger as the retailer of choice, and generate a satisfactory return for our shareholders. Significant, sustainable cost reductions will enable us to achieve our plan. Costs savings will be derived from areas such as process improvements, restructured labor contracts that will allow us to remain competitive, lower product costs, and technology utilization.

 

Kroger’s financial strength is an important competitive advantage. Our free cash flow permits us to upgrade and expand our asset base in order to offer customers clean, modern stores that enhance their shopping experience. Our cash flow also enables us to continue reducing debt and buy back stock.

 

In addition to financial strength, Kroger has many other key strengths such as a high quality asset base with leading market shares, broad geographic diversity, multiple retail formats, customer loyalty data and data analysis capability, a successful track record against supercenter competition and industry leading corporate brands.

 

Kroger is focused on consistently meeting the needs of our customers by providing improved service, selection and value. Our associates are key to Kroger’s success. We expect the successful execution of our strategy will be clearly evident in our 2005 financial results.

 

Further discussion on our industry, the current economic environment and our related strategic plans is included in “Outlook”.

 

RESULTS OF OPERATIONS

 

The following discussion summarizes our operating results for 2004 compared to 2003 and for 2003 compared to 2002. Comparability is affected by certain income and expense items that fluctuated significantly between and among the periods, including goodwill and asset impairment charges and labor disputes in West Virginia and southern California. These items are identified and discussed in more detail below in “Other Items” and “Estimated Effect of Labor Disputes.”

 

Certain amounts set forth below have been revised from those contained in the preliminary financial statements reported in Kroger’s earnings release filed on a Form 8-K dated March 8, 2005. The changes related to the correction of the amount recorded for deferred income taxes related to the Ralphs business combination. The correction resulted in a change to the goodwill impairment charge related to the Ralphs and Food 4 less operations in southern California.

 

Net Earnings (Loss)

 

We recorded a net loss totaling $100 million, or $0.14 per share, for 2004, compared to net earnings totaling $312 million, or $0.41 per diluted share, in 2003 and net earnings of $1,202 million, or $1.52 per diluted share, in 2002. The decrease in net earnings in 2004 and 2003 was significantly affected by labor disputes as well as goodwill and asset impairment charges. These items are more fully described below in “Other Items” and “Estimated Effect Of Labor Disputes.” Lower gross margins, a result of our investment in pricing due to the competitive operating environment, also affect our year-to-year net earnings results.

 

Sales

 

Total Sales

(in millions)

 

     2004

   Percentage
Increase


    2003

   Percentage
Increase


    2002

Total food store sales without fuel

   $ 51,106.2    2.9 %   $ 49,650.0    2.8 %   $ 48,295.1

Total food store fuel sales

     2,305.2    59.0 %     1,449.9    60.7 %     902.5
    

        

        

Total food store sales

   $ 53,411.4    4.5 %   $ 51,099.9    3.9 %   $ 49,197.6

Other sales

     3,023.0    12.3 %     2,690.9    5.0 %     2,561.9
    

        

        

Total Sales

   $ 56,434.4    4.9 %   $ 53,790.8    3.9 %   $ 51,759.5
    

        

        

 

The change in our total sales is driven by identical store sales and square footage growth, as well as inflation in fuel and other commodities.

 


We define a food store as an identical store when the store has been in operation without expansion or relocation for five full quarters. We calculate annualized identical food store sales based on a summation of four quarters of identical sales. Our annualized identical food store sales results are summarized below.

 

Identical Food Store Sales

(in millions)

 

                

Excluding Stores Affected

By Labor Disputes (1):


 

Dollars


   2004

    2003

    2004

    2003

 

Including supermarket fuel centers

   $ 50,135.0     $ 49,110.1     $ 43,462.4     $ 42,338.3  

Excluding supermarket fuel centers

   $ 48,068.0     $ 47,699.6     $ 41,427.9     $ 40,921.3  

Percentage Increase

                                

Including supermarket fuel centers

     2.1 %     0.4 %     2.7 %     0.7 %

Excluding supermarket fuel centers

     0.8 %     (0.4 )%     1.2 %     (0.2 )%

 

We define a food store as a comparable store when the store has been in operation for five full quarters, including expansions and relocations. We calculate annualized comparable food store sales based on a summation of four quarters of comparable sales. Our annualized comparable food store sales results are summarized in the table below.

 

Comparable Food Store Sales

(in millions)

 

                

Excluding Stores Affected

By Labor Disputes (1):


 

Dollars


   2004

    2003

    2004

    2003

 

Including supermarket fuel centers

   $ 51,581.9     $ 50,273.1     $ 44,796.4     $ 43,427.9  

Excluding supermarket fuel centers

   $ 49,440.4     $ 48,814.5     $ 42,687.3     $ 41,992.8  

Percentage Increase

                                

Including supermarket fuel centers

     2.6 %     1.0 %     3.2 %     1.3 %

Excluding supermarket fuel centers

     1.3 %     0.1 %     1.7 %     0.3 %

(1) Sales figures adjusted for the effects of the labor disputes exclude stores involved in labor disputes, as well as Food 4 Less stores whose sales results were favorably affected by the labor disputes in the southern California region.

 

Our sales in 2004 were also affected by inflation and deflation in various commodity groups, our competitive operating environment, the recovery from the labor disputes in West Virginia and southern California and the results of our strategic initiatives.

 

FIFO Gross Margin

 

We calculate First-In, First-Out (“FIFO”) Gross Margin as follows: Sales minus merchandise costs plus Last-In, First-Out (“LIFO”) charge (credit). Merchandise costs include advertising, warehousing and transportation, but exclude depreciation expense and rent expense. FIFO gross margin is an important measure used by our management to evaluate merchandising and operational effectiveness. Our FIFO gross margin rates were 25.41%, 26.38% and 26.85% in 2004, 2003 and 2002, respectively. These declining rates reflect our continued investment in lower retail prices. Higher fuel sales that carry a low gross profit rate reduced our FIFO gross margin rates by 135, 93 and 69 basis points in 2004, 2003 and 2002, respectively. The southern California labor dispute and our related recovery efforts reduced gross profit rates in both 2004 and 2003. Additionally, other items recorded as merchandise costs in 2004, 2003 and 2002 further affected our FIFO gross margin rates. These items are more fully described below in “Other Items” and “Estimated Effect of Labor Disputes.”

 

Operating, General and Administrative Expenses

 

Operating, general and administrative (“OG&A”) expenses, which consist primarily of employee-related costs such as wages, health care benefit costs and retirement plan costs, as a percent of sales were 18.80%, 19.25% and 18.58% in 2004, 2003 and 2002, respectively. Higher fuel sales reduced our OG&A rate by 105, 73 and 48 basis points in 2004, 2003 and 2002, respectively. The labor disputes and several items that are more fully described in “Other Items” and “Estimated Effect of Labor Disputes” affected our OG&A rates in 2004 and 2003.

 


We continue to emphasize cost containment efforts in all areas and especially in the wage and benefit areas. In the fourth quarter of 2004, health care costs declined slightly as a percent of sales, the result of progress we have made during labor negotiations. We expect additional improvement in our OG&A rate in 2005, particularly as we leverage increasing sales and cost reductions in key areas of our business.

 

Rent Expense

 

Rent expense, as a percent of sales, was 1.21%, 1.22% and 1.27% in 2004, 2003 and 2002, respectively. The decreases in these rates reflect our continued emphasis on ownership of real estate, partially offset by increased charges for the net present value of lease liabilities recorded for store closings.

 

Depreciation Expense

 

Depreciation expense, as a percent of sales, was 2.22%, 2.25% and 2.10% for 2004, 2003 and 2002, respectively. The change in these rates reflects our continued emphasis on ownership of real estate, offset by tightening of capital expenditures and the leveraging effect of increased sales.

 

Interest Expense

 

Net interest expense totaled $557 million, $604 million and $619 million for 2004, 2003 and 2002, respectively. The decrease in interest expense is the result of lower average borrowings and lower average rates on outstanding debt. Interest expense in 2004, 2003 and 2002 included $25 million, $18 million and $19 million, respectively, related to the early retirement of debt, more fully described in “Other Items.”

 

Income Taxes

 

Our effective income tax rate was 134.5%, 59.3% and 37.5% for 2004, 2003 and 2002, respectively. The effective tax rates for 2004 and 2003 differ from the effective tax rate for 2002 due to the impairment of non-deductible goodwill in 2004 and 2003. The effective income tax rates also differ from the expected statutory rate in all years presented due to the effect of state taxes.

 


OTHER ITEMS

 

The following table summarizes items that affected Kroger’s financial results during the periods presented. These items should not be considered alternatives to net earnings, net cash provided by operating activities or any other Generally Accepted Accounting Principles (“GAAP”) measure of performance or liquidity. These items should not be viewed in isolation or considered substitutes for Kroger’s results as reported in accordance with GAAP.

 

These items include goodwill impairment charges, asset impairment charges, restructuring charges, merger-related costs and the cumulative effect of an accounting change, all of which are shown separately in the Consolidated Statements of Operations. The items also include charges and credits that were recorded as components of FIFO gross margin, LIFO charge (credit), OG&A expense and interest expense.

 

(In millions except per share amounts)


   2004

    2003

    2002

 

Items affecting FIFO gross margin (1)

                        

Item-cost conversion

   $ —       $ —       $ 91  

Adoption of EITF Issue No. 02-16

     —         —         28  
    


 


 


Total affecting FIFO gross margin

     —         —         119  

Adoption of EITF Issue No. 02-16 – LIFO effect

     —         —         (28 )

Items affecting OG&A

                        

Lease liabilities – store closing plans

     —         (10 )     —    

Excess energy purchase commitments

     —         4       (19 )

Settlement of energy contract dispute

     —         62       —    

Property tax allowance adjustment

     —         (20 )     —    

Power outage

     —         9       —    

Charitable contribution

     —         (5 )     —    
    


 


 


Total affecting OG&A

     —         40       (19 )

Items affecting interest expense

     3       18       19  

Goodwill impairment charge

     900       444       —    

Asset impairment charges

     —         120       —    

Restructuring charges

     —         —         15  

Merger-related costs

     —         —         1  
    


 


 


Total pre-tax effect

     903       622       107  

Income tax benefit (2)

     (44 )     (66 )     (40 )
    


 


 


After-tax effect

     859       556       67  

Cumulative effect of accounting change, net of tax (3)

     —         —         16  
    


 


 


Total after-tax expense

   $ 859     $ 556     $ 83  
    


 


 


Shares used in earnings per share calculation

     736       754       791  

Approximate per share effect

   $ 1.17     $ 0.74     $ 0.11  

 

(1) FIFO gross margin is defined above in “Results of Operations.”

 

(2) Income tax benefits in 2004 and 2003 are affected by the non-deductibility of the majority of the goodwill impairment charges.

 

(3) The transitional impairment review required by the adoption of SFAS No. 142, “Goodwill and Other Intangible Assets” resulted in a write off of our jewelry store division goodwill.

 


Items Affecting FIFO Gross Margin, LIFO Charge (Credit) and Operating, General and Administrative Expense

 

Item-cost conversion

 

In 1998, prior to the merger with Fred Meyer, we changed our application of the LIFO method of accounting for certain store inventories from the retail method to the item-cost method. The change improved the accuracy of product cost calculations by eliminating the averaging and estimating inherent in the retail method.

 

During 2002, we adopted the item-cost method for the former Fred Meyer divisions. The cumulative effect of this change on periods prior to February 3, 2002, cannot be determined. The effect of the change on the February 3, 2002 inventory valuations, which includes other immaterial modifications in inventory valuation methods, was included in results for the quarter ended May 25, 2002. This change increased merchandise costs by $91 million and reduced net earnings by $57 million. We did not calculate the pro forma effect on prior periods because we were unable to determine cost information for these periods. The item-cost method did not have a material effect on earnings subsequent to adoption on February 3, 2002.

 

Adoption of Emerging Issues Task Force (“EITF”) Issue No. 02-16

 

We adopted EITF Issue No. 02-16 during 2002. This issue addresses the method by which retailers account for vendor allowances. Due to system constraints and the nature of certain allowances, it is sometimes not practicable to apply allowances to the item cost of inventory. Historically, we had recognized those allowances as they were earned, based on the fulfillment of the related obligations of the contract. This accounting treatment was consistent with GAAP. For all contracts entered into or modified after January 1, 2003, we have recognized prospectively, and will continue to recognize, vendor allowances when the related merchandise is sold, in accordance with Issue 02-16. Net earnings in 2002 were not affected by the adoption of Issue No. 02-16. Adoption of the Issue resulted in a $28 million pre-tax charge that was included in merchandise costs in 2002. This expense was offset by a corresponding $28 million pre-tax LIFO credit that also was included in merchandise costs in 2002.

 

Lease liabilities – Store Closing Plans

 

Due to operational changes, performance improved at five stores, not yet closed, for which store closing liabilities had been recorded as a part of a corporate-level strategic plan. As a result of this improved performance, in 2003 we modified our original plans and determined that these five locations will remain open. Additionally, closing and exit costs at other locations included in the original plans were less costly than anticipated. In total, in 2003, we recorded pre-tax income of $10 million to adjust these liabilities to reflect the outstanding lease commitments through 2020 at the locations remaining under the plans. Refer to Note 3 to the Consolidated Financial Statements for additional details of these liabilities.

 

No charges were recorded in 2003 for the present value of lease liabilities for stores considered in the 2003 asset impairment review. In accordance with SFAS No. 146, which is effective for all exit and disposal activities initiated after December 31, 2002, these liabilities will be recorded when these locations are closed. During fiscal 2004, we recorded lease liabilities totaling $24 million related to the closing of 41 of these stores.

 

Excess energy purchase commitments

 

During 2001, we recorded a pre-tax charge of $81 million to accrue liabilities for the estimated fair value of energy purchase commitments that provided for supplies in excess of our expected demand for electricity. SFAS No. 133 required the excess commitments to be marked to fair value through current-period earnings each quarter. We recorded pre-tax expense of $4 million and pre-tax income of $19 million as a result of the market value adjustment of these excess commitments in 2003 and 2002, respectively.

 

During 2003, we reached an agreement through which we ended supply arrangements in California with Dynegy, Inc., related to these two contracts and two other electricity contracts that had been previously accounted for as normal purchases normal sales contracts. The Federal Energy Regulatory Commission approved the agreement on July 23, 2003. During 2003, we paid $107 million, before the related tax benefits, to settle disputes with Dynegy related to prior over-payments, terminate two of the four contracts effective July 6, 2003, and terminate the remaining two agreements effective September 1, 2003. As a result of the settlement, we recorded $62 million of pre-tax expense in 2003.

 

Property Tax Allowance

 

In 2003, we recorded pre-tax income of $20 million related to the reversal of a property tax accrual after we determined the amount to be paid would be less than we originally estimated.

 


Power Outage

 

In 2003, we recorded a $9 million pre-tax expense for the August power outage in northwest Ohio and Michigan. The majority of the expense related to uninsured product losses. Generally, we classify uninsured product and property losses as OG&A expense.

 

Adjustment to Charitable Contribution Liability

 

In 2003, we recorded $5 million of pre-tax income to adjust previously recorded liabilities related to charitable contributions required as a result of the Fred Meyer merger. We are required to make the remaining $14 million contribution by May 2006.

 

Items Affecting Interest Expense

 

We adopted SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections,” in the first quarter of 2003. As a result, expenses related to the early retirement of debt, which were recorded as extraordinary items prior to the issuance of SFAS No. 145, are now classified as interest expense in the respective periods. The 2004 expenses of $3 million pre-tax, related to a premium paid in connection with the redemption of our $750 million 7.375% bonds due March 2005, net of the effect of reduced interest expense for the balance of the year. The 2003 expenses of $18 million, pre-tax, related to premiums paid in connection with the repurchase of $100 million of long-term bonds, and the write-off of the related deferred financing costs.

 

Goodwill Impairment Charge

 

We performed the annual evaluation of goodwill required by SFAS No. 142 during the fourth quarter of 2004. This review resulted in a $900 million non-cash impairment charge related to goodwill at our Ralphs and Food 4 Less divisions. The impairment charge, most of which is non-deductible for income tax purposes, adjusted the carrying value of the divisions’ goodwill to its implied fair value. The divisions’ operating performance suffered due to the intense competitive environment following the 2003 southern California labor dispute and recovery period. The decreased operating performance was the result of the investments in personnel, training, capital and price reductions necessary to regain Ralphs’ lost business and to maintain business gained by Food 4 Less stores that were not subject to the labor dispute. As a result of this decline in operating performance, the divisions’ carrying value of goodwill exceeded its implied fair value resulting in the impairment charge. No impairment for goodwill at our other divisions was indicated during this review.

 

During our annual review in 2003, we recorded a $444 million non-cash goodwill impairment charge related to the goodwill at our Smith’s division following a substantial decline in the operating performance of the division compared to 2002 operating performance and expected future performance.

 

Asset Impairment Charges and Related Items

 

In accordance with our policy on impairment of long-lived assets, we recorded impairment losses for both assets to be disposed of and assets to be held and used during 2003. These losses, which are reflected in our Consolidated Statements of Operations as “Asset impairment charges,” totaled $120 million, pre-tax. The impairment review was conducted as a consequence of a corporate-level strategic plan that coordinated the closing of several locations over a relatively short period of time as a result of deteriorating operating performance. During the fourth quarter of 2003, we authorized closure of several stores throughout the country based on operating results for 2002 and 2003, as well as updated projections for 2004 and beyond. This event triggered an impairment review of stores slated for closure as well as several other under-performing locations in the fourth quarter of 2003. These charges are more fully described in Note 3 to the Consolidated Financial Statements.

 

Restructuring Charges

 

On December 11, 2001, we outlined our Strategic Growth Plan (the “Plan”) to support additional investment in our core business to increase sales and market share. Restructuring charges related to the Plan totaled $15 million, pre-tax in 2002. The majority of the charge related to severance agreements, distribution center consolidation and conversion costs. No restructuring charges were recorded in 2004 and 2003.

 

Merger-Related Costs

 

During 2002, we recorded pre-tax expenses of $1 million from the issuance of restricted stock and the related market value adjustments. The restrictions on these stock awards lapsed in 2002 based on the achievement of synergy goals established in connection with the Fred Meyer merger. No merger-related costs were recorded during 2004 or 2003. Please refer to Note 2 to our Consolidated Financial Statements for additional details of this charge.

 


Cumulative Effect of an Accounting Change

 

We adopted SFAS No. 142 on February 3, 2002. The transitional impairment review required by SFAS No. 142 resulted in a $26 million pre-tax, non-cash loss to write-off the goodwill at our jewelry store division based on its implied fair value. Impairment primarily resulted from the recent operating performance of the division and a review of the projected cash flows on a discounted basis, rather than an undiscounted basis, as was the standard under SFAS No. 121, prior to the adoption of SFAS No. 142. We recorded this loss as a cumulative effect of an accounting change, net of a $10 million tax benefit, in the first quarter of 2002.

 

ESTIMATED EFFECT OF LABOR DISPUTES

 

The following table summarizes the estimated effect of labor disputes on Kroger’s financial results. These items should not be considered alternatives to net earnings, net cash provided by operating activities or any other GAAP measure of performance or liquidity. These items should not be viewed in isolation or considered substitutes for Kroger’s results as reported in accordance with GAAP. Due to the nature of these items, as described below, it is important to identify the items and review them in conjunction with Kroger’s financial results reported in accordance with GAAP.

 

For the dispute-affected regions, we compared actual results to budgeted results from the start of the disputes through the first two quarters of 2004. In establishing budgets for 2004, we took into account trends existing in the market prior to the labor disputes as well as changes in our business plan strategies. Based on those budgets, the estimated effects included the difference between reported sales and sales projections less reported merchandising costs and merchandising cost projections and the difference between reported OG&A and OG&A projections. While we have relied on the accuracy of our budgets, significant amounts of judgment were used to develop those budgets and actual results, had there been no labor disputes, may have differed from those budgets.

 

Included in the estimated effect of labor disputes were charges and credits that were recorded as components of merchandise costs and OG&A expense. The 2003 calculation includes the effect of both the southern California and West Virginia strikes. The estimated effect includes all costs associated with the work stoppages, including expenses under the mutual strike assistance agreement in southern California entered into with Safeway, Inc. and Albertson’s, Inc., and post-strike recovery expenses through the second quarter of 2004. In the third quarter of 2004, we discontinued reporting the estimated strike effect for southern California.

 

(In millions except per share amounts)    


   2004

    2003

 

Estimated effect of labor disputes on:

                

FIFO gross margin(1)

   $ 133     $ 177  

OG&A

     18       216  
    


 


Total pre-tax loss

   $ 151     $ 393  

Income tax effect

     (56 )     (148 )
    


 


Total after-tax loss

   $ 95     $ 245  
    


 


Shares

     736       754  

Estimated loss per share

   $ 0.13     $ 0.32  
    


 


 

(1) FIFO gross margin is defined above in “Results of Operations.”

 

Differences affecting FIFO gross margin included incremental warehousing, distribution, advertising and inventory shrinkage expenses incurred during the labor dispute, as well as the investment in FIFO gross margin, through targeted price reductions, and advertising in order to regain our sales during the post-strike recovery period. Differences in OG&A included costs associated with hiring and training replacement workers, costs associated with bringing in employees from other Kroger divisions to work on a temporary basis, expenses under the mutual strike assistance agreement and costs related to hiring and training workers to replace associates who did not return to work after the labor disputes ended.

 


COMMON STOCK REPURCHASE PROGRAM

 

In December 1999, we began a program to repurchase common stock to reduce dilution resulting from our employee stock option plans. This program is solely funded by proceeds from stock option exercises, including the tax benefit from these exercises. We repurchased approximately $28 million, $24 million and $65 million under the stock option program in during 2004, 2003 and 2002, respectively. On December 10, 2002, Kroger’s Board of Directors (the “Board”) authorized an additional stock repurchase program totaling $500 million. We made open market purchases totaling $277 million and $63 million under this plan in 2003 and 2002. During fiscal 2004, we made open market purchases of approximately $144 million to complete the program. In September 2004, the Board authorized a new $500 million stock repurchase program to replace the December 2002 program. As of January 29, 2005, we had made purchases totaling $147 million under the September 2004 program.

 

CAPITAL EXPENDITURES

 

Capital expenditures, excluding acquisitions, totaled $1.6 billion in 2004 compared to $2.0 billion in 2003 and $1.9 billion in 2002. The decline in 2004 was the result of our emphasis on the tightening of capital and increasing our focus on remodels, merchandising and productivity projects. Capital expenditure included $202 million and $192 million in 2003 and 2002, respectively, related to the purchase of assets previously financed under a synthetic lease. The table below shows our supermarket storing activity and our total food store square footage:

 

Supermarket Storing Activity

 

     2004

    2003

    2002

 

Beginning of year

   2,532     2,488     2,418  

Opened

   41     44     62  

Opened (relocation)

   15     14     17  

Acquired

   20     25     37  

Acquired (relocation)

   3     5     8  

Closed (operational)

   (56 )   (25 )   (29 )

Closed (relocation)

   (23 )   (19 )   (25 )
    

 

 

End of year

   2,532     2,532     2,488  
    

 

 

Total food store square footage (in millions)

   141     140     136  

 

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 generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosures of contingent assets and liabilities. We base our estimates on historical experience and other factors we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates.

 

We believe that 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.

 

Self-Insurance Costs

 

We primarily are self-insured for costs related to workers’ compensation and general liability claims. The liabilities represent our best estimate, using generally accepted actuarial reserving methods, of the ultimate obligations for reported claims plus those incurred but not reported for all claims incurred through January 29, 2005. Case-reserves are established for reported claims using case-basis evaluation of the underlying claim data and are updated as information becomes known.

 

The liabilities for workers’ compensation claims are accounted for on a present value basis utilizing a risk-adjusted discount rate. The difference between the discounted and undiscounted workers’ compensation liabilities was $38 million as of January 29, 2005. We have purchased stop-loss coverage to limit our exposure to any significant exposure on a per claim basis. We are insured for covered costs in excess of these per claim limits.

 


The assumptions underlying the ultimate costs of existing claim losses are subject to a high degree of unpredictability, which can affect the liability recorded for such claims. For example, variability in inflation rates of health care costs inherent in these claims can affect the amounts realized. Similarly, changes in legal trends and interpretations, as well as a change in the nature and method of how claims are settled can impact ultimate costs. Although our estimates of liabilities incurred do not anticipate significant changes in historical trends for these variables, any changes could have a considerable effect upon future claim costs and currently recorded liabilities.

 

Impairments of Long-Lived Assets

 

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we monitor the carrying value of long-lived assets for potential impairment each quarter based on whether certain trigger 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 trigger event occurs, an impairment calculation is performed, 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 impairment is identified for long-lived assets to be held and used, we compare discounted future cash flows to the asset’s current carrying value. We record impairment when the carrying value exceeds the discounted cash flows. With respect to owned property and equipment held for disposal, the value of the property and equipment is adjusted to reflect recoverable values based on our previous efforts to dispose of similar assets and current economic conditions. Impairment is recognized for the excess of the carrying value over the estimated fair market value, reduced by estimated direct costs of disposal.

 

The factors that most significantly affect the impairment calculation are our estimates of future cash flows. Our cash flow projections project several years into the future and include assumptions on variables such as inflation, the economy and market competition.

 

We perform impairment reviews at both the division and corporate levels. Generally, for reviews performed by local management, costs to reduce the carrying value of long-lived assets are reflected in the Consolidated Statements of Earnings as “Operating, general and administrative” expense. Costs to reduce the carrying value of long-lived assets that result from corporate-level strategic plans are separately identified in the Consolidated Statements of Earnings as “Asset impairment charges.” Refer to “Other Items” for a description of asset impairment charges recorded during 2003.

 

Goodwill

 

Goodwill is reviewed for impairment during the fourth quarter of each year, and also upon the occurrence of trigger events. The reviews are performed at the operating division level. Generally, fair value represents a multiple of earnings, or discounted projected future cash flows, and is compared to the carrying value of a division for purposes of identifying potential impairment. Projected future cash flows are based on management’s knowledge of the current operating environment and expectations for the future. If potential for impairment is identified, the fair value of a division is measured against the fair value of its underlying assets and liabilities, excluding goodwill, to estimate an implied fair value of the division’s goodwill. Goodwill impairment is recognized for any excess of the carrying value of the division’s goodwill over the implied fair value. Results of the goodwill impairment reviews performed during 2004, 2003 and 2002 are summarized in Note 5 to the Consolidated Financial Statements.

 

The annual impairment review requires the extensive use of accounting judgment and financial estimates. Application of alternative assumptions and definitions, such as reviewing goodwill for impairment at a different organizational level, could produce significantly different results. Similar to our policy on impairment of long-lived assets, the cash flow projections embedded in our goodwill impairment reviews can be affected by several items such as inflation, the economy and market competition.

 

Intangible Assets

 

In addition to goodwill, the Company has recorded intangible assets totaling $20 million and $29 million for liquor licenses and pharmacy prescription file purchases, respectively, at January 29, 2005. Balances at January 31, 2004, were $20 million for liquor licenses and $21 million for pharmacy prescription files. Owned liquor licenses are not amortized, while liquor licenses that must be renewed are amortized over their useful life. Pharmacy prescription file purchases are amortized over seven years. We test these assets annually for impairment.

 


Store Closing Costs

 

We provide for closed store liabilities relating to the present value of the estimated remaining noncancellable lease payments after the closing date, net of estimated subtenant income. We estimate the net lease liabilities using a discount rate to calculate the present value of the remaining net rent payments on closed stores. The closed store lease liabilities usually are paid over the lease terms associated with the closed stores, which generally have remaining terms ranging from one to 20 years. Adjustments to closed store liabilities primarily relate to changes in subtenant income and actual exit costs differing from original estimates. Adjustments are made for changes in estimates in the period in which the change becomes known. Store closing liabilities are reviewed quarterly to ensure that any accrued amount that is not a sufficient estimate of future costs, or that no longer is needed for its originally intended purpose, is adjusted to income in the proper period.

 

We estimate subtenant income, future cash flows and asset recovery values based on our experience and knowledge of the market in which the closed store is located, our previous efforts to dispose of similar assets and current economic conditions. However, the ultimate cost of the disposition of the leases and the related assets is affected by current real estate markets, inflation rates and general economic conditions.

 

Owned stores held for disposal are reduced to their estimated net realizable value. Costs to reduce the carrying values of property, equipment and leasehold improvements are accounted for in accordance with our policy on impairment of long-lived assets. Inventory write-downs, if any, in connection with store closings, are classified in “Merchandise costs.” Costs to transfer inventory and equipment from closed stores are expensed as incurred.

 

Post-Retirement Benefit Plans

 

(a) Company-Sponsored Pension Plans

 

The determination of our obligation and expense for company-sponsored pension plans and other post-retirement benefits is dependent upon our selection of assumptions used by actuaries in calculating those amounts. Those assumptions are described in Note 18 to the Consolidated Financial Statements and include, among others, the discount rate, the expected long-term rate of return on plan assets and the rate of increases in compensation and health care costs. In accordance with GAAP, actual results that differ from our assumptions are accumulated and amortized over future periods and, therefore, generally affect our recognized expense and recorded obligation in future periods. While we believe that our assumptions are appropriate, significant differences in our actual experience or significant changes in our assumptions may materially affect our pension and other post-retirement obligations and our future expense. Note 18 to the Consolidated Financial Statements discusses the impact of a 1% change in the assumed health care cost trend rate on other post-retirement benefit costs and the related liability.

 

The discount rate is based primarily on the yield on high-quality fixed income investments as of the measurement date. We lowered the discount rate to 5.75% as of January 29, 2005, from 6.25% as of January 31, 2004. The 50 basis point reduction in the discount rate increased the projected pension benefit obligation as of January 29, 2005, by $120 million. In 2005, we expect that the annual pension expense will increase by $15 million as a result of this change.

 

To determine the expected return on pension plan assets, we contemplate current and forecasted plan asset allocations as well as historical and forecasted returns on various asset categories. For 2004, we assumed a pension return rate of 8.5%, consistent with 2003. Our pension plan’s average return was 10.9% for the 10 calendar years ended December 31, 2004, net of all investment management fees and expenses. We believe the pension return assumption is appropriate because we do not expect that future returns will achieve the same level of performance as the historical average annual return.

 

In addition to the $35 million we contributed in 2004 and the $100 million we contributed in 2003, we are required to make cash contributions totaling $142 million to our company-sponsored pension plan during fiscal 2005. We may make additional contributions during 2005 in order to maintain our desired funding status. We expect any additional contributions during 2005 will decrease our required contributions in future years. Among other things, investment performance of plan assets, the interest rates required to be used to calculate the pension obligations, and future changes in legislation, will determine the amounts of any additional contributions.

 

(b) Multi-Employer Plans

 

We also contribute to various multi-employer pension plans based on obligations arising from most of our collective bargaining agreements. These plans provide retirement benefits to participants based on their service to contributing employers. The benefits are paid from assets held in trust for that purpose. Trustees are appointed in equal number by employers and unions. The trustees typically are responsible for determining the level of benefits to be provided to participants as well as for such matters as the investment of the assets and the administration of the plans.

 


We recognize expense in connection with these plans as contributions are funded, in accordance with GAAP. We made contributions to these plans, and recognized expense, of $180 million in 2004, $169 million in 2003, and $153 million in 2002. We estimate we would have contributed an additional $2 million in 2004 and $13 million in 2003, but our obligation to contribute was suspended during the labor disputes.

 

Based on the most recent information available to us, we believe that the present value of actuarial accrued liabilities in most or all of these multi-employer plans substantially exceeds the value of the assets held in trust to pay benefits. We have attempted to estimate the amount by which these liabilities exceed the assets, i.e., the amount of underfunding, as of December 31, 2004. Because Kroger is only one of a number of employers contributing to these plans, we also have attempted to estimate the ratio of Kroger’s contributions to the total of all contributions to these plans in a year as a way of assessing Kroger’s “share” of the underfunding. As of December 31, 2004, we estimate that Kroger’s share of the underfunding of multi-employer plans to which Kroger contributes was $1.0 to $1.3 billion, pre-tax. Our estimate is based on actuarial evaluations and other data (which, itself, includes estimates). Our estimate is imprecise and not necessarily reliable.

 

We have made and disclosed this estimate not because this underfunding is a direct liability of Kroger. Rather, we believe the underfunding is likely to have important consequences. We expect our contributions to these multi-employer plans will continue to increase each year, and therefore the expense we recognize under GAAP will increase. We expect our contributions in 2005 will increase approximately 20 percent, and we expect that amount to increase by about five percent each year thereafter. The amount of increases in 2005 and beyond has been favorably affected by the labor agreements negotiated in southern California and elsewhere during 2004 and by related trustee actions. Although underfunding can result in the imposition of excise taxes on contributing employers, increased contributions can reduce underfunding so that excise taxes are not triggered. Our estimate of future contribution increases takes into account the avoidance of those taxes. Finally, underfunding means that in the event we were to exit certain markets or otherwise cease making contributions to these funds, 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 is disclosed for the purpose described. The amount could decline, and Kroger’s future expense would be favorably affected, if the values of net assets held in the trust significantly increase or if further changes occur through collective bargaining, trustee action or favorable legislation. On the other hand, Kroger’s share of the underfunding would increase and Kroger’s future expense could be adversely affected if net asset values decline, or if employers currently contributing to these funds cease participation or if changes occur through collective bargaining, trustee action or adverse legislation.

 

Deferred Rent

 

We recognize rent holidays, including the time period during which we have access to the property for construction of buildings or improvements, as well as construction allowances and escalating rent provisions on a straight-line basis over the term of the lease. The deferred amount is included in Other Current Liabilities and Other Long-Term Liabilities on the Consolidated Balance Sheets.

 

Tax Contingencies

 

Various taxing authorities periodically audit our income tax returns. These audits include questions regarding our tax filing positions, including the timing and amount of deductions and the allocation of income to various tax jurisdictions. In evaluating the exposures connected with these various tax filing positions, including state and local taxes, we record allowances for probable exposures. A number of years may elapse before a particular matter, for which we have established an allowance, is audited and fully resolved. As of January 29, 2005, tax years 1999 to 2002 were undergoing examination by the Internal Revenue Service.

 

The establishment of our tax contingency allowances relies on the judgment of management to estimate the exposures associated with our various filing positions. Although management believes those estimates and judgments are reasonable, actual results could differ, resulting in gains or losses that may be material to our Consolidated Statements of Operations.

 

To the extent the we prevail in matters for which allowances have been established, or are required to pay amounts in excess of these allowances, our effective tax rate in any given financial statement period could be materially affected. An unfavorable tax settlement could require use of cash and result in an increase in our effective tax rate in the year of resolution. A favorable tax settlement would be recognized as a reduction in our effective tax rate in the year of resolution.

 

Stock Option Plans

 

We apply Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for our stock option plans. Accordingly, because the exercise price of the option granted equals the market value of the underlying stock on the option grant date, no stock-based compensation expense is included in net earnings, other than expenses

 


related to restricted stock awards. Notes 1 and 13 to the Consolidated Financial Statements describe the effect on net earnings if compensation cost for all options had been determined based on the fair market value at the grant date for awards, consistent with the methodology prescribed under SFAS No. 123, “Accounting for Stock-Based Compensation.”

 

Inventories

 

Inventories are stated at the lower of cost (principally on a LIFO basis) or market. In total, approximately 97% of inventories for 2004 and 2003, respectively, were valued using the LIFO method. Cost for the balance of the inventories was determined using the first-in, first-out (“FIFO”) method. Replacement cost was higher than the carrying amount by $373 million at January 29, 2005, and by $324 million at January 31, 2004. We follow the Link-Chain, Dollar-Value LIFO method for purposes of calculating our LIFO charge or credit.

 

The item-cost method of accounting to determine inventory cost before the LIFO adjustment is followed for substantially all non-perishable store inventories and some perishable departments at our supermarket divisions. This method involves counting each item in inventory, assigning costs to each of these items based on the actual purchase costs (net of vendor allowances) of each item and recording the actual cost of items sold. The item-cost method of accounting allows for more accurate reporting of periodic inventory balances and enables management to more precisely manage inventory and purchasing levels when compared to the methodology followed under the retail method of accounting.

 

We evaluate inventory shortages throughout the year based on actual physical counts in our facilities. We record allowances for inventory shortages based on the results of recent physical counts to provide for estimated shortages from the last physical count to the financial statement date.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Cash Flow Information

 

Net cash provided by operating activities

 

We generated $2,330 million of cash from operations in 2004 compared to $2,215 million in 2003 and $3,183 million in 2002. Changes in our operating assets and liabilities also affect the net amount of cash provided by our operating activities. During 2004, we realized a $21 million increase in operating assets and liabilities compared to a $255 million increase during 2003 and a $302 million reduction during 2002. Fluctuations in our accounts payable balances and store deposit in-transit balances contributed to the changes in operating assets and liabilities in 2003 and 2002. The increase in our store deposits in-transit balances in 2003 was primarily related to our decision to discontinue the practice of transferring deposits to our concentration account prior to receiving credit for those deposits from other banks. Offsetting the changes in our store deposits in-transit balances, our other current liabilities increased in 2003 as a result of the labor disputes discussed in “Estimated Effect of Labor Disputes.” In 2002, our accounts payable balances increased substantially due to an enterprise systems conversion that enabled our western divisions to improve their accounts payable position.

 

The amount of cash paid for income taxes in 2004 was higher than the amount paid in 2003 due primarily to higher earnings before the effect of goodwill impairment charges. In addition, the bonus depreciation provision, which expired in December 2004 reduced our cash taxes in 2004, 2003 and 2002, and we expect the cash benefit will reverse in 2005. This provision reduced our cash taxes by approximately $106 million, $130 million and $106 million in 2004, 2003 and 2002, respectively.

 

Our 2004 and 2003 operating cash flow results also reflect cash contributions totaling $35 million and $100 million, respectively, to our company-sponsored pension plan.

 

Net cash used by investing activities

 

Cash used by investing activities was $1,608 million in 2004, compared to $2,026 million in 2003 and $1,907 million in 2002. The amount of cash used by investing activities in 2004 decreased from 2003 and 2002 due to reduced capital expenditures.

 

Net cash used by financing activities

 

Financing activities used $737 million of cash in 2004, compared to $201 million in 2003 and $1,266 million in 2002. The increase in cash used by financing in 2004 compared to 2003 was primarily related to the amount of cash used to reduce our outstanding debt. The decrease in the use of cash in 2003 versus 2002 was due primarily to a reduction in the amount of cash used to reduce our outstanding debt and to a reduction in treasury stock purchases. The decreased use of cash was also due to increases in book overdrafts in 2003 versus 2002 as well as to proceeds received in 2003 from interest rate swap terminations.

 


Debt Management

 

Total debt, including both the current and long-term portions of capital leases, decreased $393 million to $8.0 billion as of year-end 2004 from $8.4 billion as of year-end 2003. Total debt decreased $210 million to $8.4 billion as of year-end 2003 from $8.6 billion as of year-end 2002. The decreases were primarily the result of using cash flow from operations to reduce outstanding debt. Approximately $65 million of the decrease experienced in 2003 resulted from the consolidation of a financing entity.

 

Our total debt balances were also affected by our prefunding of employee benefit costs and by the mark-to-market adjustments necessary to record fair value interest rate hedges of our fixed rate debt, pursuant to SFAS No. 133. We had prefunded employee benefit costs of $300 million at year-end 2004, 2003 and 2002. The mark-to-market adjustments increased the carrying value of our debt by $70 million, $104 million and $110 million as of year-end 2004, 2003 and 2002, respectively.

 

Factors Affecting Liquidity

 

We currently borrow on a daily basis approximately $500 million to $600 million under our A2/P2/F2 rated commercial paper (“CP”) program. These borrowings are backed by our credit facilities, and reduce the amount we can borrow under the credit facilities. We have capacity available under our credit facilities to backstop all CP amounts outstanding. If our credit rating declined below its current level of BBB/ Baa2/BBB, the ability to borrow under our current CP program could be adversely affected for a period of time immediately following the reduction of our credit rating. This could require us to borrow additional funds under the credit facilities, under which we believe we have sufficient capacity. Borrowings under the credit facilities may be more costly than the money we borrow under our current CP program, depending on the current interest rate environment. However, in the event of a ratings decline, we do not anticipate that access to the CP markets currently available to us would be significantly limited for an extended period of time (i.e., in excess of 30 days).

 

Although our ability to borrow under the credit facilities is not affected by our credit rating, the interest cost on borrowings under the credit facilities would be affected by a decrease in our credit rating or a decrease in our Applicable Percentage Ratio. On March 16, 2005, Standard & Poor’s Ratings Services placed its ratings for Kroger, as well as Safeway Inc. and Albertson’s, Inc., on CreditWatch with negative implications. Standard & Poor’s indicated they expect any downgrade, if warranted by their review, should be limited to one level, with ratings not expected to fall below investment grade.

 

Our credit facilities also require 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 facilities. These financial covenants and ratios are described below:

 

    Our Applicable Percentage Ratio (the ratio of Consolidated EBITDA to Consolidated Total Interest Expense, as defined in the credit facilities) was 5.65 to 1 as of January 29, 2005. If this ratio declined to below 4.75 to 1, the cost of our borrowings under the credit facilities would increase at least 0.125%. The cost of our borrowings under the credit facilities would be similarly impacted by a one-level downgrade in our credit rating.

 

    Our Leverage Ratio (the ratio of Net Debt to Consolidated EBITDA, as defined in the credit facilities) was 2.67 to 1 as of January 29, 2005. If this ratio exceeded 3.50 to 1, we would be in default of our credit facilities and our ability to borrow under these facilities would be impaired.

 

    Our Fixed Charge Coverage Ratio (the ratio of Consolidated EBITDA plus Consolidated Rental Expense to Consolidated Cash Interest Expense plus Consolidated Rental Expense, as defined in the credit facilities) was 3.02 to 1 as of January 29, 2005. If this ratio fell below 1.70 to 1, we would be in default of our credit facilities and our ability to borrow under these facilities would be impaired.

 

Consolidated EBITDA, as defined in our credit facilities, includes an adjustment for unusual gains and losses. Our credit agreements are more particularly described in Note 8 to the Consolidated Financial Statements. We were in compliance with our financial covenants at year-end 2004.

 


The tables below illustrate our significant contractual obligations and other commercial commitments as of January 29, 2005 (in millions of dollars):

 

     2005

   2006

   2007

   2008

   2009

   Thereafter

   Total

Contractual Obligations

                                                

Long-term debt

   $ 46    $ 554    $ 525    $ 998    $ 1,094    $ 4,288    $ 7,505

Interest on long-term debt (1)

     466      448      401      324      298      2,134      4,071

Capital lease obligations

     62      59      55      53      51      372      652

Operating lease obligations

     794      756      682      649      603      4,391      7,875

Charitable contributions

     —        14      —        —        —        —        14

Minimum contributions to company-sponsored pension plan

     142      —        —        —        —        —        142

Low-income housing obligations

     49      32      6      2      —        —        89

Financed lease obligations

     5      5      5      5      5      60      85

Construction commitments

     86      —        —        —        —        —        86

Purchase obligations

     362      60      18      5      1      —        446
    

  

  

  

  

  

  

Total

   $ 2,012    $ 1,928    $ 1,692    $ 2,036    $ 2,052    $ 11,245    $ 20,965
    

  

  

  

  

  

  

Other Commercial Commitments

                                                

Credit facilities (2)

   $ —      $ —      $ —      $ —      $ 694    $ —      $ 694

Standby letters of credit

     312      —        —        —        —        —        312

Surety bonds

     128      —        —        —        —        —        128

Guarantees

     12      —        —        —        —        —        12
    

  

  

  

  

  

  

Total

   $ 452    $ —      $ —      $ —      $ 694    $ —      $ 1,146
    

  

  

  

  

  

  

 

(1) Amounts include contractual interest payments using the interest rate as of January 29, 2005 applicable to the Company’s variable interest debt instruments, excluding commercial paper borrowings due to the short-term nature of these borrowings, and stated fixed interest rates for all other debt instruments.

 

(2) These borrowings are currently in the form of short-term commercial paper and are also included in the long-term debt contractual obligation amount. They are considered long-term because the Company expects that these borrowings will be refinanced by the same type of securities. They are scheduled as due in the year of maturity of the existing credit facilities.

 

We are required to make cash contributions totaling $142 million to our company-sponsored pension plans during fiscal 2005. We may make additional contributions to these plans in order to maintain our desired funding status. We expect any additional contributions made during 2005 will reduce our minimum required contributions in future years. Among other things, investment performance of plan assets, the interest rates required to be used to calculate the pension obligations, and future changes in legislation, will determine the amounts of any additional contributions. At this time, it is not reasonably practicable to estimate contribution amounts for 2006 and beyond.

 

Our construction commitments include funds owed to third parties for projects currently under construction. These amounts are reflected in accounts payable in our Consolidated Balance Sheets.

 

Our purchase obligations include commitments to be utilized in the normal course of business, such as several contracts to purchase raw materials utilized in our manufacturing plants and several contracts to purchase energy to be used in our stores and manufacturing facilities. Our obligations also include management fees for facilities operated by third parties. 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 January 29, 2005, we maintained a five-year revolving credit facility totaling $1.8 billion, which terminates in 2009. In addition, we maintained a $700 million five-year credit facility that terminates in 2007. Outstanding borrowings under the credit agreements and commercial paper borrowings, and some outstanding letters of credit, reduce funds available under the credit facilities. In addition to the credit facilities, we maintain a $75 million money market line, borrowings under which also reduce the funds available under our credit facilities. As of January 29, 2005, our outstanding credit agreement and commercial paper borrowings totaled $694 million. We had no borrowings under the money market line as of January 29, 2005. The outstanding letters of credit that reduced the funds available under our credit facilities totaled $312 million as of January 29, 2005. We have the ability to

 


refinance these borrowings on a long-term basis, and have presented the amounts accordingly. The money market line borrowings allow us to borrow from banks at mutually agreed upon rates, usually at rates below the rates offered under the credit agreements.

 

At January 29, 2005, we also had a $100 million pharmacy receivable securitization facility that provided capacity incremental to the $2.5 billion described above. Funds received under this $100 million facility do not reduce funds available under the credit facilities. Collection rights to some of our pharmacy accounts receivable balances are sold to initiate the drawing of funds under the facility. As of January 29, 2005, we had no borrowings under this $100 million facility.

 

In addition to the available credit mentioned above, as of January 29, 2005, we had available for issuance $1.2 billion of securities under a shelf registration statement filed with the SEC and declared effective on December 9, 2004.

 

We also maintain surety bonds related primarily to our self-insured insurance costs. These bonds are required by most states in which we are self-insured for workers’ compensation and general liability exposures, and are made with third-party insurance providers to insure payment of our obligations in the event we are unable to make those payments. These bonds do not represent liabilities of Kroger, as we already have liabilities on our books for the insurance costs. However, we do pay annual maintenance fees to have these bonds in place. 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 impact our ability to access these surety bonds, if this does become an issue, we likely would issue letters of credit against our credit facilities to meet the state bonding requirements. This could increase our cost and decrease the funds available under our credit facilities.

 

Most of our outstanding public debt is jointly and severally, fully and unconditionally guaranteed by The Kroger Co. and some of its subsidiaries. See Note 8 to the Consolidated Financial Statements for a more detailed discussion of those arrangements. In addition, we have guaranteed half of the indebtedness of four real estate joint ventures in which we are a partner with 50% ownership. Our share of the responsibility for this indebtedness, should the partnerships be unable to meet their obligations, totals approximately $12 million. Based on the covenants underlying this indebtedness as of January 29, 2005, it is unlikely that we will be responsible for repayment of these obligations.

 

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 pension trust fund withdrawal liabilities.

 

In addition to the above, the Company enters into various indemnification agreements and takes 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 the Company; indemnities related to the sale of Company 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 the Company’s aggregate indemnification obligation could result in a material liability, the Company is aware of no current matter that it expects to result in a material liability

 

RECENTLY ISSUED ACCOUNTING STANDARDS

 

In May 2004, the FASB issued Staff Position (“FSP”) No. 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003.” FSP No. 106-2 supersedes FSP No. 106-1, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003,” and provides guidance on the accounting, disclosure and transition related to the Prescription Drug Act. FSP No. 106-2 became effective for the third quarter of 2004. The adoption of FSP No. 106-2 had no material effect on our Consolidated Financial Statements. Detailed regulations in this area continue to evolve that could have an effect on the Company going forward, which effect we do not expect to be material.

 

In December 2004, the FASB issued FSP No. 109-1, “Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction of Qualified Production Activities Provided by the American Jobs Creation Act of 2004,” which provides accounting and disclosure guidance on the Act’s qualified production activities deduction. The Company is currently evaluating the impact of this guidance on its effective tax rate for 2005 and subsequent periods.

 

In December 2004, the FASB issued SFAS No. 123 (Revised 2004), “Share-Based Payment” (“SFAS No. 123R”), which replaces SFAS No. 123, supersedes APB No. 25 and related interpretation and amends SFAS No. 95, “Statement of Cash Flows.” The provisions of SFAS No. 123R are similar to those of SFAS No. 123; however, SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements as compensation cost based on their fair value on the date of grant. Fair value of share-based awards will be determined using option price models (e.g. Black-Scholes

 


or binomial models) and assumptions that appropriately reflect the specific circumstances of the awards. Compensation cost will be recognized over the vesting period based on the fair value of awards that actually vest. We expect to adopt SFAS No. 123R in the first quarter of 2006 and expect it will reduce net earnings by $0.04 to $0.05 per diluted share for fiscal 2006.

 

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” which clarifies that inventory costs that are “abnormal” are required to be charged to expense as incurred as opposed to being capitalized into inventory as a product cost. SFAS No. 151 provides examples of “abnormal” costs to included costs of idle facilities, excess freight and handling costs and spoilage. SFAS No. 151 will become effective for our fiscal year beginning January 29, 2006. We do not expect the adoption of SFAS No. 151 to have a material effect on our Consolidated Financial Statements.

 

FASB Interpretation No. 47 (“FIN 47”) “Accounting for Conditional Asset Retirement Obligations” was issued by the FASB in March 2005. FIN 47 provides guidance relating to the identification of and financial reporting for legal obligations to perform an asset retirement activity. The Interpretation requires recognition of a liability for the fair value of a conditional asset retirement obligation when incurred if the liability’s fair value can be reasonably estimated. FIN 47 is effective no later than the end of fiscal years ending after December 15, 2005. We do not expect adoption of FIN 47 to have a material effect on our Consolidated Financial Statements.

 

OUTLOOK

 

This discussion and analysis contains certain forward-looking statements about Kroger’s future performance. These statements are based on management’s assumptions and beliefs in light of the information currently available. Such statements relate to, among other things: projected change in net earnings; identical sales growth; expected pension plan contributions; our ability to generate operating cash flow; projected capital expenditures; square footage growth; opportunities to reduce costs; cash flow requirements; and our operating plan for the future; and are indicated by words such as “comfortable,” “committed,” “expect,” “goal,” “should,” “intend,” “target,” “believe,” “anticipate,” and similar words or phrases. These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially.

 

Statements elsewhere in this report and below regarding our expectations, projections, beliefs, intentions or strategies are forward-looking statements within the meaning of Section 21 E of the Securities Exchange Act of 1934. While we believe that the statements are accurate, uncertainties about the general economy, our labor relations, our ability to execute our plans on a timely basis and other uncertainties described below could cause actual results to differ materially.

 

    We expect net earnings in 2005 to exceed $1.21 per diluted share.

 

    We expect identical food store sales growth, including southern California and excluding fuel sales, to exceed 2.0% in 2005.

 

    We plan to use one-third of cash flow for debt reduction and two-thirds for stock repurchase or payment of a cash dividend.

 

    We expect to obtain sales growth from new square footage, as well as from increased productivity from existing locations.

 

    Capital expenditures reflect our strategy of growth through expansion and acquisition, as well as focusing on productivity increase from our existing store base through remodels. In addition, we will continue our emphasis on self-development and ownership of real estate, logistics and technology improvements. The continued capital spending in technology is focused on improving store operations, logistics, manufacturing procurement, category management, merchandising and buying practices, and should reduce merchandising costs. We intend to continue using cash flow from operations to finance capital expenditure requirements. We expect capital investment for 2005 to be in the range of $1.6 - $1.8 billion, excluding acquisitions. Total food store square footage is expected to grow at 2-3% before acquisitions and operational closings.

 

    Based on current operating trends, we believe that cash flow from operations and other sources of liquidity, including borrowings under our commercial paper program and bank credit facilities, will be adequate to meet anticipated requirements for working capital, capital expenditures, interest payments and scheduled principal payments for the foreseeable future. We also believe we have adequate coverage of our debt covenants to continue to respond effectively to competitive conditions.

 

    We expect that our OG&A results will be affected by increased costs, such as health care benefit costs, pension costs and credit card fees, as well as any future labor disputes, offset by improved productivity from process changes, cost savings negotiated in recently completed labor agreements and sales leverage.

 

    We expect rent expense, as a percent of total sales and excluding closed-store activity, will decrease due to the emphasis our current strategy places on ownership of real estate.

 

    We expect that our effective tax rate for 2005 will be approximately 37.5%.

 

    We will continue to evaluate under-performing stores. We anticipate operational closings will continue at an above-historical rate.

 

    We believe that in 2005 there will be opportunities to reduce our operating costs in such areas as administration, labor, shrink, warehousing and transportation. These savings will be invested in our core business to drive profitable sales growth and offer improved value and shopping experiences for our customers.

 

   

In addition to the $35 million and $100 million contributed to Company-sponsored pension plans in 2004 and 2003, respectively, we are required to make cash contributions totaling $142 million during fiscal 2005. We may make additional contributions during 2005 in order to maintain our desired funding levels. We expect the additional contributions made during 2005 will reduce our contributions in future years. Among other things, investment

 


 

performance of plan assets, the interest rates required to be used to calculate pension obligations and future changes in legislation will determine the amounts of any additional contributions.

 

    We expect our contributions in 2005 to increase approximately twenty percent over the $180 million contributed in 2004. We expect our contributions to these plans to increase by about five percent each year for each year thereafter.

 

Various uncertainties and other factors could cause us to fail to achieve our goals. These include:

 

    In 2005, we have major UFCW contracts expiring in: Atlanta, Columbus. Dallas, Portland (non-food), Roanoke. Teamsters contracts in southern California and one that covers several facilities in the Midwest also expire. In all of these contracts, rising health care and pension costs will continue to be an important issue in negotiations. A prolonged work stoppage at a substantial number of stores could have a material effect on our results.

 

    Our ability to achieve sales and earnings goals, for the entire Company and southern California in particular, may be affected by: labor disputes; industry consolidation; pricing and promotional activities of existing and new competitors, including non-traditional competitors; our response to these actions; the state of the economy, including the inflationary and deflationary trends in certain commodities; stock repurchases; and the success of our future growth plans.

 

    In addition to the factors identified above, our identical store sales growth could be affected by increases in Kroger private label sales, the effect of our “sister stores” (new stores opened in close proximity to an existing store) and reductions in retail pricing.

 

    We have estimated our exposure to the claims and litigation arising in the normal course of business and believe we have made adequate provisions for them where it is reasonably possible to estimate and where we believe an adverse outcome is probable. Unexpected outcomes in these matters, however, could result in an adverse effect on our earnings.

 

    The proportion of cash flow used to reduce outstanding debt, repurchase common stock or pay a cash dividend may be affected by the amount of outstanding debt available for pre-payments, changes in borrowing rates and the market price of Kroger common stock.

 

    Consolidation in the food industry is likely to continue and the effects on our business, either favorable or unfavorable, cannot be foreseen.

 

    Rent expense, which includes subtenant rental income, could be adversely affected by the state of the economy, increased store closure activity and future consolidation.

 

    Depreciation expense, which includes the amortization of assets recorded under capital leases, is computed principally using the straight-line method over the estimated useful lives of individual assets, or the remaining terms of leases. Use of the straight-line method of depreciation creates a risk that future asset write-offs or potential impairment charges related to store closings would be larger than if an accelerated method of depreciation was followed.

 

    Our effective tax rate may differ from the expected rate due to changes in laws, the status of pending items with various taxing authorities and the deductibility of certain expenses.

 

    We believe the multi-employer pension funds to which we contribute are substantially underfunded, and we believe the effect of that underfunding will be the increased contributions we have projected over the next several years. Should asset values in these funds deteriorate, or if employers withdraw from these funds without providing for their share of the liability, or should our estimates prove to be understated, our contributions could increase more rapidly than we have anticipated.

 

    The grocery retail industry continues to experience fierce competition from other traditional food retailers, supercenters, mass merchandisers, club or warehouse stores, drug stores and restaurants. Our continued success is dependent upon our ability to compete in this industry and to reduce operating expenses, including managing health care and pension costs contained in our collective bargaining agreements. The competitive environment may cause us to reduce our prices in order to gain or maintain share of sales, thus reducing margins. While we believe our opportunities for sustained profitable growth are considerable, unanticipated actions of competitors could adversely affect our sales.

 

    Changes in laws or regulations, including changes in accounting standards, taxation requirements and environmental laws may have a material effect on our financial statements.

 

    Changes in the general business and economic conditions in our operating regions, including the rate of inflation, population growth and employment and job growth in the markets in which we operate, may affect our ability to hire and train qualified employees to operate our stores. This would negatively affect earnings and sales growth. General economic changes may also affect the shopping habits of our customers, which could affect sales and earnings.

 

    Changes in our product mix may negatively affect certain financial indicators. For example, we continue to add supermarket fuel centers to our store base. Since gasoline generates low profit margins, including generating decreased margins as the market price increases, we expect to see our FIFO gross profit margins decline as gasoline sales increase. Although this negatively affects our FIFO gross margin, gasoline sales provide a positive effect on operating, general and administrative expenses as a percent of sales.

 

    Our ability to integrate any companies we acquire or have acquired, and achieve operating improvements at those companies, will affect our operations.

 


    Our capital expenditures could differ from our estimate if we are unsuccessful in acquiring suitable sites for new stores, if development costs vary from those budgeted or if our logistics and technology projects are not completed in the time frame expected or on budget.

 

    Interest expense could be adversely affected by the interest rate environment, changes in the Company’s credit ratings, fluctuations in the amount of outstanding debt, decisions to incur prepayment penalties on the early redemption of debt and any factor that adversely impacts our operations that results in an increase in debt.

 

    Adverse weather conditions could increase the cost our suppliers charge for their products, or may decrease the customer demand for certain products. Additionally, increases in the cost of inputs, such as utility costs or raw material costs, could negatively impact financial ratios and earnings.

 

    Although we presently operate only in the United States, civil unrest in foreign countries in which our suppliers do business may affect the prices we are charged for imported goods. If we are unable to pass on these increases to our customers, our FIFO gross margin and net earnings will suffer.

 

We cannot fully foresee the effects of changes in economic conditions on Kroger’s business. We have assumed economic and competitive situations will not change significantly for 2005.

 

Other factors and assumptions not identified above could also cause actual results to differ materially from those set forth in the forward-looking information. Accordingly, actual events and results may vary significantly from those included in, contemplated or implied by forward-looking statements made by us or our representatives.

 


ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Financial Risk Management

 

We use derivative financial instruments primarily to reduce our exposure to adverse fluctuations in interest rates and, to a lesser extent, adverse fluctuations in commodity prices and other market risks. We do not enter into derivative financial instruments for trading purposes. As a matter of policy, all of our derivative positions are intended to reduce risk by hedging an underlying economic exposure. Because of the high correlation between the hedging instrument and the underlying exposure, fluctuations in the value of the instruments generally are offset by reciprocal changes in the value of the underlying exposure. The interest rate derivatives we use are straightforward instruments with liquid markets.

 

We manage our exposure to interest rates and changes in the fair value of our debt instruments primarily through the strategic use of variable and fixed rate debt, and interest rate swaps. Our current program relative to interest rate protection contemplates both fixing the rates on variable rate debt and hedging the exposure to changes in the fair value of fixed-rate debt attributable to changes in interest rates. To do this, we use the following guidelines: (i) use average daily bank balance to determine annual debt amounts subject to interest rate exposure, (ii) limit the annual amount of debt subject to interest rate reset and the amount of floating rate debt to a combined total of $2.5 billion or less, (iii) include no leveraged products, and (iv) hedge without regard to profit motive or sensitivity to current mark-to-market status.

 

As of January 29, 2005, we maintained ten interest rate swap agreements, with notional amounts totaling approximately $1,375 million, to manage our exposure to changes in the fair value of our fixed rate debt resulting from interest rate movements by effectively converting a portion of our debt from fixed to variable rates. These agreements mature at varying times between July 2006 and January 2015. Variable rates for our agreements are based on U.S. dollar London Interbank Offered Rate (“LIBOR”). The differential between fixed and variable rates to be paid or received is accrued as interest rates change in accordance with the agreements and is recognized over the life of the agreements as an adjustment to interest expense. These agreements are accounted for as fair value hedges. All interest rate swap agreements are being accounted for as fair value hedges. As of January 29, 2005, liabilities totaling $11 million were recorded to reflect the fair value of these agreements, offset by decreases in the fair value of the underlying debt.

 

During 2003, we terminated six interest rate swap agreements that were accounted for as fair value hedges. Approximately $114 million of proceeds received as a result of these terminations were recorded as adjustments to the carrying values of the underlying debt and are being amortized over the remaining lives of the debt. As of January 29, 2005, the unamortized balances totaled approximately $81.

 

Annually, we review with the Financial Policy Committee of our Board of Directors compliance with the guidelines. The guidelines may change as our business needs dictate.

 

The tables below provide information about our interest rate derivatives and underlying debt portfolio as of January 29, 2005. The amounts shown for each year represent the contractual maturities of long-term debt, excluding capital leases, and the average outstanding notional amounts of interest rate derivatives as of January 29, 2005. Interest rates reflect the weighted average for the outstanding instruments. The variable component of each interest rate derivative and the variable rate debt is based on U.S. dollar LIBOR using the forward yield curve as of January 29, 2005. The Fair-Value column includes the fair-value of our debt instruments and interest rate derivatives as of January 29, 2005. Refer to Notes 8, 9 and 10 to the Consolidated Financial Statements:

 

     Expected Year of Maturity

 
     2005

    2006

    2007

    2008

    2009

    Thereafter

    Total

    Fair-Value

 
     (In millions)  

Debt

                                                                

Fixed rate

   $ (46 )   $ (545 )   $ (524 )   $ (992 )   $ (384 )   $ (4,181 )   $ (6,672 )   $ (7,471 )

Average interest rate

     7.10 %     7.07 %     7.00 %     6.93 %     6.87 %     6.85 %                

Variable rate

   $ —       $ (9 )   $ (1 )   $ (6 )   $ (710 )   $ (107 )   $ (833 )   $ (833 )

Average interest rate

     2.91 %     3.59 %     3.88 %     4.09 %     4.16 %     3.72 %                

 


     Average Notional Amounts Outstanding

 
     2005

    2006

    2007

    2008

    2009

    Thereafter

    Total

   Fair Value

 
     (In millions)  

Interest Rate Derivatives

                                                               

Variable to fixed

   $ —       $ —       $ —       $ —       $ —       $ —       $ —      $ —    

Average pay rate

                                                               

Average receive rate

                                                               

Fixed to variable

   $ 1,375     $ 1,251     $ 1,050     $ 363     $ 300     $ 300     $ 1,375    $ (11 )

Average pay rate

     6.29 %     6.99 %     7.06 %     5.24 %     4.82 %     5.75 %               

Average receive rate

     6.98 %     6.90 %     6.74 %     5.38 %     4.95 %     4.95 %               

 

Commodity Price Protection

 

We enter into purchase commitments for various resources, including raw materials utilized in our manufacturing facilities and energy to be used in our stores, manufacturing facilities and administrative offices. We enter into commitments expecting to take delivery of and to utilize those resources in the conduct of normal business. Those commitments for which we expect to utilize or take delivery in a reasonable amount of time in the normal course of business qualify as normal purchases and normal sales. For any commitments for which we do not expect to take delivery and, as a result, will require net settlement, the contracts are marked to fair value on a quarterly basis.

 

Some of the product we purchase is shipped in corrugated cardboard packaging. We sell corrugated cardboard when it is economical to do so. In the fourth quarter of 2004, we entered into six derivative instruments to protect us from declining corrugated cardboard prices. The derivatives, accounted for as cash flow hedges, contain a three-year term. None of the contracts, either individually or in the aggregate, hedge more than 50% of our expected corrugated cardboard sales. As of January 29, 2005, a liability totaling $1.7 million had been recorded for the instruments. Corresponding charges were recorded as Other Comprehensive Loss, net of income tax effects.

 


ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Report of Independent Registered Public Accounting Firm

 

To the Shareowners and Board of Directors of The Kroger Co.:

 

We have completed an integrated audit of The Kroger Co.’s January 29, 2005 consolidated financial statements and of its internal control over financial reporting as of January 29, 2005 and audits of its January 31, 2004 and February 1, 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

 

Consolidated financial statements

 

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, cash flows and changes in shareowners’ equity present fairly, in all material respects, the financial position of The Kroger Co. and its subsidiaries at January 29, 2005 and January 31, 2004, and the results of their operations and their cash flows for each of the three years in the period ended January 29, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

As discussed in note 19 to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections, as of February 2, 2003. As discussed in notes 1 and 5 to the consolidated financial statements, the Company also adopted the provisions of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, as of February 3, 2002, and Emerging Issues Task Force Issue No. 02-16, “Accounting by a Customer (including a Reseller) for Certain Consideration Received from a Vendor,” as of January 1, 2003.

 

Internal control over financial reporting

 

Also, we have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting appearing in Item 9A, that The Kroger Co. did not maintain effective internal controls over financial reporting as of January 29, 2005, because the Company did not maintain effective control over the determination of deferred income tax balances related to a business combination, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 


Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weakness has been identified and included in management’s assessment. As of January 29, 2005, the Company did not maintain effective controls over the determination of deferred income tax balances related to a business combination. Specifically, controls over the processes and procedures in calculating deferred income tax liabilities related to a business combination were not effective to ensure that the deferred income tax liabilities and allocated goodwill were fairly stated in accordance with generally accepted accounting principles. This deficiency resulted in a year-end audit adjustment affecting deferred income tax liabilities, goodwill and the goodwill impairment charge. Therefore, the Company concluded that this control deficiency constitutes a material weakness. This material weakness was considered in determining the nature, timing, and extent of audit tests applied in our audit of the January 29, 2005 consolidated financial statements, and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those consolidated financial statements.

 

In our opinion, management’s assessment that The Kroger Co. did not maintain effective internal control over financial reporting as of January 29, 2005, is fairly stated, in all material respects, based on Internal Control – Integrated Framework issued by the COSO. Also, in our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria, The Kroger Co. has not maintained effective internal control over financial reporting as of January 29, 2005, based on Internal Control – Integrated Framework issued by the COSO.

 

 

Cincinnati, Ohio

April 15, 2005

 


 

THE KROGER CO.

CONSOLIDATED BALANCE SHEETS

 

(In millions)


   January 29,
2005


    January 31,
2004


 

ASSETS

                

Current assets

                

Cash and temporary cash investments

   $ 144     $ 159  

Deposits In-Transit

     506       579  

Receivables

     661       674  

Receivables - Taxes

     167       66  

FIFO Inventory

     4,729       4,493  

LIFO Credit

     (373 )     (324 )

Prefunded employee benefits

     300       300  

Prepaid and other current assets

     272       251  
    


 


Total current assets

     6,406       6,198  

Property, plant and equipment, net

     11,497       11,178  

Goodwill, net

     2,191       3,134  

Fair value interest rate hedges

     —         6  

Other assets

     397       247  
    


 


Total Assets

   $ 20,491     $ 20,763  
    


 


LIABILITIES

                

Current liabilities

                

Current portion of long-term debt including obligations under capital leases and financing obligations

   $ 71     $ 248  

Accounts payable

     3,778       3,637  

Accrued salaries and wages

     659       547  

Deferred income taxes

     267       138  

Other current liabilities

     1,541       1,595  
    


 


Total current liabilities

     6,316       6,165  

Long-term debt including obligations under capital leases and financing obligations

                

Face value long-term debt including obligations under capital leases and financing obligations

     7,830       8,012  

Adjustment to reflect fair value interest rate hedges

     70       104  
    


 


Long-term debt including obligations under capital leases and financing obligations

     7,900       8,116  

Deferred income taxes

     939       974  

Other long-term liabilities

     1,796       1,523  
    


 


Total Liabilities

     16,951       16,778  
    


 


Commitments and Contingencies

                

SHAREOWNERS’ EQUITY

                

Preferred stock, $100 par, 5 shares authorized and unissued

     —         —    

Common stock, $1 par, 1,000 shares authorized: 918 shares issued in 2004 and 913 shares issued in 2003

     918       913  

Additional paid-in capital

     2,432       2,382  

Accumulated other comprehensive loss

     (202 )     (124 )

Accumulated earnings

     3,541       3,641  

Common stock in treasury, at cost, 190 shares in 2004 and 170 shares in 2003

     (3,149 )     (2,827 )
    


 


Total Shareowners’ Equity

     3,540       3,985  
    


 


Total Liabilities and Shareowners’ Equity

   $ 20,491     $ 20,763  
    


 


 

The accompanying notes are an integral part of the consolidated financial statements.

 


 

THE KROGER CO.

CONSOLIDATED STATEMENTS OF OPERATIONS

 

Years Ended January 29, 2005, January 31, 2004, and February 1, 2003

 

(In millions, except per share amounts)    


   2004
(52 weeks)


    2003
(52 weeks)


   2002
(52 weeks)


 

Sales

   $ 56,434     $ 53,791    $ 51,760  

Merchandise costs, including advertising, warehousing, and transportation, excluding items shown separately below

     42,140       39,637      37,810  

Operating, general and administrative

     10,611       10,354      9,618  

Rent

     680       657      660  

Depreciation and amortization

     1,256       1,209      1,087  

Goodwill impairment charge

     900       444      —    

Asset impairment charges

     —         120      —    

Restructuring charges

     —         —        15  

Merger-related costs

     —         —        1  
    


 

  


Operating Profit

     847       1,370      2,569  

Interest expense

     557       604      619  
    


 

  


Earnings before income tax expense and cumulative effect of accounting change

     290       766      1,950  

Income tax expense

     390       454      732  
    


 

  


Earnings (loss) before cumulative effect of accounting change

     (100 )     312      1,218  

Cumulative effect of an accounting change, net of income tax benefit of $10 in 2002

     —         —        (16 )
    


 

  


Net earnings (loss)

   $ (100 )   $ 312    $ 1,202  
    


 

  


Earnings (loss) per basic common share:

                       

Earnings (loss) before cumulative effect of accounting change

   $ (0.14 )   $ 0.42    $ 1.56  

Cumulative effect of an accounting change, net of income tax benefit

     —         —        (0.02 )
    


 

  


Net earnings (loss)

   $ (0.14 )   $ 0.42    $ 1.54  
    


 

  


Average number of common shares used in basic calculation

     736       747      779  

Earnings (loss) per diluted common share:

                       

Earnings (loss) before cumulative effect of accounting change

   $ (0.14 )   $ 0.41    $ 1.54  

Cumulative effect of an accounting change, net of income tax benefit

     —         —        (0.02 )
    


 

  


Net earnings (loss)

   $ (0.14 )   $ 0.41    $ 1.52  
    


 

  


Average number of common shares used in diluted calculation

     736       754      791  

 

The accompanying notes are an integral part of the consolidated financial statements.

 


 

THE KROGER CO.

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

Years Ended January 29, 2005, January 31, 2004 and February 1, 2003

 

(In millions)


   2004
(52 weeks)


    2003
(52 weeks)


    2002
(52 weeks)


 

Cash Flows From Operating Activities:

                        

Net earnings (loss)

   $ (100 )   $ 312     $ 1,202  

Adjustments to reconcile net earnings (loss) to net cash provided by operating activities:

                        

Cumulative effect of an accounting change, net of income tax benefit of $10 in 2002

     —         —         16  

Depreciation and amortization

     1,256       1,209       1,087  

LIFO charge (credit)

     49       34       (50 )

Merger-related costs

     —         —         1  

Goodwill impairment charge

     857       444       —    

Asset impairment charges

     —         120       —    

Item-cost conversion

     —         —         91  

EITF 02-16 adoption

     —         —         28  

Deferred income taxes

     230       329       468  

Other

     59       22       38  

Changes in operating assets and liabilities net of effects from acquisitions of businesses:

                        

Store deposits in-transit

     73       (363 )     77  

Inventories

     (236 )     (20 )     (62 )

Receivables

     13       3       2  

Prepaid expenses

     (31 )     5       (34 )

Accounts payable

     167       44       282  

Accrued expenses

     104       224       (4 )

Income taxes receivable (payable)

     (86 )     (62 )     (11 )

Contribution to company sponsored pension plans

     (35 )     (100 )     —    

Other

     10       14       52  
    


 


 


Net cash provided by operating activities

     2,330       2,215       3,183  
    


 


 


Cash Flows From Investing Activities:

                        

Capital expenditures, excluding acquisitions

     (1,615 )     (2,000 )     (1,891 )

Capital expenditures, lease-financing transactions

     (6 )     —         —    

Capital expenditures, sale-leaseback transactions

     (13 )     —         —    

Proceeds from sale of assets

     86       68       90  

Payments for acquisitions, net of cash acquired

     (25 )     (87 )     (126 )

Other

     (35 )     (7 )     20  
    


 


 


Net cash used by investing activities

     (1,608 )     (2,026 )     (1,907 )
    


 


 


Cash Flows From Financing Activities:

                        

Proceeds from issuance of long-term debt

     616       347       1,353  

Proceeds from lease-financing transactions

     6       —         —    

Reductions in long-term debt

     (1,010 )     (487 )     (1,757 )

Debt prepayment costs

     (25 )     (17 )     (14 )

Financing charges incurred

     (5 )     (3 )     (16 )

Proceeds from issuance of capital stock

     25       39       41  

Treasury stock purchases

     (319 )     (301 )     (785 )

Cash received from interest rate swap terminations

     —         114       —    

Increase (decrease) in book overdrafts

     (25 )     107       (88 )
    


 


 


Net cash used by financing activities

     (737 )     (201 )     (1,266 )

Net increase (decrease) in cash and temporary cash investments

     (15 )     (12 )     10  

Cash and temporary cash investments:

                        

Beginning of year

     159       171       161  
    


 


 


End of year

   $ 144     $ 159     $ 171  
    


 


 


Disclosure of cash flow information:

                        

Cash paid during the year for interest

   $ 590     $ 589     $ 585  

Cash paid during the year for income taxes

   $ 206     $ 139     $ 268  

Non-cash changes related to purchase acquisitions:

                        

Fair value of inventory acquired

   $ —       $ 8     $ 4  

Fair value of other assets acquired

   $ 20     $ 71     $ 120  

Goodwill recorded

   $ 6     $ 9     $ 9  

Liabilities assumed

   $ (1 )   $ (1 )   $ (7 )

 

The accompanying notes are an integral part of the consolidated financial statements.

 


 

THE KROGER CO.

CONSOLIDATED STATEMENT OF CHANGES IN SHAREOWNERS’ EQUITY

 

Years Ended January 29, 2005, January 31, 2004 and February 1, 2003

 

     Common Stock

  

Additional
Paid-In

Capital


   Treasury Stock

   

Accumulated
Other

Comprehensive
Gain (Loss)


   

Accumulated

Earnings


    Total

 

(In millions)


   Shares

   Amount

      Shares

   Amount

       

Balances at February 2, 2002

   901    $ 901    $ 2,217    106    $ (1,730 )   $ (33 )   $ 2,127     $ 3,482  

Issuance of common stock:

                                                        

Stock options and warrants exercised

   6      6      35    —        —         —         —         41  

Restricted stock issued

   1      1      15    —        —         —         —         16  

Treasury stock purchases, at cost

                                                        

Treasury stock purchases, at cost

                      43      (785 )                     (785 )

Stock options and restricted stock exchanged

                      1      (6 )                     (6 )

Tax benefits from exercise of stock options and warrants

   —        —        50    —        —         —         —         50  

Other comprehensive loss, net of income tax of $102

   —        —        —      —        —         (173 )     —         (173 )

Net earnings

   —        —        —      —        —         —         1,202       1,202  
    
  

  

  
  


 


 


 


Balances at February 1, 2003

   908      908      2,317    150      (2,521 )     (206 )     3,329       3,827  

Issuance of common stock:

                                                        

Stock options and warrants exercised

   4      4      35    —        —         —         —         39  

Restricted stock issued

   1      1      9    —        —         —         —         10  

Treasury stock activity:

                                                        

Treasury stock purchases, at cost

   —        —        —      19      (301 )     —         —         (301 )

Stock options and restricted stock exchanged

   —        —        —      1      (5 )                     (5 )

Tax benefits from exercise of stock options and warrants

   —        —        21    —        —         —         —         21  

Other comprehensive gain, net of income tax of $(49)

   —        —        —      —        —         82       —         82  

Net earnings

   —        —        —      —        —         —         312       312  
    
  

  

  
  


 


 


 


Balances at January 31, 2004

   913      913      2,382    170      (2,827 )     (124 )     3,641       3,985  

Issuance of common stock:

                                                        

Stock options and warrants exercised

   4      4      25    —        —         —         —         29  

Restricted stock issued

   1      1      9    —        —         —         —         10  

Treasury stock activity:

                                                        

Treasury stock purchases, at cost

   —        —        —      18      (294 )     —         —         (294 )

Stock options and restricted stock exchanged

   —        —        —      2      (28 )     —         —         (28 )

Tax benefits from exercise of stock options and warrants

   —        —        16    —        —         —         —         16  

Other comprehensive loss net of income tax of $47

   —        —        —      —        —         (78 )     —         (78 )

Net loss

   —        —        —      —        —         —         (100 )     (100 )
    
  

  

  
  


 


 


 


Balances at January 29, 2005

   918    $ 918    $ 2,432    190    $ (3,149 )   $ (202 )   $ 3,541     $ 3,540  
    
  

  

  
  


 


 


 


 

Comprehensive income:

 

     2004

    2003

   2002

 

Net earnings (loss)

   $ (100 )   $ 312    $ 1,202  

Reclassification adjustment for losses included in net earnings (loss), net of income tax of $(14) in 2003 and $(11) in 2002

     —         23      18  

Unrealized gain (loss) on hedging activities, net of income tax of $1 in 2004, $(2) in 2003 and $6 in 2002

     (1 )     3      (11 )

Additional minimum pension liability adjustment, net of income tax of $46 in 2004, $(33) in 2003 and $107 in 2002

     (77 )     56      (180 )
    


 

  


Comprehensive income (loss)

   $ (178 )   $ 394    $ 1,029  
    


 

  


 

The accompanying notes are an integral part of the consolidated financial statements.

 


NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

All amounts are in millions except per share amounts.

 

Certain prior-year amounts have been reclassified to conform to current year presentation.

 

1. ACCOUNTING POLICIES

 

The following is a summary of the significant accounting policies followed in preparing these financial statements.

 

Description of Business, Basis of Presentation and Principles of Consolidation

 

The Kroger Co. (the “Company”) was founded in 1883 and incorporated in 1902. As of January 29, 2005, the Company was one of the largest retailers in the United States based on annual sales. The Company also manufactures and processes food for sale by its supermarkets. The Company employs approximately 289,000 full and part-time employees. The accompanying financial statements include the consolidated accounts of the Company and its subsidiaries. Significant intercompany transactions and balances have been eliminated.

 

Fiscal Year

 

The Company’s fiscal year ends on the Saturday nearest January 31. The last three fiscal years consist of the 52-week period ended January 29, 2005, the 52-week period ended January 31, 2004, and the 52-week period ended February 1, 2003.

 

Pervasiveness of Estimates

 

The preparation of financial statements in conformity with Generally Accepted Accounting Principles (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities. Disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of consolidated revenues and expenses during the reporting period also is required. Actual results could differ from those estimates.

 

Inventories

 

Inventories are stated at the lower of cost (principally on a last-in, first-out “LIFO” basis) or market. In total, approximately 97% of inventories for 2004 and approximately 97% of inventories for 2003 were valued using the LIFO method. Cost for the balance of the inventories was determined using the first-in, first-out (“FIFO”) method. Replacement cost was higher than the carrying amount by $373 at January 29, 2005 and $324 at January 31, 2004. The Company follows the Link-Chain, Dollar-Value LIFO method for purposes of calculating its LIFO charge or credit.

 

The item-cost method of accounting to determine inventory cost before the LIFO adjustment is followed for substantially all non-perishable store inventories at the Company’s supermarket divisions. This method involves counting each item in inventory, assigning costs to each of these items based on the actual purchase costs (net of vendor allowances) of each item and recording the actual cost of items sold. The item-cost method of accounting allows for more accurate reporting of periodic inventory balances and enables management to more precisely manage inventory when compared to the retail method of accounting.

 

The Company evaluates inventory shortages throughout the year based on actual physical counts in its facilities. Allowances for inventory shortages are recorded based on the results of these counts to provide for estimated shortages as of the financial statement date.

 

Property, Plant and Equipment

 

Generally, property, plant and equipment are recorded at cost. Depreciation expense, which includes the amortization of assets recorded under capital leases, is computed principally using the straight-line method over the estimated useful lives of individual assets. Leasehold improvements are depreciated over the shorter of the remaining life of the applicable lease or the useful life of the asset. Buildings and land improvements are depreciated based on lives varying from 10 to 40 years. Some store equipment acquired as a result of the Fred Meyer merger was assigned a 15-year life. The life of this equipment was not changed. All new purchases of store equipment are assigned lives varying from three to nine years. Manufacturing plant and distribution center equipment is depreciated over lives varying from three to 15 years. Leasehold improvements are amortized over the lives of the leases to which they relate, which vary from four to 25 years. Depreciation expense was $1,256 in 2004, $1,209 in 2003 and $1,087 in 2002.

 


Interest costs on significant projects constructed for the Company’s own use are capitalized as part of the costs of the newly constructed facilities. Upon retirement or disposal of assets, the cost and related accumulated depreciation are removed from the balance sheet and any gain or loss is reflected in net earnings.

 

Deferred Rent

 

The Company recognizes rent holidays, including the time period during which the Company has access to the property for construction of buildings or improvements, as well as construction allowances and escalating rent provisions on a straight-line basis over the term of the lease. The deferred amount is included in Other Current Liabilities and Other Long-Term Liabilities on the Company’s Consolidated Balance Sheets.

 

Goodwill

 

The Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 142 on February 3, 2002. Accordingly, goodwill was reviewed for impairment during the first and fourth quarters of 2002, and also during the fourth quarters of 2003 and 2004. Results of these impairment reviews are summarized in Note 5.

 

The Company reviews goodwill for impairment during the fourth quarter of each year, and also upon the occurrence of trigger events. The reviews are performed at the operating division level. Potential impairment is indicated when the carrying value of a division, including goodwill, exceeds its fair value. Generally, fair value represents a multiple of earnings, or discounted projected future cash flows. Projected future cash flows are based on management’s knowledge of the current operating environment and expectations for the future. If potential for impairment exists, the fair value of a division is subsequently measured against the fair value of its underlying assets and liabilities, excluding goodwill, to estimate an implied fair value of the division’s goodwill. Impairment loss is recognized for any excess of the carrying value of the division’s goodwill over the implied fair value.

 

Intangible Assets

 

In addition to goodwill, the Company has recorded intangible assets totaling $20 and $29 for liquor licenses and pharmacy prescription file purchases, respectively at January 29, 2005. Balances at January 31, 2004 were $20 for liquor licenses and $21 for pharmacy prescription files. Owned liquor licenses are not amortized, while liquor licenses that must be renewed are amortized over their useful life. Pharmacy prescription file purchases are amortized over seven years. These assets are tested annually for impairment.

 

Impairment of Long-Lived Assets

 

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the Company monitors the carrying value of long-lived assets for potential impairment each quarter based on whether certain trigger 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 trigger event occurs, an impairment calculation is performed, comparing projected undiscounted future cash flows, utilizing current cash flow information and expected growth rates related to specific stores, to the carrying value for those stores. If impairment is identified for long-lived assets to be held and used, discounted future cash flows are compared to the asset’s current carrying value. Impairment is recorded when the carrying value exceeds the discounted cash flows. With respect to owned property and equipment held for disposal, the value of the property and equipment is adjusted to reflect recoverable values based on previous efforts to dispose of similar assets and current economic conditions. Impairment is recognized for the excess of the carrying value over the estimated fair market value, reduced by estimated direct costs of disposal.

 

The Company performs impairment reviews at both the division and corporate levels. Generally, for reviews performed by local divisional management, costs to reduce the carrying value of long-lived assets are reflected in the Consolidated Statements of Earnings as “Operating, general and administrative” expense. Cost to reduce the carrying value of long-lived assets that result from corporate–level strategic plans are separately identified in the Consolidated Statements of Earnings as “Asset impairment charges.”

 

Refer to Note 3 for a description of the asset impairment charge recorded during 2003.

 

Store Closing Costs

 

All closed store liabilities related to exit or disposal activities initiated after December 31, 2002, are accounted for in accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The Company provides for closed store liabilities relating to the present value of the estimated remaining noncancellable lease payments after the closing date, net of estimated subtenant income. The Company estimates the net lease liabilities using a discount rate to calculate the present value of the remaining net rent payments on closed stores. The closed store lease liabilities usually are paid over the lease terms associated with the closed stores, which generally have remaining terms ranging from one to 20 years. Adjustments to closed store liabilities primarily

 


relate to changes in subtenant income and actual exit costs differing from original estimates. Adjustments are made for changes in estimates in the period in which the change becomes known. Store closing liabilities are reviewed quarterly to ensure that any accrued amount that is not a sufficient estimate of future costs, or that no longer is needed for its originally intended purpose, is adjusted to income in the proper period.

 

Owned stores held for disposal are reduced to their estimated net realizable value. Costs to reduce the carrying values of property, equipment and leasehold improvements are accounted for in accordance with our policy on impairment of long-lived assets. Inventory write-downs, if any, in connection with store closings, are classified in “Merchandise costs.” Costs to transfer inventory and equipment from closed stores are expensed as incurred.

 

The following table summarizes accrual activity for future lease obligations of stores closed that were closed in the normal course of business, not part of a coordinated closing.

 

     Future Lease
Obligations


 

Balance at February 3, 2002

   $ 66  

Additions

     (14 )

Payments

     (16 )

Adjustments

     —    
    


Balance at February 2, 2003

     36  

Additions

     10  

Payments

     (9 )

Adjustments

     (2 )
    


Balance at February 1, 2004

     35  

Additions

     28  

Payments

     (10 )

Adjustments

     12  
    


Balance at February 31, 2005

   $ 65  
    


 

Interest Rate Risk Management

 

The Company uses derivative instruments primarily to manage its exposure to changes in interest rates. The Company’s current program relative to interest rate protection and the methods by which the Company accounts for its derivative instruments are described in Note 9.

 

Commodity Price Protection

 

The Company enters into purchase commitments for various resources, including raw materials utilized in its manufacturing facilities and energy to be used in its stores, manufacturing facilities and administrative offices. The Company enters into commitments expecting to take delivery of and to utilize those resources in the conduct of the normal course of business. The Company’s current program relative to commodity price protection and the methods by which the Company accounts for its purchase commitments are described in Note 9.

 

Benefit Plans

 

The determination of the obligation and expense for company-sponsored pension plans and other post-retirement benefits is dependent on the selection of assumptions used by actuaries and the Company in calculating those amounts. Those assumptions are described in Note 18 and include, among others, the discount rate, the expected long-term rate of return on plan assets and the rates of increase in compensation and health care costs. In accordance with generally accepted accounting principles, actual results that differ from the assumptions are accumulated and amortized over future periods and, therefore, generally affect the recognized expense and recorded obligation in future periods. While the Company believes that the assumptions are appropriate, significant differences in actual experience or significant changes in assumptions may materially affect the pension and other post-retirement obligations and future expense.

 

The Company also participates in various multi-employer plans for substantially all union employees. Pension expense for these plans is recognized as contributions are funded. Refer to Note 18 for additional information regarding the Company’s benefit plans.

 

Stock Option Plans

 

The Company applies Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its stock option plans. The Company grants options for common stock at an option price equal to the fair market value of the stock at the date of the grant. Accordingly, the Company does not record stock-based compensation expense for these options. The Company also makes restricted stock awards. Compensation expense included in net earnings for restricted stock awards totaled approximately $8, $8 and $6 after-tax, in 2004, 2003 and 2002, respectively. The Company’s stock option plans are more fully described in Note 13.

 


The following table illustrates the effect on net earnings, net earnings per basic common share and net earnings per diluted common share if compensation cost for all options had been determined based on the fair market value recognition provision of SFAS No. 123:

 

     2004

    2003

    2002

 

Net earnings (loss), as reported

   $ (100 )   $ 312     $ 1,202  

Add: Stock-based compensation expense included in net earnings, net of income tax benefits

     8       8       6  

Subtract: Total stock-based compensation expense determined under fair value method for all awards, net of income tax benefits (1)

     (48 )     (48 )     (47 )
    


 


 


Pro forma net earnings (loss)

   $ (140 )   $ 272     $ 1,161  
    


 


 


Earnings (loss) per basic common share, as reported

   $ (0.14 )   $ 0.42     $ 1.54  

Pro forma earnings (loss) per basic common share

   $ (0.19 )   $ 0.36     $ 1.49  

Earnings (loss) per diluted common share, as reported

   $ (0.14 )   $ 0.41     $ 1.52  

Pro forma earnings (loss) per diluted common share

   $ (0.19 )   $ 0.36     $ 1.47  

 

(1) Refer to Note 13 for a summary of the assumptions used for options issued in each year at an option price equal to the fair market value of the stock at the date of the grant.

 

Deferred Income Taxes

 

Deferred income taxes are recorded to reflect the tax consequences of differences between the tax basis of assets and liabilities and their financial reporting basis. Refer to Note 6 for the types of differences that give rise to significant portions of deferred income tax assets and liabilities. Deferred income taxes are classified as a net current or noncurrent asset or liability based on the classification of the related asset or liability for financial reporting purposes. A deferred tax asset or liability that is not related to an asset or liability for financial reporting is classified according to the expected reversal date.

 

Tax Contingencies

 

Various taxing authorities periodically audit the Company’s income tax returns. These audits include questions regarding the Company’s tax filing positions, including the timing and amount of deductions and the allocation of income to various tax jurisdictions. In evaluating the exposures connected with these various tax filing position, including state and local taxes, the Company records allowances for probable exposures. A number of years may elapse before a particular matter, for which an allowance has been established, is audited and fully resolved. As of January 29, 2005, tax years 1999 to 2002 were undergoing examination by the Internal Revenue Service.

 

The establishment of the Company’s tax contingency allowances relies on the judgment of management to estimate the exposures associated with the Company’s various filing positions. Although management believes those estimates and judgments are reasonable, actual results could differ, resulting in gains or losses that may be material to the Consolidated Statements of Operations.

 

To the extent the Company prevails in matters for which allowances have been established, or are required to pay amounts in excess of these allowances, the Company’s effective tax rate in any given financial statement period could be materially affected. An unfavorable tax settlement could require use of cash and result in an increase in the Company’s effective tax rate in the year of resolution. A favorable tax settlement would be recognized as a reduction in the Company’s effective tax rate in the year of resolution.

 

Self-Insurance Costs

 

The Company primarily is self-insured for costs related to workers’ compensation and general liability claims. Liabilities are actuarially determined and are recognized based on claims filed and an estimate of claims incurred but not reported. The liabilities for workers’ compensation claims are accounted for on a present value basis. The Company has purchased stop-loss coverage to limit its exposure to any significant exposure on a per claim basis. The Company is insured for covered costs in excess of these per claim limits.

 


The assumptions underlying the ultimate costs of existing claim losses are subject to a high degree of unpredictability, which can affect the liability recorded for such claims. For example, variability in inflation rates of health care costs inherent in these claims can impact amounts realized. Similarly, changes in legal trends and interpretations, as well as a change in the nature and method of how claims are settled can impact ultimate costs. Although the Company’s estimates of liabilities incurred do not anticipate significant changes in historical trends for these variables, any changes could have a considerable impact on future claim costs and currently recorded liabilities.

 

Revenue Recognition

 

Revenues from the sale of products are recognized at the point of sale of the Company’s products. Discounts provided to customers by the Company at the time of sale are recognized as a reduction in sales as the products are sold. Discounts provided by vendors, usually in the form of paper coupons, are not recognized as a reduction in sales provided the coupons are redeemable at any retailer that accepts coupons. The Company does not recognize a sale when it sells gift cards and gift certificates. Rather, a sale is recognized when the gift card or gift certificate is redeemed to purchase the Company’s products.

 

Merchandise Costs

 

In addition to the product costs, net of discounts and allowances; advertising costs (see separate discussion below); inbound freight charges; warehousing costs, including receiving and inspection costs; transportation costs; and manufacturing production and operational costs are included in the “Merchandise costs” line item of the Consolidated Statements of Earnings. Warehousing, transportation and manufacturing management salaries are also included in the “Merchandise costs” line item; however, purchasing management salaries and administration costs are included in the “Operating, general, and administrative” line item along with most of the Company’s other managerial and administrative costs. Rent expense and depreciation expense are shown separately in the Consolidated Statements of Operations.

 

Warehousing and transportation costs include distribution center direct wages, repairs and maintenance, utilities, inbound freight and, where applicable, third party warehouse management fees, as well as transportation direct wages and repairs and maintenance. These costs are recognized in the periods the related expenses are incurred.

 

The Company believes the classification of costs included in merchandise costs could vary widely throughout the industry. The Company’s approach is to include in the “Merchandise costs” line item the direct, net costs of acquiring products and making them available to customers in its stores. The Company believes this approach most accurately presents the actual costs of products sold.

 

The Company recognizes all vendor allowances as a reduction in merchandise costs when the related product is sold. When possible, vendor allowances are applied to the related product by item and therefore reduce the carrying value of inventory by item. When the items are sold, the vendor allowance is recognized. When it is not possible, due to systems constraints, to allocate vendor allowances to the product by item, vendor allowances are recognized as a reduction in merchandise costs based on inventory turns and therefore recognized as the product is sold. In fiscal 2004, the Company recognized approximately $3,100 of vendor allowances as a reduction in merchandise costs. More than 80% of all vendor allowances were recognized in the item cost with the remainder being based on inventory turns.

 

Prior to the adoption of Emerging Issues Task Force (“EITF”) Issue No. 02-16, “Accounting By A Customer (Including A Reseller) For Certain Consideration Received From A Vendor,” promotional and contract allowances were recognized when the promotion ran and slotting allowances were recognized when the product was first stocked. For all contracts entered into or modified after January 1, 2003, the Company has recognized prospectively, and will continue to recognize, vendor allowances when the related merchandise is sold. Net earnings in 2002 were not affected by the adoption of Issue No. 02-16. Adoption of the Issue resulted in a $28 pre-tax charge that was included in merchandise costs in 2002. This expense was offset by a corresponding $28 pre-tax LIFO credit that also was included in merchandise costs in 2002.

 

Advertising Costs

 

The Company’s advertising costs are recognized in the periods the related expenses are incurred and are included in the “Merchandise costs” line item of the Consolidated Statements of Operations. The Company’s pre-tax advertising costs totaled $528 in 2004, $527 in 2003 and $510 in 2002. The Company does not record vendor allowances for co-operative advertising as a reduction of advertising expense.

 


Consolidated Statements of Cash Flows

 

For purposes of the Consolidated Statements of Cash Flows, the Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be temporary cash investments. Book overdrafts, which are included in accounts payable, represent disbursements that are funded as the item is presented for payment. Book overdrafts totaled $562, $587 and $480 as of January 29, 2005, January 31, 2004, and February 1, 2003, respectively, and are reflected as a financing activity in the Consolidated Statements of Cash Flows.

 

Segments

 

The Company operates retail food and drug stores, multi-department stores, jewelry stores, and convenience stores throughout the United States. The Company’s retail operations, which represent approximately 99% of consolidated sales, are its only reportable segment. All of the Company’s operations are domestic.

 

2. MERGER-RELATED COSTS

 

There were no merger-related costs incurred in 2004 or 2003. Pre-tax, merger-related costs totaled $1 in 2002. All of the costs in 2002 resulted from the issuance of restricted stock and the related market value adjustments. Restrictions on these stock awards lapsed in 2002 based on the achievement of synergy goals established in connection with the Fred Meyer merger. All synergy-based awards were earned provided that recipients were still employed on the stated restriction lapsing date.

 

The following table shows the changes in accruals related to business combinations:

 

     Facility
Closure Costs


    Incentive
Awards and
Contributions


 

Balance at February 2, 2002

   $ 94     $ 30  

Additions

     —         1  

Payments

     (20 )     (11 )
    


 


Balance at February 1, 2003

     74       20  

Adjustment of charitable contribution allowance

     —         (5 )

Payments

     (10 )     —    
    


 


Balance at January 31, 2004

     64       15  

Payments

     (7 )     (1 )
    


 


Balance at January 29, 2005

   $ 57     $ 14  
    


 


 

The $57 liability for facility closure costs primarily represents the present value of lease obligations remaining through 2019 for locations closed in California prior to the Fred Meyer merger. The $14 liability relates to a charitable contribution required as a result of the Fred Meyer merger. The Company is required to make this contribution by May 2006.

 

3. ASSET IMPAIRMENT CHARGES AND RELATED ITEMS

 

During 2003, the Company authorized closure of several stores throughout the country based on results for 2002 and 2003, as well as updated projections for 2004 and beyond. This event triggered an impairment review of stores slated for closure as well as several other under-performing locations in the fourth quarter 2003. The review resulted in a pre-tax charge totaling $120. These charges are more fully described below. No corporate-level asset impairment charges were recorded in 2004 or 2002.

 

Assets to be Disposed of

 

The impairment charges for assets to be disposed of related primarily to the carrying values of land, buildings, equipment and leasehold improvements for stores that have closed or have been approved for closure. The impairment charges were determined by estimating the fair values of the locations, less costs of disposal. Fair values were based on third party offers to purchase the assets, or market value for comparable properties, if available. As a result, pre-tax impairment charges related to assets to be disposed of were recognized, reducing the carrying value of fixed assets by $54 in 2003.

 


Assets to be Held and Used

 

The impairment charges for assets to be held and used related primarily to the carrying values of land, buildings, equipment and leasehold improvements for stores that will continue to be operated by the Company. Updated projections, based on revised operating plans, were used, on a gross basis, to determine whether the assets were impaired. Then, discounted cash flows were used to estimate the fair value of the assets for purposes of measuring the impairment charge. As a result, impairment charges related to assets to be held and used were recognized, reducing the carrying value of fixed assets by $66 in 2003.

 

Related Items: Lease Liabilities – Coordinated Store Closing Plans

 

In 2000 and 2001, the Company recorded expense related to the present value of lease liabilities for stores identified for closure. Due to operational changes, performance improved at five stores subsequent to the recording of the future lease liabilities. As a result of this improved performance, in the first quarter of 2003 the Company modified its original plans and determined that these five locations will remain open. Additionally, closing and exit costs at other locations previously recorded were less costly than anticipated. In total, in the first quarter of 2003, the Company recorded pre-tax income of $10 to adjust these liabilities to reflect the outstanding lease commitments through 2020 at the locations remaining under the plans. The following table summarizes the changes in the balances of the liabilities:

 

Balances at February 2, 2002 (1)

   $ 64  

Payments

     (4 )
    


Balances at February 1, 2003

     60  

Lease liabilities reversed

     (10 )

Payments, including $12 related to the synthetic lease buyout

     (18 )
    


Balances at January 31, 2004

     32  

Payments

     19  
    


Balances at January 29, 2005

   $ 13  
    


 

(1) The beginning balance represents the balance of impairment charges recorded in prior years.

 

The $13 liability for store closing liabilities relates to the present value of lease obligations remaining through 2020. Sales at store remaining under the plan totaled $18, $17 and $17 in 2004, 2003 and 2002, respectively.

 

4. RESTRUCTURING CHARGES

 

On December 11, 2001, the Company outlined the Strategic Growth Plan (the “Plan”) to support additional investment in its core business to increase sales and market share. The Plan had three key elements: reduction of operating, general and administrative expenses, increased coordination of merchandising and procurement activities, and targeted retail price reductions. During 2001, the Company recorded a pre-tax restructuring charge of $37 primarily for severance agreements associated with the Plan. Restructuring charges related to the Plan totaled $15, pre-tax, in 2002. The majority of the 2002 expenses related to severance agreements, distribution center consolidation and conversion costs. No restructuring charges related to the plan were incurred in 2004 and 2003.

 

The following table summarizes the changes in the balances of the liabilities associated with the Plan:

 

     Severance &
Other Costs


 

Balance at February 2, 2002

   $ 37  

Additions

     15  

Payments

     (44 )
    


Balance at February 1, 2003

   $ 8  

Additions

     —    

Payments

     (3 )
    


Balance at January 31, 2004

   $ 5  

Additions

     —    

Payments

     (1 )
    


Balance at January 29, 2005

   $ 4  
    


 


All severance agreements associated with these liabilities have been paid. The remaining $4 of liabilities represent long-term obligations, including lease commitments through 2009 related to the consolidation of the Company’s Nashville division office.

 

5. GOODWILL, NET

 

As described in Note 1, the Company adopted SFAS No. 142 on February 3, 2002. The transitional impairment review required by SFAS No. 142 resulted in a $26 pre-tax non-cash loss to write off the jewelry store division goodwill based on its implied fair value. Impairment primarily resulted from the recent operating performance of the division and review of the division’s projected future cash flows on a discounted basis, rather than on an undiscounted basis, as was the standard under SFAS No. 121, prior to adoption of SFAS No. 142. This loss was recorded as a cumulative effect of an accounting change, net of a $10 tax benefit, in the first quarter of 2002.

 

The annual evaluation of goodwill performed during the fourth quarter of 2003 resulted in a $444 non-cash impairment charge related to the goodwill at the Company’s Smith’s division. In 2003, the Company’s Smith’s division experienced a substantial decline in operating performance when compared to prior year performance and budgeted 2003 result. Additionally, the Company forecasted a further decline in the future operating performance of the division reflecting the necessary investments in capital and targeted retail price reductions in order to maintain and grow market share and provide acceptable long-term return on capital. The impairment charge, which was non-deductible for income tax purposes, adjusted the carrying value of the division’s goodwill to its implied fair value.

 

The annual evaluation of goodwill performed during the fourth quarter of 2004 resulted in a $900 pre-tax, non-cash impairment charge related to goodwill at the Company’s Ralphs and Food 4 Less divisions. The divisions’ operating performance suffered due to the intense competitive environment during the 2003 southern California labor dispute and recovery period after the labor dispute. The decreased operating performance was the result of the investments in personnel, training, capital and price reductions necessary to help regain Ralphs’ business lost during the labor dispute and to maintain business gained by Food 4 Less that were not subject to the labor dispute. As a result of this decline and the decline in future expected operating performance, the divisions’ carrying value of goodwill exceeded its implied fair value resulting in the impairment charge. Most of the impairment charge was non-deductible for income tax purposes. After the impairment charge, the Company maintains $1,458 of goodwill for the Ralphs and Food 4 Less divisions.

 

The following table summarizes the changes in the Company’s net goodwill balance through January 29, 2005.

 

Balance at February 2, 2002

   $ 3,594  

Cumulative effect of an accounting change

     (26 )

Goodwill recorded

     9  

Reclassifications

     (2 )
    


Balance at February 1, 2003

   $ 3,575  

Goodwill impairment charge

     (444 )

Goodwill recorded

     9  

Purchase accounting adjustments

     (6 )
    


Balance at January 31, 2004

   $ 3,134  

Goodwill impairment charge

     (900 )

Goodwill recorded

     6  

Purchase accounting adjustments

     (49 )
    


Balance at January 29, 2005

   $ 2,191  
    


 


6. PROPERTY, PLANT AND EQUIPMENT, NET

 

Property, plant and equipment, net consists of:

 

     2004

    2003

 

Land

   $ 1,580     $ 1,519  

Buildings and land improvements

     4,975       4,435  

Equipment

     7,797       7,745  

Leasehold improvements

     3,804       3,555  

Construction-in-progress

     541       636  

Leased property under capital leases

     506       535  
    


 


       19,203       18,425  

Accumulated depreciation and amortization

     (7,706 )     (7,247 )
    


 


Total

   $ 11,497     $ 11,178  
    


 


 

Accumulated depreciation for leased property under capital leases was $252 at January 29, 2005 and $246 at January 31, 2004.

 

Approximately $982 and $1,180, original cost, of Property, Plant and Equipment collateralized certain mortgages at January 29, 2005 and January 31, 2004, respectively.

 

7. TAXES BASED ON INCOME

 

The provision for taxes based on income consists of:

 

     2004

   2003

   2002

 

Federal

                      

Current

   $ 96    $ 177    $ 293  

Deferred

     258      238      360  
    

  

  


       354      415      653  

State and local

     36      39      79  
    

  

  


       390      454      732  

Tax benefit from cumulative effect of an accounting change

     —        —        (10 )
    

  

  


     $ 390    $ 454    $ 722  
    

  

  


 

A reconciliation of the statutory federal rate and the effective rate follows:

 

     2004

    2003

    2002

 

Statutory rate

   35.0 %   35.0 %   35.0 %

State income taxes, net of federal tax benefit

   2.6 %   3.3 %   2.6 %

Non-deductible goodwill

   99.8 %   20.3 %   0.0 %

Other changes, net

   (2.9 )%   0.7 %   (0.1 )%
    

 

 

     134.5 %   59.3 %   37.5 %
    

 

 

 


The tax effects of significant temporary differences that comprise tax balances were as follows:

 

     2004

    2003

 

Current deferred tax assets:

                

Net operating loss carryforwards

   $ 19     $ 19  
    


 


Total current deferred tax assets

     19       19  

Current deferred tax liabilities:

                

Compensation related costs

     (19 )     (4 )

Insurance related costs

     (136 )     (13 )

Inventory related costs

     (100 )     (127 )

Other

     (31 )     (13 )
    


 


Total current deferred tax liabilities

     (286 )     (157 )
    


 


Current deferred taxes

   $ (267 )   $ (138 )
    


 


Long-term deferred tax assets:

                

Compensation related costs

   $ 383     $ 264  

Insurance related costs

     15       15  

Lease accounting

     45       46  

Closed store reserves

     115       91  

Net operating loss carryforwards

     79       98  

Other

     129       96  
    


 


       766       610  

Valuation allowance

     —         (150 )
    


 


Long-term deferred tax assets, net

     766       460  

Long-term deferred tax liabilities:

                

Depreciation

     (1,502 )     (1,243 )

Deferred income

     (203 )     (191 )
    


 


Total long-term deferred tax liabilities

     (1,705 )     (1,434 )
    


 


Long-term deferred taxes

   $ (939 )   $ (974 )
    


 


 

At January 29, 2005, the Company had net operating loss carryforwards for federal income tax purposes of $256 that expire from 2010 through 2018. In addition, the Company had net operating loss carryforwards for state income tax purposes of $467 that expire from 2009 through 2023. The utilization of certain of the Company’s net operating loss carryforwards may be limited in a given year.

 

The Company’s valuation allowance pertained to a Ralphs Grocery Co., pre-acquisition federal tax controversy. It was determined that it is more likely than not that the associated tax benefits will be utilized by the Company. As a result, the valuation allowance was removed and goodwill was reduced. Separately, an allowance was established with regard to the pre-acquisition controversy with an offsetting increase to goodwill.

 

At January 29, 2005, the Company had state Alternative Minimum Tax Credit carryforwards of $4. In addition, the Company had other state credits of $18, which expire from 2005 through 2014. The utilization of certain of the Company’s credits may be limited in a given year.

 

The amounts of cash paid for income taxes in 2004, 2003 and 2002 were reduced by approximately $106, $130 and $106, respectively, as a result of federal bonus depreciation. This provision expired in December 2004 and the Company expects the related cash benefit will begin to reverse in 2005.

 


8. DEBT OBLIGATIONS

 

Long-term debt consists of:

 

     2004

    2003

 

Credit Facilities

   $ 694     $ 391  

4.95% to 8.92% Senior Notes and Debentures due through 2031

     6,391       6,842  

5.00% to 10.23% mortgages due in varying amounts through 2017

     218       481  

Other

     202       159  
    


 


Total debt

     7,505       7,873  

Less current portion

     (46 )     (225 )
    


 


Total long-term debt

   $ 7,459     $ 7,648  
    


 


 

As of January 29, 2005, the Company had a $1,800 Five-Year Credit Agreement maturing in 2009, and a $700 Five-Year Credit Agreement maturing in 2007, unless earlier terminated by the Company. Borrowings under these credit agreements bear interest at the option of the Company at a rate equal to either (i) the highest, from time to time of (A) the base rate of Citibank, N.A., (B) ½% over a moving average of secondary market morning offering rates for three-month certificates of deposit adjusted for reserve requirements, and (C) ½% over the federal funds rate or (ii) an adjusted Eurodollar rate based upon the London Interbank Offered Rate (“Eurodollar Rate”) plus an Applicable Margin. In addition, the Company pays a Facility Fee in connection with these credit agreements. Both the Applicable Margin and the Facility Fee vary based upon the Company’s achievement of a financial ratio or credit rating. At January 29, 2005, the Applicable Margin was .375% and the Facility Fee was .125% for both facilities. The credit agreements contain covenants, which, among other things, require the maintenance of certain financial ratios, including fixed charge coverage and leverage ratios. The Company may prepay the credit agreements in whole or in parts, at any time, without a prepayment penalty. The weighted average interest rate on the amounts outstanding under the credit facilities was 2.49% and 1.13% at January 29, 2005 and January 31, 2004, respectively.

 

At January 29, 2005, the Company had borrowed $694 under the A2/P2/F2 rated commercial paper program. These borrowings are backed by the Company’s credit facilities and reduce the amount available under the credit facilities.

 

At January 29, 2005, the Company also maintained a $75 money market line. In addition to credit agreement borrowings, borrowings under the money market line and some outstanding letters of credit reduce funds available under the Company’s credit agreements. At January 29, 2005, these letters of credit totaled $312. The Company had no borrowings under the money market line at January 29, 2005. The Company’s credit agreement borrowings have been classified as long-term borrowings because the Company expects that these borrowings will be refinanced using the same type of securities. The Company has the ability to refinance these borrowings on a long-term basis, and has presented the amounts accordingly.

 

At January 29, 2005, the Company also had a $100 pharmacy receivable securitization facility that provided capacity incremental to the $2,500 described above. Funds received under this $100 facility do not reduce funds available under the Credit Facilities. Collection rights to some of the Company’s pharmacy accounts receivable balances are sold to initiate the drawing of funds under the facility. As of January 29, 2005, the Company had no borrowings under this $100 facility.

 

Most of the Company’s outstanding public debt is subject to early redemption at varying times and premiums, at the option of the Company. In addition, subject to certain conditions, some of the Company’s publicly issued debt will be subject to redemption, in whole or in part, at the option of the holder upon the occurrence of a redemption event, upon not less than five days’ notice prior to the date of redemption, at a redemption price equal to the default amount, plus a specified premium. “Redemption Event” is defined in the indentures as the occurrence of (i) any person or group, together with any affiliate thereof, beneficially owning 50% or more of the voting power of the Company or (ii) any one person or group, or affiliate thereof, succeeding in having a majority of its nominees elected to the Company’s Board of Directors, in each case, without the consent of a majority of the continuing directors of the Company.

 


The aggregate annual maturities and scheduled payments of long-term debt, as of year-end 2004, for the years subsequent to 2004 are:

 

2005

   $ 46

2006

   $ 554

2007

   $ 525

2008

   $ 998

2009

   $ 1,094

Thereafter

   $ 4,288
    

Total debt

   $ 7,505

 

9. FINANCIAL INSTRUMENTS

 

Interest Rate Risk Management

 

The Company historically has used derivatives to manage its exposure to changes in interest rates. The interest differential to be paid or received is accrued as interest expense. SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, defines derivatives, requires that derivatives be carried at fair value on the balance sheet and provides for hedge accounting when certain conditions are met. In accordance with this standard, the Company’s derivative financial instruments are recognized on the balance sheet at fair value. Changes in the fair value of derivative instruments designated as “cash flow” hedges, to the extent the hedges are highly effective, are recorded in other comprehensive income, net of tax effects. Ineffective portions of cash flow hedges, if any, are recognized in current period earnings. Other comprehensive income or loss is reclassified into current period earnings when the hedged transaction affects earnings. Changes in the fair value of derivative instruments designated as “fair value” hedges, along with corresponding changes in the fair values of the hedged assets or liabilities, are recorded in current period earnings.

 

The Company assesses, both at the inception of the hedge and on an ongoing basis, whether derivatives used as hedging instruments are highly effective in offsetting the changes in the fair value or cash flow of the hedged items. If it is determined that a derivative is not highly effective as a hedge or ceases to be highly effective, the Company discontinues hedge accounting prospectively.

 

The Company’s current program relative to interest rate protection contemplates both fixing the rates on variable rate debt and hedging the exposure to changes in the fair value of fixed-rate debt attributable to changes in interest rates. To do this, the Company uses the following guidelines: (i) used average daily bank balance to determine annual debt amounts subject to interest rate exposure, (ii) limit the annual amount subject to interest rate reset and the amount of floating rate debt to a combined total of $2.5 billion or less, (iii) include no leverage products, and (iv) hedge without regard to profit motive or sensitivity to current mark-to-market status.

 

Annually, the Company reviews with the Financial Policy Committee of the Board of Directors compliance with the guidelines. These guidelines may change as the Company’s needs dictate.

 

The table below summarizes the outstanding interest rate swaps designated as hedges as of January 29, 2005, and January 31, 2004. The variable component of each interest rate swap outstanding at January 29, 2005, was based on LIBOR as of January 29, 2005. The variable component of each interest rate swap outstanding at January 31, 2004, was based on LIBOR as of January 31, 2004.

 

     2004

   2003

 
     Pay
Floating


    Pay
Fixed


   Pay
Floating


    Pay
Fixed


 

Notional amount

   $ 1,375     $   —      $ 1,825     $ 300  

Duration in years

     4.29       —        2.63       0.04  

Average variable rate

     6.29 %     —        5.67 %     1.12 %

Average fixed rate

     6.98 %     —        7.45 %     3.22 %

 


Commodity Price Protection

 

The Company enters into purchase commitments for various resources, including raw materials utilized in its manufacturing facilities and energy to be used in its stores, manufacturing facilities and administrative offices. The Company enters into commitments expecting to take delivery of and to utilize those resources in the conduct of normal business. Those commitments for which the Company expects to utilize or take delivery in a reasonable amount of time in the normal course of business qualify as normal purchases and normal sales. Any commitments for which the Company does not expect to take delivery, and, as a result will require net settlement, are marked to fair value on a quarterly basis.

 

Some of the product the Company purchases is shipped in corrugated cardboard packaging. The corrugated cardboard is sold when it is economical to do so. In the fourth quarter of 2004, the Company entered into six derivative instruments to protect it from declining corrugated cardboard prices. The derivatives, accounted for as cash flow hedges, contain a three-year term. None of the contracts, either individually or in the aggregate, hedge more than 50% of the Company’s expected corrugated cardboard sales. As of January 29, 2005, a liability totaling $2 had been recorded for the instruments. Corresponding charges were recorded as Other Comprehensive Loss, net of income tax effects.

 

10. FAIR VALUE OF FINANCIAL INSTRUMENTS

 

The following methods and assumptions were used to estimate the fair value of each class of financial instrument for which it was practicable to estimate that value:

 

Cash and Temporary Cash Investments, Store Deposits In-Transit, Receivables, Prepaid and Other Current Assets, Accounts Payable, Accrued Salaries and Wages and Other Current Liabilities

 

The carrying amounts of these items approximated fair value.

 

Long-term Investments

 

The fair values of these investments were estimated based on quoted market prices for those or similar investments.

 

Long-term Debt

 

The fair value of the Company’s long-term debt, including the current portion thereof and excluding borrowings under the credit facilities, was estimated based on the quoted market price for the same or similar issues. If quoted market prices were not available, the fair value was based upon the net present value of the future cash flows using the forward interest rate yield curve in effect at the respective year-ends. The carrying values of long-term debt outstanding under the Company’s credit facilities approximated fair value.

 

Interest Rate Protection Agreements

 

The fair value of these agreements was based on the net present value of the future cash flows using the forward interest rate yield curve in effect at the respective year-ends.

 


The estimated fair values of the Company’s financial instruments are as follows:

 

     2004

    2003

 
     Carrying
Value


    Estimated
Fair Value


    Carrying
Value


    Estimated
Fair Value


 

Cash and temporary cash investments

   $ 144     $ 144     $ 159     $ 159  

Store deposits in-transit

   $ 506     $ 506     $ 579     $ 579  

Long-term investments for which it is

                                

Practicable

   $ 89     $ 89     $ 70     $ 70  

Not Practicable

   $ 15     $ —       $ 15     $ —    

Debt for which it is (1)

                                

Practicable

   $ (7,505 )   $ (8,304 )   $ (7,873 )   $ (8,919 )

Not Practicable

   $ —       $ —       $ —       $ —    

Interest Rate Protection Agreements

                                

Receive fixed swaps (2)

   $ (11 )   $ (11 )   $ 6     $ 6  

Corrugated Cardboard Price Protection Agreements(3)

   $ (2 )   $ (2 )   $ —       $ —    

 

(1) Excludes capital lease obligations

 

(2) As of January 29, 2005, the Company maintained 10 interest rate swap agreements, with notional amounts totaling approximately $1,375, to manage its exposure to changes in the fair value of its fixed rate debt resulting from interest rate movements by effectively converting a portion of the Company’s debt from fixed to variable rates. These agreements mature at varying times between July 2006 and January 2015. Variable rates for these agreements are based on U.S. dollar London Interbank Offered Rate (“LIBOR”). The differential between fixed and variable rates to be paid or received is accrued as interest rates change in accordance with the agreements and is recognized over the life of the agreements as an adjustment to interest expense. All interest rate swap agreements are being accounted for as fair value hedges. As of January 29, 2005, liabilities totaling $11 were recorded to reflect the fair value of these agreements, offset by decreases in the fair value of the underlying debt.

 

(3) See Note 9 for a description of the corrugated cardboard price protection agreements.

 

11. LEASES AND LEASE-FINANCED TRANSACTIONS

 

The Company operates primarily in leased facilities. Lease terms generally range from 10 to 20 years with options to renew for varying terms. Terms of certain leases include escalation clauses, percentage rent based on sales or payment of executory costs such as property taxes, utilities or insurance and maintenance. Rent expense for leases with escalation clauses, capital improvement funding or other lease concessions is accounted for on a straight-line basis beginning with the earlier of the lease commencement date or the date the Company takes possession. Portions of certain properties are subleased to others for periods generally ranging from one to 20 years.

 

Rent expense (under operating leases) consists of:

 

     2004

    2003

    2002

 

Minimum rentals

   $ 772     $ 744     $ 743  

Contingent payments

     9       9       10  

Sublease income

     (101 )     (96 )     (93 )
    


 


 


     $ 680     $ 657     $ 660  
    


 


 


 


Minimum annual rentals and payments under capital leases and lease-financed transactions for the five years subsequent to 2004 and in the aggregate are:

 

     Capital
Leases


    Operating
Leases


   Lease-
Financed
Transaction


2005

   $ 62     $ 794    $ 5

2006

     59       756      5

2007

     55       682      5

2008

     53       649      5

2009

     51       603      5

Thereafter

     372       4,391      60
    


 

  

       652     $ 7,875    $ 85
            

  

Less estimated executory costs included in capital leases

     (4 )             
    


            

Net minimum lease payments under capital leases

     648               

Less amount representing interest

     (296 )             
    


            

Present value of net minimum lease payments under capital leases

   $ 352               
    


            

 

Total future minimum rentals under noncancellable subleases at January 29, 2005, were $401.

 

12. EARNINGS PER COMMON SHARE

 

Basic earnings per common share equals net earnings divided by the weighted average number of common shares outstanding. Diluted earnings per common share equals net earnings divided by the weighted average number of common shares outstanding after giving effect to dilutive stock options and warrants.

 

The following table provides a reconciliation of earnings before the cumulative effect of an accounting change and shares used in calculating basic earnings per share to those used in calculating diluted earnings per share.

 

     For the year ended
January 29, 2005


    For the year ended
January 31, 2004


   For the year ended
February 1, 2003


     Earnings
(Numer-
ator)


    Shares
(Denomi-
nator)


   Per
Share
Amount


    Earnings
(Numer-
ator)


   Shares
(Denomi-
nator)


   Per
Share
Amount


   Earnings
(Numer-
ator)


   Shares
(Denomi-
nator)


   Per
Share
Amount


Basic EPS

   $ (100 )   736    $ (0.14 )   $ 312    747    $ 0.42    $ 1,218    779    $ 1.56

Dilutive effect of stock option awards and warrants

           —                     7                  12       
    


 
          

  
         

  
      

Diluted EPS

   $ (100 )   736    $ (0.14 )   $ 312    754    $ 0.41    $ 1,218    791    $ 1.54
    


 
          

  
         

  
      

 

For the years ended January 29, 2005, January 31, 2004 and February 1, 2003, there were options outstanding for approximately 61.5, 33.7 and 25.0 shares of common stock, respectively, that were excluded from the computation of diluted EPS. These shares were excluded because their inclusion would have had an anti-dilutive effect on EPS.

 


13. STOCK OPTION PLANS

 

The Company applies Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for its stock option plans. All awards become immediately exercisable upon certain changes of control of the Company.

 

The Company grants options for common stock to employees under various plans, as well as to its non-employee directors, at an option price equal to the fair market value of the stock at the date of grant. In addition to cash payments, the plans generally provide for the exercise of options by exchanging issued shares of stock of the Company. At January 29, 2005, approximately 8.0 shares of common stock were available for future options under these plans. Options generally will expire 10 years from the date of grant. Options vest in one year to five years from the date of grant or, for certain options, the earlier of the Company’s stock reaching certain pre-determined market prices or nine years and six months from the date of grant.

 

In addition to the stock options described above, the Company also awards restricted stock to employees under various plans. The restrictions on these awards generally lapse in one year to five years from the date of the awards and expense is recognized over the lapsing cycle. The Company generally records expense for restricted stock awards in an amount equal to the fair market value of the underlying stock on the date of award. For approximately 1.0 shares of restricted stock that vested in 2002 based on the achievement of synergy goals established in connection with the Fred Meyer merger, the Company recorded expense in an amount equal to the fair market value of the underlying stock on the date the synergy goals were achieved. The Company issued approximately 0.2, 0.7 and 1.1 shares of restricted stock in 2004, 2003 and 2002, respectively. As of January 29, 2005, approximately 0.1 shares of common stock were available for future restricted stock awards. Compensation expense included in net earnings for restricted stock awards totaled approximately $8, $8 and $6, after-tax, in 2004, 2003 and 2002, respectively.

 

Changes in options outstanding under the stock option plans, excluding restricted stock awards, were:

 

     Shares subject
to option


    Weighted average
exercise price


Outstanding, year-end 2001

   59.7     $ 15.48

Granted

   14.5     $ 18.53

Exercised

   (6.8 )   $ 6.27

Canceled or Expired

   (1.2 )   $ 22.31
    

     

Outstanding, year-end 2002

   66.2     $ 16.97

Granted

   0.3     $ 16.34

Exercised

   (4.9 )   $ 7.59

Canceled or Expired

   (1.5 )   $ 21.19
    

     

Outstanding, year-end 2003

   60.1     $ 17.62

Granted

   6.7     $ 17.28

Exercised

   (4.2 )   $ 7.29

Canceled or Expired

   (1.1 )   $ 20.99
    

     

Outstanding, year-end 2004

   61.5     $ 18.20
    

     

 

A summary of options outstanding and exercisable at January 29, 2005 follows:

 

Range of Exercise Prices


   Number
Outstanding


   Weighted-
Average
Remaining
Contractual
Life


   Weighted-
Average
Exercise
Price


   Options
Exercisable


   Weighted-
Average
Exercise
Price


          (In years)               

$  3.57 - $10.37

   $ 9.7    1.00    $ 8.78    9.7    $ 8.78

$10.38 - $14.92

   $ 12.6    5.66    $ 14.34    9.0    $ 14.11

$14.93 - $16.59

   $ 6.2    5.15    $ 16.55    4.8    $ 16.56

$16.60 - $22.81

   $ 13.5    6.26    $ 19.31    5.9    $ 21.05

$22.82 - $31.91

   $ 19.5    5.74    $ 25.14    14.1    $ 25.45
    

              
      

$  3.57 - $31.91

   $ 61.5    5.03    $ 18.20    43.5    $ 17.81
    

              
      

 


If compensation cost for the Company’s stock option plans had been determined based upon the fair value at the grant date for awards under these plans consistent with the methodology prescribed under SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company’s net earnings and diluted earnings per common share would have been reduced to the pro forma amounts below:

 

     2004

    2003

   2002

     Actual

    Pro Forma

    Actual

   Pro Forma

   Actual

   Pro Forma

Net earnings (loss)

   $ (100 )   $ (140 )   $ 312    $ 272    $ 1,202    $ 1,161

Earnings (loss) per diluted common share

   $ (0.14 )   $ (0.19 )   $ 0.41    $ 0.36    $ 1.52    $ 1.47

 

The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model, based on historical assumptions shown in the table below. These amounts reflected in this pro forma disclosure are not indicative of future amounts. The following table reflects the assumptions used for grants awarded in each year to option holders:

 

     2004

    2003

    2002

 

Weighted average expected volatility (based on historical volatility)

   30.13 %   30.23 %   29.72 %

Weighted average risk-free interest rate

   3.99 %   3.33 %   4.40 %

Expected term (based on historical results)

   8.7 years     8.5 years     8.4 years  

 

The weighted average fair value of options granted during 2004, 2003 and 2002 was $7.91, $7.09 and $8.49, respectively. The Company utilizes a risk-free interest rate based upon the yield of a treasury note maturing at a date that approximates the option’s vest date.

 

Grants in 2004 returned to normal levels after grants in 2003 were unusually low and, conversely, grants in 2002 were unusually high, due primarily to a general grant of approximately 3.8 stock options to management and support employees, and approximately 3.9 options to executives including senior officers and division presidents, that was approved by the Compensation Committee of the Board of Directors on December 12, 2002 (fiscal 2002). This grant replaced a planned grant in May 2003 and was accelerated to secure the continued alignment of employee interests with those of the shareholders as strategic plans are implemented. The Committee also made awards of restricted stock to senior officers and division presidents in recognition of their vital role in a challenging operating environment. The restrictions on these shares will lapse after three years, assuming the recipients’ continued employment with the Company during that period.

 

In addition to the stock options described above, at January 29, 2005, there were 4.2 warrants outstanding. The warrants, exercisable at $11.91, were originally issued pursuant to a Warrant Agreement dated May 23, 1996. Approximately 0.5 warrants expire in May 2005 and the remaining 3.7 warrants expire in May 2006.

 

14. COMMITMENTS AND CONTINGENCIES

 

The Company continuously evaluates contingencies based upon the best available evidence.

 

The Company believes that allowances for loss have been provided to the extent necessary and that its assessment of contingencies is reasonable. To the extent that resolution of contingencies results in amounts that vary from the Company’s estimates, future earnings will be charged or credited.

 

The principal contingencies are described below:

 

Insurance — The Company’s workers’ compensation risks are self-insured in certain states. In addition, other workers’ compensation risks and certain levels of insured general liability risks are based on retrospective premium plans, deductible plans, and self-insured retention plans. The liability for workers’ compensation risks is accounted for on a present value basis. Actual claim settlements and expenses incident thereto may differ from the provisions for loss. Property risks have been underwritten by a subsidiary and are reinsured with unrelated insurance companies. Operating divisions and subsidiaries have paid premiums, and the insurance subsidiary has provided loss allowances, based upon actuarially determined estimates.

 

Litigation — The United States Attorney’s Office for the Central District of California is investigating the hiring practices of Ralphs Grocery Company (“Ralphs”), a wholly-owned subsidiary of The Kroger Co., during the labor dispute from October 2003

 


through February 2004. Among matters under investigation is the extent to which some locked-out employees were allowed to work under false identities or false Social Security numbers, despite Company policy forbidding such conduct. A grand jury has convened to consider whether such acts violated federal criminal statutes. The Company is cooperating with the investigation. Although the Company expects some adverse action to be taken, management is not able to estimate the dollar amount of penalties or liability Ralphs may incur. In addition, these alleged practices are the subject of claims that Ralphs’ conduct of the lockout was unlawful, and that Ralphs is liable under the National Labor Relations Act (“NLRA”). The Los Angeles Regional Office of the National Labor Relations Board (“NLRB”) has notified the charging parties that all charges alleging that Ralphs’ lockout violated the NLRA have been dismissed. That decision is being appealed to the General Counsel of the NLRB.

 

On February 2, 2004, the Attorney General for the State of California filed an action in Los Angeles federal court (California, ex rel Lockyer v. Safeway, Inc. dba Vons, a Safeway Company; Albertson’s, Inc. and Ralphs Grocery Company, a division of The Kroger Co., United States District Court Central District of California, Case No. CV04-0687) alleging that certain provisions of the Mutual Strike Assistance Agreement (the “Agreement”) between the Company, Albertson’s, Inc. and Safeway Inc. (collectively, the “Retailers”) which contained a provision designed to prevent the union from placing disproportionate pressure on one or more of the Retailers by picketing such Retailer(s) but not the other Retailer(s) during the labor dispute in southern California violated Section 1 of the Sherman Act. The lawsuit seeks declarative and injunctive relief. Under the Agreement, the Company paid approximately $147 million to the other Retailers. The lawsuit raises claims that could question the validity of those payments as well as claims that the Retailers unlawfully restrained competition. The Company continues to believe it has strong defenses against this lawsuit and is vigorously defending it. Although this lawsuit is subject to uncertainties inherent to the litigation process, based on the information presently available to the Company, management does not expect that the ultimate resolution of this action will have a material effect, favorable or adverse, on the Company’s financial condition, results of operation or cash flows.

 

On November 24, 2004, the Company was notified by the office of the United States Attorney for the District of Colorado that the Drug Enforcement Agency (“DEA”) had referred a matter to it for investigation regarding alleged violations of the Controlled Substances Act by the Company’s King Soopers division. The government alleges that ineffective controls and procedures, as well as improper record keeping, permitted controlled substances to be diverted from pharmacies operated by King Soopers. As a result of these allegations, the Company has retained a consultant to assist it in reviewing its policies and procedures, record keeping and training in its pharmacies, and is taking corrective action, as warranted. The Company is cooperating with the Assistant U.S. Attorney and the DEA, and expects to resolve this matter in the near future. The Company does not expect that the ultimate resolution of this investigation will have a material effect on the Company’s financial condition, results of operations or cash flows.

 

On March 30, 2005, the United States District Court for the Northern District of Illinois rendered a decision in an action (Central States, Southeast and Southwest Areas Pension Fund et al. v. The Kroger Co.) alleging that the Company has failed to make contributions to a multi-employer pension fund in connection with certain employees the Company had viewed as exempt from the contribution requirement. The Court’s decision was adverse to the Company’s position, resulting in an order that would require payments of approximately $13 million. The Company has not yet decided whether to appeal. A related decision, also adverse to the Company, has been appealed to the United States Court of Appeals for the Seventh Circuit and is awaiting decision. The ultimate resolution is not expected to have a material effect on the results of operations as the Company believes it has recorded adequate allowances related to these contingencies.

 

Various claims and lawsuits arising in the normal course of business, including suits charging violations of certain antitrust and civil rights laws, are pending against the Company. Some of these suits purport or have been determined to be class actions and/or seek substantial damages. Any damages that may be awarded in antitrust cases will be automatically trebled. Although it is not possible at this time to evaluate the merits of all of these claims and lawsuits, nor their likelihood of success, the Company is of the belief that any resulting liability will not have a material adverse effect on the Company’s financial position.

 

The Company continually evaluates its exposure to loss contingencies arising from pending or threatened litigation and believes it has made adequate provisions therefor. Nonetheless, assessing and predicting the outcomes of these matters involves substantial uncertainties. It remains possible that despite management’s current belief, material differences in actual outcomes or changes in management’s evaluation or predications could arise that could have a material adverse impact on the Company’s financial condition or results of operation.

 

Guarantees – The Company periodically enters into real estate joint ventures in connection with the development of certain properties. The Company usually sells its interests in such partnerships upon completion of the projects. As of January 29, 2005, the Company was a partner with 50% ownership in four real estate joint ventures for which it has guaranteed approximately $12 of debt incurred by the ventures. Based on the covenants underlying this indebtedness as of January 29, 2005, it is unlikely that the Company will be responsible for repayment of these obligations.

 

Assignments – The Company is contingently liable for leases that have been assigned to various third parties in connection with facility closings and dispositions. The Company could be required to satisfy the obligations under the leases if any of the assignees are unable to fulfill their lease obligations. Due to the wide distribution of the Company’s assignments among third parties, and various other remedies available, the Company believes the likelihood that it will be required to assume a material amount of these obligations is remote.

 

15. SUBSEQUENT EVENTS

 

On March 16, 2005, Standard & Poor’s Ratings Services placed its ratings for the Company, as well as Safeway Inc. and Albertson’s, Inc., on CreditWatch with negative implications. Standard & Poor’s indicated that it expects any downgrade, if warranted by their review, to be limited to one level, with ratings not expected to fall below investment grade.

 


16. WARRANT DIVIDEND PLAN

 

On February 28, 1986, the Company adopted a warrant dividend plan providing for stock purchase rights to owners of the Company’s common stock. The plan was amended and restated as of April 4, 1997, and further amended on October 18, 1998. Each share of common stock currently has attached one-fourth of a right. Each right, when exercisable, entitles the holder to purchase from the Company one ten-thousandth of a share of Series A Preferred Shares, par value $100 per share, at $87.50 per one ten-thousandth of a share. The rights will become exercisable, and separately tradable, 10 business days following a tender offer or exchange offer resulting in a person or group having beneficial ownership of 10% or more of the Company’s common stock. In the event the rights become exercisable and thereafter the Company is acquired in a merger or other business combination, each right will entitle the holder to purchase common stock of the surviving corporation, for the exercise price, having a market value of twice the exercise price of the right. Under certain other circumstances, including certain acquisitions of the Company in a merger or other business combination transaction, or if 50% or more of the Company’s assets or earnings power are sold under certain circumstances, each right will entitle the holder to receive upon payment of the exercise price, shares of common stock of the acquiring company with a market value of two times the exercise price. At the Company’s option, the rights, prior to becoming exercisable, are redeemable in their entirety at a price of $0.01 per right. The rights are subject to adjustment and expire March 19, 2006.

 

17. STOCK

 

Preferred Stock

 

The Company has authorized 5 shares of voting cumulative preferred stock; 2 were available for issuance at January 29, 2005. Fifty thousand shares have been designated as “Series A Preferred Shares” and are reserved for issuance under the Company’s warrant dividend plan. The stock has a par value of $100 and is issuable in series.

 

Common Stock

 

The Company has authorized 1,000 shares of common stock, $1 par value per share. On May 20, 1999, the shareholders authorized an amendment to the Amended Articles of Incorporation to increase the authorized shares of common stock from 1,000 to 2,000 when the Board of Directors determines it to be in the best interest of the Company.

 

Common Stock Repurchase Program

 

In December 1999, the Company began a program to repurchase common stock to reduce dilution resulting from its employee stock option plans. This program is solely funded by proceeds from stock option exercises, including the tax benefit. The Company reacquired approximately $28, $24 and $65 under the stock option program in fiscal 2004, 2003 and 2002, respectively. Effective December 10, 2002, the Board authorized an additional stock repurchase program totaling $500. The Company made open market purchases of $277 and $63 under this plan in fiscal 2003 and 2002, respectively. During fiscal 2004, the Company made open market purchases totaling $144 to complete the program. In September 2004, the Board authorized a new $500 stock repurchase program to replace the December 2002 program. As of January 29, 2005, the Company had made open market purchases totaling $147 under the September 2004 program. Purchases of stock under the Board approved repurchase programs are made when the expected return exceeds our cost of capital.

 


18. BENEFIT PLANS

 

The Company administers non-contributory defined benefit retirement plans for substantially all non-union employees and some union-represented employees as determined by the terms and conditions of collective bargaining agreements. Funding for the pension plans is based on a review of the specific requirements and on evaluation of the assets and liabilities of each plan.

 

In addition to providing pension benefits, the Company provides certain health care benefits for retired employees. The majority of the Company’s employees may become eligible for these benefits if they reach normal retirement age while employed by the Company. Funding of retiree health care benefits occurs as claims or premiums are paid.

 

Information with respect to change in benefit obligation, change in plan assets, net amounts recognized at end of fiscal years, weighted average assumptions and components of net periodic benefit cost follow:

 

     Pension Benefits

    Other Benefits

 
     2004

    2003

    2004

    2003

 

Change in benefit obligation:

                                

Benefit obligation at beginning of fiscal year

   $ 1,844     $ 1,674     $ 363     $ 352  

Service cost

     107       100       10       8  

Interest cost

     115       107       21       21  

Plan participants’ contributions

     —         —         9       8  

Amendments

     —         13       (24 )     (41 )

Actuarial loss

     161       35       19       44  

Benefits paid

     (95 )     (85 )     (32 )     (29 )
    


 


 


 


Benefit obligation at end of fiscal year

   $ 2,132     $ 1,844     $ 366     $ 363  
    


 


 


 


Change in plan assets:

                                

Fair value of plan assets at beginning of fiscal year

   $ 1,379     $ 1,089     $   —       $   —    

Actual return on plan assets

     135       271       —         —    

Employer contribution

     39       104       23       21  

Plan participants’ contributions

     —         —         9       8  

Benefits paid

     (95 )     (85 )     (32 )     (29 )
    


 


 


 


Fair value of plan assets at end of fiscal year

   $ 1,458     $ 1,379     $   —       $   —    
    


 


 


 


 

Pension plan assets include $112 and $134 of common stock of The Kroger Co. at January 29, 2005 and January 31, 2004, respectively. The plan owned 6.6 and 7.3 shares of The Kroger Co. common stock at January 29, 2005 and January 31, 2004, respectively.

 

     Pension Benefits

    Other Benefits

 
     2004

    2003

    2004

    2003

 

Net liability recognized at end of fiscal year:

                                

Funded status at end of year

   $ (674 )   $ (465 )   $ (366 )   $ (363 )

Unrecognized actuarial (gain) loss

     498       361       45       34  

Unrecognized prior service cost

     22       28       (60 )     (50 )

Unrecognized net transition (asset) obligation

     —         (1 )     1       1  
    


 


 


 


Net liability recognized at end of fiscal year

   $ (154 )   $ (77 )   $ (380 )   $ (378 )
    


 


 


 


Prepaid benefit cost

   $ —       $ 2     $ —       $ —    

Accrued benefit liability

     (376 )     (79 )     (380 )     (378 )

Additional minimum liability

     (123 )     (227 )     —         —    

Intangible asset

     24       29       —         —    

Accumulated other comprehensive loss

     321       198       —         —    
    


 


 


 


Net liability recognized at end of fiscal year

   $ (154 )   $ (77 )   $ (380 )   $ (378 )
    


 


 


 


 


     Pension Benefits

    Other Benefits

 
Weighted average assumptions    2004

    2003

    2004

    2003

 

Discount rate – Benefit obligation

   5.75 %   6.25 %   5.75 %   6.25 %

Discount rate – Net periodic benefit cost

   6.25 %   6.75 %   6.25 %   6.75 %

Expected return on plan assets

   8.50 %   8.50 %            

Rate of compensation increase

   3.50 %   3.50 %            

 

To determine the expected return on pension plan assets, the Company contemplates current and forecasted plan asset allocations as well as historical and forecasted returns on various asset categories. The average annual return on pension plan assets was 10.9% for the ten calendar years ended December 31, 2004, net of all fees and expenses. The Company reduced the pension return assumption to 8.5% for 2004 and 2003 from 9.5% in 2002. The Company believes the reduction in the pension return assumption was appropriate because future returns are not expected to achieve the same level of performance as the historical average annual return. For measurement purposes, a 9% initial annual rate of increase, and a 5% ultimate annual rate of increase, in the per capita cost of other benefits, were assumed for pre-retirement age personnel in 2004. In 2003, a 10% initial annual rate of increase, and a 5% ultimate annual rate of increase were assumed.

 

     Pension Benefits

    Other Benefits

 
     2004

    2003

    2002

    2004

    2003

    2002

 

Components of net periodic benefit cost:

                                                

Service cost

   $ 107     $ 100     $ 78     $ 10     $ 8     $ 13  

Interest cost

     115       107       108       21       21       24  

Expected return on plan assets

     (121 )     (122 )     (134 )     —         —         —    

Amortization of:

                                                

Transition asset

     (1 )     (1 )     (1 )     —         —         —    

Prior service cost

     5       5       3       (5 )     (5 )     (2 )

Actuarial (gain) loss

     12       3       2       —         —         (2 )
    


 


 


 


 


 


Net periodic benefit cost

   $ 117     $ 92     $ 56     $ 26     $ 24     $ 33