Kroger Company 10-K 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
THE KROGER CO.
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code (513) 762-4000
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to section 12(g) of the Act:
(Title of class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes x No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes o No x
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 o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§299.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).
Yes o No x
The aggregate market value of the Common Stock of The Kroger Co. held by non-affiliates as of August 18, 2007: $18,043 million.
There were 661,600,170 shares of Common Stock ($1 par value) outstanding as of March 28, 2008.
Documents Incorporated by Reference:
Proxy statement to be filed pursuant to Regulation 14A of the Exchange Act on or before June 2, 2008, incorporated by reference into Part III of Form 10-K.
ITEM 1. BUSINESS.
The Kroger Co. was founded in 1883 and incorporated in 1902. As of February 2, 2008, 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 Companys 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 or furnished them electronically with the SEC.
The Companys 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.
The Company employs approximately 323,000 full and part-time employees. A majority of the Companys employees are covered by collective bargaining agreements negotiated with local unions affiliated with one of several different international unions. There are approximately 330 such agreements, usually with terms of three to five years.
During fiscal 2008, the Company has major labor contracts covering its store employees expiring in Columbus, Indianapolis, Las Vegas, Louisville, Nashville, Phoenix and Portland. Negotiations in 2008 will be challenging as the Company must have competitive cost structures in each market while meeting our associates needs for good wages and affordable health care.
As of February 2, 2008, the Company operated, either directly or through its subsidiaries, 2,486 supermarkets and multi-department stores, 696 of which had fuel centers. Approximately 43% of these supermarkets were operated in Company-owned facilities, including some Company-owned buildings on leased land. The Companys current strategy emphasizes self-development and ownership of store real estate. The Companys 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; marketplace stores; or price impact warehouses.
The combo stores are the primary food store format. They are typically able to earn a return above the Companys 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 natural food and organic 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 products, toys and fine jewelry. Many multi-department stores include a fuel center.
Marketplace stores are smaller in size than multi-department stores. They offer full-service grocery and pharmacy departments as well as an expanded general merchandise area that includes outdoor living products, electronics, home goods and toys. Many marketplace 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, 782 convenience stores and 394 fine jewelry stores. Substantially all of our fine jewelry stores are operated in leased locations. Subsidiaries operated 691of the convenience stores, while 91 were operated through franchise agreements. Approximately 50% 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.
The Company operates retail food and drug stores, multi-department stores, jewelry stores, and convenience stores throughout the United States. The Companys retail operations, which represent substantially all of the Companys consolidated sales, earnings and total assets, are its only reportable segment. All of the Companys operations are domestic. Revenues, profit and losses, and total assets are shown in the Companys Consolidated Financial Statements set forth in Item 8 below.
MERCHANDISING AND MANUFACTURING
Corporate brand products play an important role in the Companys merchandising strategy. Supermarket divisions typically stock approximately 14,400 private label items. The Companys corporate brand products are produced and sold in three quality tiers. Private Selection is the premium quality brand designed to be a unique item in a category or to meet or beat the gourmet or upscale brands. The banner brand (Kroger, Ralphs, King Soopers, etc.), which represents the majority of the Companys 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. Kroger Value or local banner name is the value brand, designed to deliver good quality at a very affordable price.
Approximately 43% of the corporate brand units sold are produced in the Companys manufacturing plants; the remaining corporate brand items are produced to the Companys 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 February 2, 2008, 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 1A. RISK FACTORS.
There are risks and uncertainties that can affect our business. The significant risk factors are discussed below. Please also see the Outlook section in Item 7 of this Form 10-K for forward-looking statements and factors that could cause us not to realize our goals or meet our expectations.
The operating environment for the food retailing industry continues to be characterized by intense price competition, aggressive supercenter expansion, increasing fragmentation of retail formats, entry of non-traditional competitors and market consolidation. We have developed a strategic plan that we believe is a balanced approach that will enable Kroger to meet the wide-ranging needs and expectations of our customers in this challenging economic environment. However, the nature and extent to which our competitors implement various pricing and promotional activities in response to increasing competition - including our execution of our strategic plan - and our response to these competitive actions, can adversely affect our profitability. Our profitability and growth could also be adversely affected by changes in the overall economic environment that impact consumer spending, including discretionary spending.
Customers count on Kroger to provide them with wholesome food products. Concerns regarding the safety of food products sold by Kroger could cause shoppers to avoid purchasing certain products from us, or to seek alternative sources of supply for all of their food needs, even if the basis for the concern is outside of our control. Any lost confidence on the part of our customers would be difficult and costly to reestablish. As such, any issue regarding the safety of any food items sold by Kroger, regardless of the cause, could have a substantial and adverse effect on our operations.
A significant majority of our employees are covered by collective bargaining agreements with unions, and our relationship with those unions, including any work stoppages, could have an adverse impact on our financial results.
We are a party to approximately 330 collective bargaining agreements. We have major contracts expiring in 2008 covering store employees in Columbus, Indianapolis, Las Vegas, Louisville, Nashville, Phoenix and Portland. In future negotiations with labor unions, we expect that rising health care, pension and employee benefit costs, among other issues, will continue to be important topics for negotiation. Upon the expiration of our collective bargaining agreements, work stoppages by the affected workers could occur if we are unable to negotiate acceptable contracts with labor unions. This could significantly disrupt our operations. Further, if we are unable to control health care, pension and wage costs, or gain operational flexibility under our collective bargaining agreements, we may experience increased operating costs and an adverse impact on future results of operations.
Our strategy focuses on improving our customers shopping experience through enhanced service, product selection and value. Successful execution of this strategy requires a balance between sales growth and earnings growth. Maintaining this strategy requires the ability to identify and execute plans to generate cost savings and productivity improvements that can be invested in the merchandising and pricing initiatives necessary to support our customer-focused programs, as well as recognizing and implementing organizational changes as required. If we are unable to execute our plans, or if our plans fail to meet our customers expectations, our sales and earnings growth expectations could be adversely affected.
DATA AND TECHNOLOGY
Our business is increasingly dependent on information technology systems that are complex and vital to continuing operations. If we were to experience difficulties maintaining existing systems or implementing new systems, we could incur significant losses due to disruptions in our operations. Additionally, these systems contain valuable proprietary data that, if breached, would have an adverse effect on Kroger.
As of year-end 2007, Krogers outstanding indebtedness, including capital leases and financing obligations, totaled approximately $8.1 billion. This indebtedness could reduce our ability to obtain additional financing for working capital, acquisitions or other purposes and could make us more vulnerable to economic downturns and competitive pressures. If debt markets do not permit us to refinance certain maturing debt, we may be required to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness. Changes in our credit ratings, or in the interest rate environment, could have an adverse effect on our financing costs and structure.
From time to time, we are a party to legal proceedings, including matters involving personnel and employment issues, personal injury, antitrust claims and other proceedings. Some of these proceedings, including product liability cases, could result in a substantial loss to Kroger in the event that other potentially responsible parties are unable (for financial reasons or otherwise) to satisfy a judgment entered against them. Others purport to be brought as class actions on behalf of similarly situated parties. We estimate our exposure to these legal proceedings and establish accruals for the estimated liabilities. Assessing and predicting the outcome of these matters involves substantial uncertainties. While we currently do not expect any outstanding legal proceedings to have a material effect on the financial condition of Kroger, unexpected outcomes in these legal proceedings, or changes in our evaluations or predictions about the proceedings, could have a material adverse effect on our financial results. Please also refer to the Legal Proceedings section in Item 3 below.
MULTI-EMPLOYER POST-RETIREMENT OBLIGATIONS
As discussed in more detail below in Managements Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies-Post-Retirement Benefit Plans, Kroger contributes to several multi-employer pension plans based on obligations arising under collective bargaining agreements with unions representing employees covered by those agreements. In addition to future contribution obligations that Kroger may have under those plans, there is a risk that the agencies that rate Krogers outstanding debt instruments could view the underfunded nature of these plans unfavorably when determining their ratings on the Companys debt securities. Any downgrading of Krogers debt ratings likely would increase Krogers cost of borrowing.
We use a combination of insurance and self-insurance to provide for potential liability for workers compensation, automobile and general liability, property, director and officers liability, and employee health care benefits. Any actuarial projection of losses is subject to a high degree of variability. Changes in legal trends and interpretations, variability in inflation rates, changes in the nature and method of claims settlement, benefit level changes due to changes in applicable laws, and changes in discount rates could all affect ultimate settlements of claims.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
ITEM 2. PROPERTIES.
As of February 2, 2008, 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 Companys 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 Companys owned assets and capitalized leases at February 2, 2008, was $22,436 million while the accumulated depreciation was $9,938 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, manufacturing and miscellaneous facilities generally are payable monthly at stated amounts. For additional information on lease obligations, see Note 8 to the Consolidated Financial Statements.
ITEM 3. LEGAL PROCEEDINGS.
On October 6, 2006, the Company petitioned the Tax Court (In Re: Ralphs Grocery Company and Subsidiaries, formerly known as Ralphs Supermarkets, Inc., Docket No. 20364-06) for a redetermination of deficiencies set by the Commissioner of Internal Revenue. The dispute at issue involves a 1992 transaction in which Ralphs Holding Company acquired the stock of Ralphs Grocery Company and made an election under Section 338(h)(10) of the Internal Revenue Code. The Commissioner has determined that the acquisition of the stock was not a purchase as defined by Section 338(h)(3) of the Internal Revenue Code and that the acquisition does not qualify as a purchase. The Company believes that it has strong arguments in favor of its position and believes it is more likely than not that its position will be sustained. However, due to the inherent uncertainty involved in the litigation process, there can be no assurances that the Tax Court will rule in favor of the Company. As of February 2, 2008, an adverse decision would require a cash payment of approximately $419 million including interest.
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; Albertsons, Inc. and Ralphs Grocery Company, a division of The Kroger Co., United States District Court Central District of California, Case No. CV04-0687) alleging that the Mutual Strike Assistance Agreement (the Agreement) between the Company, Albertsons, Inc. and Safeway Inc. (collectively, the Retailers), which was designed to prevent the union from placing disproportionate pressure on one or more of the Retailers by picketing such Retailer(s) but not the other Retailer(s) during the labor dispute in southern California, violated Section 1 of the Sherman Act. The lawsuit seeks declarative and injunctive relief. On May 25, 2005, the Court denied a motion for a summary judgment filed by the defendants. Ralphs and the other defendants filed a notice of an interlocutory appeal to the United States Court of Appeals for the Ninth Circuit. On November 29, 2005, the appellate court dismissed the appeal. On December 7, 2006, the Court denied a motion for summary judgment filed by the State of California. 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 adverse effect on the Companys financial condition, results of operations or cash flows.
Various claims and lawsuits arising in the normal course of business, including suits charging violations of certain antitrust, wage and hour, or 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 Companys 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 involve substantial uncertainties. It remains possible that despite managements current belief, material differences in actual outcomes or changes in managements evaluation or predictions could arise that could have a material adverse impact on the Companys financial condition or results of operation.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
COMMON STOCK PRICE RANGE
Main trading market: New York Stock Exchange (Symbol KR)
During fiscal 2006, the Companys Board of Directors adopted a dividend policy and paid three quarterly dividends of $0.065 per share. During fiscal 2007, the Company paid one and three quarterly dividends of $0.065 and $0.075, respectively. On March 1, 2008, the Company paid its fourth quarterly dividend of $0.075 per share. On March 13, 2008, the Company announced that its Board of Directors had increased the quarterly dividend to $.09 per share, payable on June 1, 2008, to shareholders of record at the close of business on May 15, 2008.
Set forth below is a line graph comparing the five-year cumulative total shareholder return on Krogers common stock, based on the market price of the common stock and assuming reinvestment of dividends, with the cumulative total return of companies in the Standard & Poors 500 Stock Index and the Peer Group composed of food and drug companies.
Historically, our peer group has consisted of the major food store companies. In recent years there have been significant changes in the industry, including consolidation and increased competition from supercenters, drug chains, and discount stores. As a result, in 2003 we changed our peer group (the Peer Group) to include companies operating supermarkets, supercenters and warehouse clubs in the United States as well as the major drug chains with which Kroger competes.
Krogers fiscal year ends on the Saturday closest to January 31.
* Total assumes $100 invested on February 2, 2003, in The Kroger Co., S&P 500 Index and the Peer Group, with reinvestment of dividends.
** The Peer Group consists of Albertsons, Inc., Costco Wholesale Corp., CVS Corp, Delhaize Group SA (ADR), Great Atlantic & Pacific Tea Company, Inc., Koninklijke Ahold NV (ADR), Marsh Supermarkets Inc. (Class A), Safeway, Inc., Supervalu Inc., Target Corp., Wal-Mart Stores Inc., Walgreen Co., Whole Foods Market Inc. and Winn-Dixie Stores, Inc. Albertsons, Inc., was substantially acquired by Supervalu in July 2006, and is included through 2005. Marsh Supermarkets was acquired by Marsh Supermarkets Holding Corp. in September 2006, and is included through 2005. Winn-Dixie emerged from bankruptcy in 2006 as a new issue and returns for the old and new issue were calculated then weighted to determine the 2006 return.
Data supplied by Standard & Poors.
The foregoing Performance Graph will not be deemed incorporated by reference into any other filing, absent an express reference thereto.
ISSUER PURCHASES OF EQUITY SECURITIES
ITEM 6. SELECTED FINANCIAL DATA.
ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The Kroger Co. was founded in 1883 and incorporated in 1902. It is one of the nations largest retailers, operating 2,486 supermarket and multi-department stores under two dozen banners including Kroger, Ralphs, Fred Meyer, Food 4 Less, King Soopers, Smiths, Frys, Frys Marketplace, Dillons, QFC and City Market. Of these stores, 696 have fuel centers. We also operate 782 convenience stores and 394 fine jewelry stores.
Kroger operates 42 manufacturing plants, primarily bakeries and dairies, which supply approximately 43% of the corporate brand units sold in our 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. Our operations are reported as a single reportable segment: the retail sale of merchandise to individual customers.
OUR 2007 PERFORMANCE
2007 was a great year for Kroger. Once again, our actual results compare very favorably to our expectations for the year.
At the outset of fiscal 2007, we expected to grow identical sales, excluding fuel, by 3% to 5%. We achieved identical sales, excluding fuel, of 5.3% for fiscal year 2007, exceeding the upper end of our original guidance. We are particularly pleased with such strong identical sales growth in a challenging economic environment, and we believe this demonstrates the resiliency of our business model.
Krogers initial guidance for fiscal 2007 earnings was a range of $1.60 to $1.65 per diluted share. Our 2007 earnings were $1.69 per diluted share, also exceeding the upper end of our original guidance. This equates to 15% growth after adjusting for the extra week in fiscal 2006. This growth, plus Krogers dividend yield of slightly more than 1%, created strong value for shareholders.
Krogers business model is structured to produce sustainable earnings per share growth in a variety of economic and competitive conditions, primarily through strong identical sales growth. We recognize that continual investment in our customers shopping experience is necessary to drive strong, sustainable identical sales growth, and we have the operating cost structure that allows us to afford those pricing and service investments. We believe that Krogers dividend program and the sustainable earnings per share growth created by strong identical sales, slight operating margin improvement, and continued share repurchases is a solid approach to increasing shareholder value.
While the objective of our business model is to create shareholder value, the objective of Krogers Customer 1st strategy is to serve customers. Our Customer 1st strategy and business model work in tandem to build our successful business.
Kroger has several advantages that allow us to grow our business in a competitive industry. Our strong market share and geographic diversity are among the most important. Kroger serves customers in 44 major markets across 31 different states. We define a major market as one in which we operate nine or more stores. Our broad geographical diversity enables us to withstand competitive pressures in multiple markets and to manage unusual economic challenges. Economic conditions can affect our business, but our Customer 1st strategy and business model allow us to provide a strong value proposition to customers whose spending may be pinched by economic pressures.
Market share is critical to us because it allows us to leverage the fixed costs in our business over a wider revenue base. We hold the number one or number two share position in 39 of our 44 major markets. Our fundamental operating philosophy is to maintain and increase market share.
During fiscal 2007, we grew our market share by roughly 65 basis points in our 44 major markets, based on our internal data and analysis. This was on top of very strong growth in 2005 and 2006. During the last three fiscal years combined, Krogers share has increased approximately 165 basis points across our major markets.
RESULTS OF OPERATIONS
The following discussion summarizes our operating results for 2007 compared to 2006 and for 2006 compared to 2005. Comparability is affected by certain income and expense items that fluctuated significantly between and among the periods.
Net earnings totaled $1,181 million for 2007, compared to net earnings totaling $1,115 and $958 million in 2006 and 2005, respectively. The increase in our net earnings for 2007, compared to 2006 and 2005, resulted from spreading fixed costs over our increased identical sales. In addition, 2006 net earnings, compared to 2005, increased due to a 53rd week in that year.
Earnings per diluted share totaled $1.69 in 2007, compared to $1.54 and $1.31 per share in 2006 and 2005, respectively. Earnings per diluted share increased 15% after adjusting for the extra week in fiscal 2006. Net earnings in 2006 benefited from a 53rd week by an estimated $0.07 per share. Our earnings per share growth in 2007, 2006 and 2005 resulted from increased net earnings, strong identical sales growth and the repurchase of Kroger stock. During fiscal 2007, we repurchased 53 million shares of Kroger stock for a total investment of $1,421 million. During fiscal 2006, we repurchased 29 million shares of our stock for a total investment of $633 million. During fiscal 2005, we repurchased 15 million shares of Kroger stock for a total investment of $252 million.
(1) Other sales primarily relate to sales at convenience stores, including fuel, jewelry stores and sales by our manufacturing plants to outside firms.
The growth in our total sales was primarily the result of identical store sales increases and inflation in many core grocery and perishable categories. Increased transaction count and average transaction size were both responsible for our increases in identical supermarket sales, excluding retail fuel operations. After adjusting for the extra week in fiscal 2006, total sales increased 8.2% in 2007 over fiscal 2006.
We define a supermarket as identical when it has been in operation without expansion or relocation for five full quarters. Differences between total supermarket sales and identical supermarket sales primarily relate to changes in supermarket square footage. Annualized identical supermarket sales include all sales at the Fred Meyer multi-department stores. We calculate annualized identical supermarket sales based on a summation of four quarters of identical supermarket sales. Our identical supermarket sales results are summarized in the table below, based on the 52-week period of 2007, compared to the same 52-week period of the previous year. The identical store count in the table below represents the total number of identical supermarkets as of February 2, 2008 and February 3, 2007.
Identical Supermarket Sales
We define a supermarket as comparable when it has been in operation for five full quarters, including expansions and relocations. Annualized comparable supermarket sales include all Fred Meyer multi-departments. We calculate annualized comparable supermarket sales based on a summation of four quarters of comparable sales. Our annualized comparable supermarket sales results are summarized in the table below, based on the 52-week period of 2007, compared to the same 52-week period of the previous year. The comparable store count in the table below represents the total number of comparable supermarkets as of February 2, 2008 and February 3, 2007.
Comparable Supermarket Sales
FIFO Gross Margin
We calculate First-In, First-Out (FIFO) Gross Margin as follows: Sales minus merchandise costs plus Last-In, First-Out (LIFO) charge (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 23.65%, 24.27% and 24.80% in 2007, 2006 and 2005, respectively. Retail fuel sales lowered our FIFO gross margin rate due to the very low FIFO gross margin on retail fuel sales as compared to non-fuel sales. Excluding the effect of retail fuel operations, our FIFO gross margin rates decreased 20 basis points, 26 basis points and 4 basis points in 2007, 2006 and 2005, respectively. The decrease in our non-fuel FIFO gross margin rate reflects our continued reinvestment of operating cost savings into lower prices for our customers.
The LIFO charge in 2007, 2006, and 2005 was $154 million, $50 million and $27 million, respectively. Like many food retailers, we continue to experience product cost inflation at levels that have not occurred for several years. We estimate that product cost inflation was approximately 3% to 3.5% throughout 2007, as compared to estimated inflation rates that averaged approximately 1% over the previous two years. This increase in product cost inflation caused the increase in the LIFO charge in 2007.
Operating, General and Administrative Expenses
Operating, general and administrative (OG&A) expenses consist primarily of employee-related costs such as wages, health care benefit costs and retirement plan costs. Among other items, rent expense, depreciation and amortization expense, and interest expense are not included in OG&A.
OG&A expenses, as a percent of sales, were 17.31%, 17.91% and 18.21% in 2007, 2006 and 2005, respectively. The growth in our retail fuel sales lowers our OG&A rate due to the very low OG&A rate on retail fuel sales as compared to non-fuel sales. OG&A expenses, as a percent of sales excluding fuel, decreased 33 basis points, 9 basis points and 13 basis points in 2007, 2006 and 2005, respectively. Excluding the effect of retail fuel operations and expenses recorded for legal reserves, our OG&A rate declined 16 basis points in 2006. The decrease in our OG&A rate in 2007, excluding the effect of retail fuel operations, was primarily the result of strong identical sales growth, increased productivity, and progress we have made in controlling our utility, health care and pension costs. These improvements were partially offset by increases in credit card fees.
Rent expense was $644 million in 2007, as compared to $649 million and $661 million in 2006 and 2005, respectively. Rent expense, as a percent of sales, was 0.92% in 2007, as compared to 0.98% in 2006 and 1.09% in 2005. The decrease in rent expense, as a percent of sales, reflects our increasing sales and our continued emphasis on owning rather than leasing whenever possible.
Depreciation and Amortization Expense
Depreciation expense was $1,356 million, $1,272 million and $1,265 million for 2007, 2006 and 2005, respectively. The increases in depreciation and amortization expense were the result of capital expenditures totaling $2,060 million, $1,777 million and $1,306 million in 2007, 2006 and 2005, respectively. Depreciation and amortization expense, as a percent of sales, was 1.93%, 1.92% and 2.09% in 2007, 2006 and 2005, respectively. The increase in our depreciation and amortization expense compared to 2006, as a percent of sales, is due to an annual depreciation charge in both years with 2006 containing 53 weeks of sales due to the structure of our fiscal calendar. Excluding the effect of retail fuel operations, the decrease in our depreciation and amortization expense compared to 2005, as a percent of sales, is primarily the result of identical store sales increases.
Net interest expense totaled $474 million, $488 million and $510 million for 2007, 2006 and 2005, respectively. The decrease in interest expense was the result of replacing borrowings with new borrowings at a lower interest rate. The average total debt balance in 2007 was comparable to both 2006 and 2005.
Our effective income tax rate was 35.4%, 36.2% and 37.2% for 2007, 2006 and 2005, respectively. The effective tax rates for 2007 and 2006 differ from the expected federal statutory rate due to the resolution of certain tax issues and an adjustment of certain deferred tax balances, respectively. In addition, the effective income tax rates differ from the expected federal statutory rate in all years presented due to the effect of state taxes.
During the third quarter of 2007, we resolved favorably certain tax issues. This resulted in a 2007 tax benefit of approximately $40 million and reduced our effective rate by 1.9%.
In 2006, during the reconciliation of our deferred tax balances, and after the filing of our annual federal and state tax returns, we identified adjustments to be made in the previous years deferred tax reconciliation. We corrected these deferred tax balances in our Consolidated Financial Statements for the year ended February 3, 2007, which resulted in a reduction of our fiscal 2006 provision for income tax expense of approximately $21 million and reduced the rate by 1.2%. We do not believe these adjustments are material to our Consolidated Financial Statements for the year ended February 3, 2007, or to any prior years Consolidated Financial Statements. As a result, we have not restated any prior year amounts.
COMMON STOCK REPURCHASE PROGRAM
We maintain stock repurchase programs that comply with Securities Exchange Act Rule 10b5-1 and allow for the orderly repurchase of our common stock, from time to time. We made open market purchases totaling $1,151 million, $374 million and $239 million under these repurchase programs during fiscal 2007, 2006 and 2005, respectively. In addition to these repurchase programs, 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, and the tax benefit from these exercises. We repurchased approximately $270 million, $259 million and $13 million under the stock option program during 2007, 2006 and 2005, respectively.
Capital expenditures, including changes in construction-in-progress payables and excluding acquisitions, totaled $2,060 million in 2007 compared to $1,777 million in 2006 and $1,306 million in 2005. The increase in capital spending in 2007 compared to 2006 and 2005 was the result of increasing our focus on remodels, merchandising and productivity projects. The table below shows our supermarket storing activity and our total food store square footage:
Supermarket Storing Activity
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 (GAAP) requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, and related disclosures of contingent assets and liabilities. We base our estimates on historical experience and other factors we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates.
We believe 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.
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 February 2, 2008. We establish case reserves for reported claims using case-basis evaluation of the underlying claim data and we update as information becomes known.
For both workers compensation and general liability claims, 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. We account for the liabilities for workers compensation claims on a present value basis utilizing a risk-adjusted discount rate. A 25 basis point decrease in our discount rate would increase our liability by approximately $3 million. General liability claims are not discounted.
We are also similarly self-insured for property-related losses. We have purchased stop-loss coverage to limit our exposure to losses in excess of $25 million on a per claim basis, except in the case of an earthquake, for which stop-loss coverage is in excess of $50 million per claim, up to $200 million per claim in California and $300 million outside of California.
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 affect ultimate costs. Our estimates of liabilities incurred do not anticipate significant changes in historical trends for these variables, and any changes could have a considerable effect on future claim costs and currently recorded liabilities.
Impairments of Long-Lived Assets
In accordance with Statement of Financial Accounting Standards (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, we perform an impairment calculation, comparing projected undiscounted cash flows, utilizing current cash flow information and expected growth rates related to specific stores, to the carrying value for those stores. If we identify impairment for long-lived assets to be held and used, we compare discounted future cash flows to the assets 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, we adjust the value of the property and equipment to reflect recoverable values based on our previous efforts to dispose of similar assets and current economic conditions. We recognize impairment for the excess of the carrying value over the estimated fair market value, reduced by estimated direct costs of disposal. We recorded asset impairments in the normal course of business totaling $24 million, $61 million, and $48 million in 2007, 2006 and 2005, respectively. We record costs to reduce the carrying value of long-lived assets in the Consolidated Statements of Operations as Operating, general and administrative expense.
The factors that most significantly affect the impairment calculation are our estimates of future cash flows. Our cash flow projections look several years into the future and include assumptions on variables such as inflation, the economy and market competition. Application of alternative assumptions and definitions, such as reviewing long-lived assets for impairment at a different organizational level, could produce significantly different results.
We review goodwill for impairment during the fourth quarter of each year, and also upon the occurrence of trigger events. We perform reviews at the operating division level. Generally, fair value is determined using a multiple of earnings, or discounted projected future cash flows, and we compare fair value to the carrying value of a division for purposes of identifying potential impairment. We base projected future cash flows on managements knowledge of the current operating environment and expectations for the future. If we identify potential for impairment, we measure the fair value of a division against the fair value of its underlying assets and liabilities, excluding goodwill, to estimate an implied fair value of the divisions goodwill. We recognize goodwill impairment for any excess of the carrying value of the divisions goodwill over the implied fair value. If actual results differ significantly from anticipated future results for certain reporting units, we would need to recognize an impairment loss for any excess of the carrying value of the divisions goodwill over the implied fair value. Results of the goodwill impairment reviews performed during 2007, 2006 and 2005 are summarized in Note 2 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.
In addition to goodwill, we have recorded intangible assets totaling $32 million, $24 million and $34 million for leasehold equities, liquor licenses and pharmacy prescription file purchases, respectively, at February 2, 2008. Balances at February 3, 2007, were $26 million, $22 million and $28 million for lease equities, liquor licenses and pharmacy prescription files, respectively. We amortize leasehold equities over the remaining life of the lease. We do not amortize owned liquor licenses, however, we amortize liquor licenses that must be renewed over their useful lives. We amortize pharmacy prescription file purchases over seven years. We consider these assets annually during our testing 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. We usually pay closed store lease liabilities 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. We make adjustments for changes in estimates in the period in which the change becomes known. We review store closing liabilities 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 earnings 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. 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.
We reduce owned stores held for disposal to their estimated net realizable value. We account for costs to reduce the carrying values of property, equipment and leasehold improvements in accordance with our policy on impairment of long-lived assets. We classify inventory write-downs in connection with store closings, if any, in Merchandise costs. We expense costs to transfer inventory and equipment from closed stores as they are incurred.
Post-Retirement Benefit Plans
(a) Company-sponsored Pension Plans
We account for our pension plans using the recognition and disclosure provisions of SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB Statements No. 87, 99, 106 and 132(R), which require the recognition of the funded status of retirement plans on the Consolidated Balance Sheet. We record, as a component of Accumulated Other Comprehensive Income (AOCI), actuarial gains or losses, prior service costs or credits and transition obligations that have not yet been recognized. We currently use a December 31 measurement date. Effective for 2008, the statement also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position. We will adopt the measurement date change in fiscal 2008.
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 14 to the Consolidated Financial Statements and include, among others, the discount rate, the expected long-term rate of return on plan assets, average life expectancy and the rate of increases in compensation and health care costs. 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, including the discount rate used and the expected return on plan assets, may materially affect our pension and other post-retirement obligations and our future expense. Note 14 to the Consolidated Financial Statements discusses the effect of a 1% change in the assumed health care cost trend rate on other post-retirement benefit costs and the related liability.
The objective of our discount rate assumption is to reflect the rate at which the pension benefits could be effectively settled. In making this determination, we take into account the timing and amount of benefits that would be available under the plans. Our methodology for selecting the discount rate as of year-end 2007 was to match the plans cash flows to that of a yield curve that provides the equivalent yields on zero-coupon corporate bonds for each maturity. Benefit cash flows due in a particular year can be settled theoretically by investing them in the zero-coupon bond that matures in the same year. The discount rate is the single rate that produces the same present value of cash flows. The selection of the 6.50% discount rate as of year-end 2007 represents the equivalent single rate under a broad-market AA yield curve constructed by an outside consultant. We utilized a discount rate of 5.90% for year-end 2006. The 60 basis point increase in the discount rate decreased the projected pension benefit obligation as of February 2, 2008, by approximately $184 million.
To determine the expected return on pension plan assets, we consider current and forecasted plan asset allocations as well as historical and forecasted returns on various asset categories. For 2007 and 2006, we assumed a pension plan investment return rate of 8.5%. Our pension plans average return was 8.5% for the 10 calendar years ended December 31, 2007, net of all investment management fees and expenses. Our actual return for the pension plan calendar year ending December 31, 2007, on that same basis, was 9.5%. We believe the pension return assumption is appropriate because we expect that future returns will achieve the same level of performance as the historical average annual return. We have been advised that during 2008, the trustees plan to increase the allocation of non-core assets, including high yield debt securities, commodities, hedge funds and real estate from 42% to 52%. The trustees have also indicated that they plan to increase hedge funds within these sectors from 17% to 22% to augment risk and return. Collectively, these changes should improve the diversification of pension plan assets. The trustees have advised us that they expect these changes will have little effect on the total return but will reduce the expected volatility of the return. See Note 14 to the Consolidated Financial Statements for more information on the asset allocations of pension plan assets.
Sensitivity to changes in the major assumptions used in the calculation of Krogers pension plan liabilities for the Qualified Plans is illustrated below (in millions).
We contributed $52 million and $150 million to our Company-sponsored pension plans in 2007 and 2006, respectively. Although we are not required to make cash contributions to our Company-sponsored pension plans during fiscal 2008, contributions may be made if required under the Pension Protection Act to avoid any benefit restrictions. We expect any elective contributions made during 2008 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.
Net periodic benefit cost decreased in 2007 compared to 2006 and 2005 due to participants in the Cash Balance formula of the Consolidated Retirement Benefit Plan being moved to a 401(k) retirement savings account plan effective January 1, 2007. Participants under that formula continue to earn interest on prior contributions but no additional pay credits will be earned. The 401(k) retirement savings plan provides to eligible employees both matching contributions and automatic contributions from Kroger based on participant contributions, plan compensation, and length of service. We contributed and expensed $90 million to employee 401(k) retirement savings accounts in 2007.
(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 $207 million in 2007, $204 million in 2006, and $196 million in 2005.
Based on the most recent information available to us, we believe that the present value of actuarially 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, 2007. Because Kroger is only one of a number of employers contributing to these plans, we also have attempted to estimate the ratio of Krogers contributions to the total of all contributions to these plans in a year as a way of assessing Krogers share of the underfunding. As of December 31, 2007, we estimate that Krogers share of the underfunding of multi-employer plans to which Kroger contributes was $500 million to $700 million, pre-tax, or $315 million to $440 million, after-tax. This represents a decrease in the amount of underfunding estimated as of December 31, 2006. This decrease is attributable to, among other things, the investment returns on assets held in trust for the plans during 2007. Our estimate is based on the best information available to us including actuarial evaluations and other data (that include the estimates of others), and such information may be outdated or otherwise unreliable. 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. In 2007, our contributions to these plans increased approximately 1% over the prior year and have grown at a compound annual rate of approximately 5% since 2004. We expect our contributions to remain consistent subject to collective bargaining and capital market conditions. The projected contribution amounts in 2008 and beyond has been favorably affected by significant improvement in the values of assets held in trusts, by the labor agreements negotiated in recent years, and by related trustee actions. Although underfunding can result in the imposition of excise taxes on contributing employers, increased contributions or benefit reductions can reduce underfunding so that excise taxes are not triggered. Our estimate contemplates neither increased contributions or reduced benefits. 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 SFAS No. 87, Employers Accounting for Pensions.
The amount of underfunding described above is an estimate and is disclosed for the purpose described. The amount could decline, and Krogers 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, Krogers share of the underfunding would increase and Krogers future expense could be adversely affected if net asset values decline, if employers currently contributing to these funds cease participation or if changes occur through collective bargaining, trustee action or adverse legislation.
We 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.
Uncertain Tax Positions
Effective February 4, 2007, we adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109 (FIN No. 48), which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.
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 February 2, 2008, the Internal Revenue Service has concluded an examination for tax years 2002 through 2004.
The assessment of our uncertain tax positions 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 that 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.
Share-Based Compensation Expense
We account for share-based compensation expense in accordance with the fair value recognition provisions of SFAS No. 123(R), Share-Based Payment. Under this method, we recognize compensation expense for all share-based payments granted on or after January 29, 2006, as well as all share-based payments granted prior to, but not yet vested as of, January 29, 2006, in accordance with SFAS No. 123(R). Under the fair value recognition provisions of SFAS No. 123(R), we recognize share-based compensation expense, net of an estimated forfeiture rate, over the requisite service period of the award. Prior to January 29, 2006, we applied APB No. 25, and related interpretations, in accounting for our stock option plans and provided the pro-forma disclosures required by SFAS No. 123. APB No. 25 provided for recognition of compensation expense for employee stock awards based on the intrinsic value of the award on the grant date.
Inventories are stated at the lower of cost (principally on a LIFO basis) or market. In total, approximately 97% and 98% of inventories for 2007 and 2006, 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 $604 million at February 2, 2008, and by $450 million at February 3, 2007. We follow the Link-Chain, Dollar-Value LIFO method for purposes of calculating our LIFO charge or credit.
We follow item-cost method of accounting to determine inventory cost before the LIFO adjustment for substantially all store inventories 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 and cash discounts) of each item and recording the 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.
We recognize all vendor allowances as a reduction in merchandise costs when the related product is sold. In most cases, vendor allowances are applied to the related product by item, and therefore reduce the carrying value of inventory by item. When it is not practicable to allocate vendor allowances to the product by item, we recognize vendor allowances as a reduction in merchandise costs based on inventory turns and as the product is sold. We recognized approximately $3.6 billion, $3.3 billion and $3.2 billion of vendor allowances as a reduction in merchandise costs in 2007, 2006 and 2005, respectively. We recognized more than 85% of all vendor allowances in the item cost with the remainder being based on inventory turns.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flow Information
Net cash provided by operating activities
We generated $2,581 million of cash from operations in 2007 compared to $2,351 million in 2006 and $2,192 million in 2005. The increase in cash generated from operating activities was primarily due to strong operating results adjusted for non-cash expenses. In addition, changes in our operating assets and liabilities also affect the amount of cash provided by our operating activities. We realized a $163 million, $129 million and $121 million decrease in cash from changes in operating assets and liabilities in 2007, 2006 and 2005, respectively. The decrease in 2007 is primarily attributable to an increase in forward inventory buying activity. These amounts are also net of cash contributions to our Company-sponsored pension plans totaling $52 million in 2007, $150 million in 2006 and $300 million in 2005.
The amount of cash paid for income taxes in 2007 was higher than the amounts paid in 2006 and 2005 due to higher net earnings.
Net cash used by investing activities
Cash used by investing activities was $2,218 million in 2007, compared to $1,587 million in 2006 and $1,279 million in 2005. The amount of cash used by investing activities increased in 2007 compared to 2006 and 2005 due primarily to higher capital spending and payments for two acquisitions. Capital expenditures, including changes in construction-in-progress payables and excluding acquisitions, were $2,060 million, $1,777 million and $1,306 million in 2007, 2006 and 2005, respectively. Refer to the Capital Expenditures section for an overview of our supermarket storing activity during the last three years.
Net cash used by financing activities
Financing activities used $310 million of cash in 2007 compared to $785 million in 2006 and $847 million in 2005. The decrease in the amount of cash used was primarily a result of proceeds received from the issuance of long term-debt, offset by greater stock repurchases and dividends paid. We repurchased $1,421 million of Kroger stock in 2007 compared to $633 million in 2006 and $252 million in 2005. We paid dividends totaling $202 million in 2007 compared to $140 million in 2006.
Total debt, including both the current and long-term portions of capital leases and financing obligations, increased $1,062 million to $8.1 billion as of year-end 2007 from $7.1 billion as of year-end 2006. Total debt decreased $173 million to $7.1 billion as of year-end 2006 from $7.2 billion as of year-end 2005. The increases in 2007, compared to 2006, resulted from the issuance of $600 million of senior notes bearing an interest rate of 6.4%, $750 million of senior notes bearing an interest rate of 6.15% and borrowings under the bank credit facility in 2007, offset by the repayment of $200 million of senior notes bearing an interest rate of 7.65% and $300 million of senior notes bearing an interest rate of 7.80% that came due in 2007. The decreases in 2006, compared to 2005, were primarily the result of using cash flow from operations to reduce outstanding debt.
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 Accounting for Derivative Investments and Hedging Activities, as amended. We had prefunded employee benefit costs of $300 million at year-end 2007, 2006 and 2005. The mark-to-market adjustments increased the carrying value of our debt by $44 million and $18 million as of year-end 2007 and 2006.
Factors Affecting Liquidity
We currently borrow on a daily basis approximately $250 million under our F2/P2/A3 rated commercial paper (CP) program. These borrowings are backed by our credit facility, and reduce the amount we can borrow under the credit facility. We have capacity available under our credit facility to backstop all CP amounts outstanding. If our credit rating declines 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 facility, under which we believe we have sufficient capacity. 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 facility is not affected by our credit rating, the interest cost on borrowings under the credit facility could be affected by a decrease in our credit rating or a decrease in our Applicable Percentage Ratio.
Our credit facility also requires the maintenance of a Leverage Ratio and a Fixed Charge Coverage Ratio (our financial covenants). A failure to maintain our financial covenants would impair our ability to borrow under the credit facility. These financial covenants and ratios are described below:
Consolidated EBITDA, as defined in our credit facility, includes an adjustment for unusual gains and losses. Our credit agreement is more fully described in Note 5 to the Consolidated Financial Statements. We were in compliance with our financial covenants at year-end 2007.
The tables below illustrate our significant contractual obligations and other commercial commitments, based on year of maturity or settlement, as of February 2, 2008 (in millions of dollars):
(1) The contractual obligations table excludes funding of pension and other postretirement benefit obligations, which totaled approximately $76 million in 2007. This table also excludes contributions under various multi-employer pension plans, which totaled $207 million in 2007.
(2) We adopted FIN 48 on February 4, 2007. See Note 4 to our Consolidated Financial Statements for the adoption of FIN 48. The liability related to unrecognized tax benefits has been excluded from the contractual obligations table because a reasonable estimate of the timing of future tax settlements cannot be determined.
(3) Amounts include contractual interest payments using the interest rate as of February 2, 2008 applicable to our variable interest debt instruments, excluding commercial paper borrowings due to the short-term nature of these borrowings, and stated fixed and swapped interest rates for all other debt instruments.
(4) The amounts included in the contractual obligations table for self-insurance liability have been stated on a present value basis.
Our construction commitments include funds owed to third parties for projects currently under construction. These amounts are reflected in other current liabilities 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 February 2, 2008, we maintained a $2.5 billion, five-year revolving credit facility that, unless extended, terminates in 2011. Outstanding borrowings under the credit agreement and commercial paper borrowings, and some outstanding letters of credit, reduce funds available under the credit agreement. In addition to the credit agreement, we maintained four money market lines totaling $125 million in the aggregate. The money market lines allow us to borrow from banks at mutually agreed upon rates, usually at rates below the rates offered under the credit agreement. As of February 2, 2008, we had net outstanding commercial paper and borrowings under our credit agreement totaling $345 and $225 million, respectively, that reduced amounts available under our credit agreement and had no borrowings under the money market lines. The outstanding letters of credit that reduced the funds available under our credit agreement totaled $355 million as of February 2, 2008.
In addition to the available credit mentioned above, as of February 2, 2008, we had available for issuance $1,250 million of securities under a shelf registration statement filed with the SEC and effective on December 20, 2007.
We also maintain surety bonds related primarily to our self-insured workers compensation claims. These bonds are required by most states in which we are self-insured for workers compensation and are placed with third-party insurance providers to insure payment of our obligations in the event we are unable to meet our claim payment obligations up to our self-insured retention levels. These bonds do not represent liabilities of Kroger, as we already have reserves on our books for the claims costs. Market changes may make the surety bonds more costly and, in some instances, availability of these bonds may become more limited, which could affect our costs of, or access to, such bonds. Although we do not believe increased costs or decreased availability would significantly affect our ability to access these surety bonds, if this does become an issue, we would issue letters of credit, in states where allowed, against our credit facility to meet the state bonding requirements. This could increase our cost and decrease the funds available under our credit facility.
Most of our outstanding public debt is jointly and severally, fully and unconditionally guaranteed by The Kroger Co. and some of our subsidiaries. See Note 17 to the Consolidated Financial Statements for a more detailed discussion of those arrangements. In addition, we have guaranteed half of the indebtedness of two real estate entities in which we have 50% membership interest. Our share of the responsibility for this indebtedness, should the entities be unable to meet their obligations, totals approximately $7 million. Based on the covenants underlying this indebtedness as of February 2, 2008, it is unlikely that we will be responsible for repayment of these obligations. We have also agreed to guarantee, up to $10 million, the indebtedness of an entity of which we have 25% membership interest. The guarantee is collateralized by inventory of the entity. Our share of the responsibility, as of February 2, 2008, should the entity be unable to meet its obligations, totals approximately $9 million and is collateralized by $8 million of inventory located in our stores.
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, we enter into various indemnification agreements and take on indemnification obligations in the ordinary course of business. Such arrangements include indemnities against third party claims arising out of agreements to provide services to Kroger; indemnities related to the sale of our securities; indemnities of directors, officers and employees in connection with the performance of their work; and indemnities of individuals serving as fiduciaries on benefit plans. While Krogers aggregate indemnification obligation could result in a material liability, we are not aware of any current matter that could result in a material liability.
RECENTLY ADOPTED ACCOUNTING STANDARDS
Effective February 4, 2007, we adopted FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109 (FIN No. 48), which prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.
The effect of adoption was to increase retained earnings by $4 million and to decrease our accrual for uncertain tax positions by a corresponding amount. Additionally, we decreased goodwill and accrual for uncertain tax positions by $72 million to reflect the measurement under the rules of FIN No. 48 of an uncertain tax position related to previous business combinations.
As of adoption, the total amount of unrecognized tax benefits for uncertain tax positions, including positions affecting only the timing of tax benefits, was $694 million. The amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate was $119 million.
To the extent interest and penalties would be assessed by taxing authorities on any underpayment of income tax, such amounts have been accrued and classified as a component of income tax expense in our Condensed Consolidated Statements of Operations. This accounting policy election is a continuation of our historical policy. As of February 4, 2007, the amount of accrued interest and penalties included on the Condensed Consolidated Balance Sheets was $118 million.
The IRS concluded a field examination of our 2002 2004 U.S. tax returns during the third quarter of 2007. An examination of our 1999 2001 U.S. tax returns was completed in 2005. We contested two issues at the appellate level of the IRS. One of the issues was resolved in the third quarter of 2007 and we anticipate that the remaining issue may be resolved within the next 12 months. In the opinion of management, the ultimate disposition of the item noted above will not have a significant effect on our consolidated financial position, liquidity, or results of operations. Additionally, we have a case in the U.S. Tax Court. A decision on this case is not expected within the next 12 months. In connection with this case, we have extended the statute of limitations on our tax years after 1991.
As a result of settlements with taxing authorities during the third quarter, we reclassified unrecognized tax benefits of $168 million from other long-term liabilities to deferred income taxes and accrued taxes payable.
Effective February 3, 2007, we adopted the recognition and disclosure provisions of SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB Statement No. 87, 99, 106 and 132(R), which requires the recognition of the funded status of its retirement plans on the Consolidated Balance Sheet. Actuarial gains or losses, prior service costs or credits and transition obligations that have not yet been recognized are required to be recorded as a component of Accumulated Other Comprehensive Income (AOCI). We currently use a December 31 measurement date. Effective for 2008, the statement also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position. We will adopt the measurement date change in fiscal 2008.
Effective January 29, 2006, we adopted the provisions of SFAS No. 123(R), Share-Based Payment, using the modified-prospective method. Under this method, we recognize compensation expense for all share-based awards granted prior to, but not yet vested as of, January 29, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, Accounting for Stock-Based Compensation. For all share-based awards granted on or after January 29, 2006, we recognize compensation expense based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R).
RECENTLY ISSUED ACCOUNTING STANDARDS
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurement. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurement. SFAS No. 157 does not require any new fair value measurements. SFAS No. 157 will become effective for our fiscal year beginning February 3, 2008. We are evaluating the effect the implementation of SFAS No. 157 will have on our Consolidated Financial Statements.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115. SFAS No. 159 permits entities to make an irrevocable election to measure certain financial instruments and other assets and liabilities at fair value on an instrument-by-instrument basis. Unrealized gains and losses on items for which the fair value option has been elected should be recognized into net earnings at each subsequent reporting date. SFAS No. 159 will become effective for our fiscal year beginning February 3, 2008. We are currently evaluating the effect the adoption of SFAS No. 159 will have on our Consolidated Financial Statements.
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements-an amendment of ARB No. 51. SFAS No. 160 will require the consolidation of noncontrolling interests as a component of equity. SFAS No. 160 will become effective for our fiscal year beginning February 1, 2009. We are currently evaluating the effect the adoption of SFAS No. 160 will have on our Consolidated Financial Statements.
In December 2007, the FASB issued SFAS No. 141 (Revised 2007), Business Combinations (SFAS No. 141R), which replaces SFAS No. 141. SFAS No. 141R further expands the definitions of a business and the fair value measurement and reporting in a business combination. SFAS No. 141R will become effective for our fiscal year beginning February 1, 2009. We are currently evaluating the effect the adoption of SFAS No. 141R will have on our Consolidated Financial Statements.
In March 2007, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities. SFAS No. 161 requires enhanced disclosures on an entitys derivative and hedging activities. SFAS No. 161 will become effective for our fiscal year beginning February 1, 2009. We are currently evaluating the effect the adoption of SFAS No. 161 will have on our Consolidated Financial Statements.
This discussion and analysis contains certain forward-looking statements about Krogers future performance. These statements are based on managements 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, will, 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.
Various uncertainties and other factors could cause us to fail to achieve our goals. These include:
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.
Financial Risk Management
We use derivative financial instruments primarily to manage our exposure to 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 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 outstanding borrowings to determine annual debt amounts subject to interest rate exposure, (ii) limit the average 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 February 2, 2008, we maintained six interest rate swap agreements, with notional amounts totaling approximately $1,050 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 March 2008 and January 2015. The differential between fixed and variable rates to be paid or received is accrued as interest rates change in accordance with the agreements as an adjustment to interest expense. These interest rate swap agreements are being accounted for as fair value hedges. As of February 2, 2008, other long-term assets totaling $11 million were recorded to reflect the fair value of these agreements, offset by increases in the fair value of the underlying debt.
In addition to the interest rate swaps noted above, in 2005 the Company entered into three forward-starting interest rate swap agreements with a notional amount totaling $750 million. In 2007, the Company terminated two of these forward-starting interest rate swaps in a notional amount of $500 million. A forward-starting interest rate swap is an agreement that effectively hedges future benchmark interest rates on debt for an established period of time. The Company entered into the forward-starting interest rate swaps in order to lock into fixed interest rates on forecasted issuances of debt in 2007 and 2008. The unamortized payment and proceeds on the two terminated forward-starting interest rate swaps have been recorded net of tax in other comprehensive income and will be amortized to earnings as the payments of interest to which the hedges relate are made. The one remaining forward-starting interest rate swap as of February 2, 2008 has a ten-year term with a fixed interest rate of 5.11%. As of February 2, 2008, other long-term liabilities totaling $18 million were recorded to reflect the fair value of this agreement.
During 2003, we terminated six interest rate swap agreements that we accounted for as fair value hedges. We recorded approximately $114 million of proceeds received as a result of these terminations as adjustments to the carrying values of the underlying debt and they are being amortized over the remaining lives of the debt. As of February 2, 2008, the unamortized balances totaled approximately $33 million.
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 February 2, 2008. 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 February 2, 2008. Interest rates reflect the weighted average rate 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 February 2, 2008. The Fair-Value column includes the fair-value of our debt instruments and interest rate derivatives as of February 2, 2008. Refer to Notes 5, 6 and 7 to our Consolidated Financial Statements:
We expect the average pay rate for 2008 to decline from the table above by 40 to 50 basis points due to the recent Federal Reserve interest rate cuts in March 2008.
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, warehouses, 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.
Some of the product we purchase is shipped in corrugated cardboard packaging. We sell corrugated cardboard when it is economical to do so. As of February 2, 2008, we maintained three derivative instruments to manage exposure to changes in corrugated cardboard prices. These derivatives contain a three-year term. The instruments do not qualify for hedge accounting, in accordance with SFAS No. 133, Accounting for Derivative Investments and Hedging Activities, as amended. Accordingly, changes in the fair value of these instruments are marked-to-market in our Consolidated Statements of Operations in OG&A expenses. As of February 2, 2008, an accrued liability totaling $1 million had been recorded to reflect the fair value of these instruments.
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.:
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 February 2, 2008 and February 3, 2007, and the results of their operations and their cash flows for each of the three years in the period ended February 2, 2008 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of February 2, 2008, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Companys management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Managements Report on Internal Control Over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements and on the Companys internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included 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. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
As discussed in Note 15 to the consolidated financial statements, the Company adopted the provisions of Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes, as of February 4, 2007, the recognition and disclosure provisions of Statement of Financial Accounting Standards No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans, as of February 3, 2007 and the provisions of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment, as of January 29, 2006.
A companys 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 companys 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 companys 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.
/s/ PricewaterhouseCoopers LLP
April 1, 2008
THE KROGER CO.
CONSOLIDATED BALANCE SHEETS