KROGER CO - Annual Report: 2017 (Form 10-K)

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

(Mark One)

 

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

 

For the fiscal year ended January 28, 2017.

 

OR

 

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

 

For the transition period from                    to                   

 

Commission file number 1-303

 

THE KROGER CO.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s 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:

 

NONE

(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.

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

 

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.

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

 

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 registrant’s 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. ☒

 

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.

 

 

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).

 

The aggregate market value of the Common Stock of The Kroger Co. held by non-affiliates as of August 13, 2016:  $30.6 billion.  There were 914,240,326 shares of Common Stock ($1 par value) outstanding as of March 22, 2017.

 

Documents Incorporated by Reference:

 

Portions of the proxy statement to be filed pursuant to Regulation 14A of the Exchange Act on or before May 26, 2017, are incorporated by reference into Part III of this Form 10-K.

 

 

 

PART I

 

FORWARD LOOKING STATEMENTS.

 

This Annual Report on Form 10-K contains forward-looking statements about our future performance.  These statements are based on our assumptions and beliefs in light of the information currently available to us.  These statements are subject to a number of known and unknown risks, uncertainties and other important factors, including the risks and other factors discussed in “Risk Factors” and “Outlook” below, that could cause actual results and outcomes to differ materially from any future results or outcomes expressed or implied by such forward looking statements.  Such statements are indicated by words such as “comfortable,” “committed,” “will,” “expect,” “goal,” “should,” “intend,” “target,” “believe,” “anticipate,” “plan,” and similar words or phrases.  Moreover, statements in the sections entitled Risk Factors, Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) and Outlook, and elsewhere in this report regarding our expectations, projections, beliefs, intentions or strategies are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended.

 

ITEM 1.BUSINESS.

 

The Kroger Co. (the “Company” or “Kroger”) was founded in 1883 and incorporated in 1902.  As of January 28, 2017, we are one of the largest retailers in the world based on annual sales.  We also manufacture and process some of the food for sale in our supermarkets.  We maintain a web site (www.thekrogerco.com) that includes additional information about the Company.  We make available through our web site, free of charge, our annual reports on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and our interactive data files, including amendments.  These forms are available as soon as reasonably practicable after we have filed them with, or furnished them electronically to, the SEC.

 

Our revenues are predominately earned and cash is generated as consumer products are sold to customers in our stores, fuel centers and via our online platforms. We earn income predominantly by selling products at price levels that produce revenues in excess of the 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 fiscal year ends on the Saturday closest to January 31.  All references to 2016, 2015 and 2014 are to the fiscal years ended January 28, 2017, January 30, 2016 and January 31, 2015, respectively, unless specifically indicated otherwise.

 

EMPLOYEES

 

As of January 28, 2017, Kroger employed approximately 443,000 full- and part-time employees. A majority of our employees are covered by collective bargaining agreements negotiated with local unions affiliated with one of several different international unions. There are approximately 366 such agreements, usually with terms of three to five years.

 

STORES

 

As of January 28, 2017, Kroger operated, either directly or through its subsidiaries, 2,796 supermarkets under a variety of local banner names, of which 2,255 had pharmacies and 1,445 had fuel centers.  We also offer ClickList™ and Harris Teeter ExpressLane—  personalized, order online, pick up at the store services —  at 637 of our supermarkets.  Approximately 48% of these supermarkets were operated in Company-owned facilities, including some Company-owned buildings on leased land.  Our current strategy emphasizes self-development and ownership of store real estate.  Our stores operate under a variety of banners that have strong local ties and brand recognition.  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 store is the primary food store format.  They typically draw customers from a 2 — 2.5 mile radius.  We believe 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.

 

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, outdoor living, electronics, automotive products, toys and fine jewelry.

 

Marketplace stores are smaller in size than multi-department stores.  They offer full-service grocery, pharmacy and health and beauty care departments as well as an expanded perishable offering and general merchandise area that includes apparel, home goods and toys.

 

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 the supermarkets, as of January 28, 2017, we operated, through subsidiaries, 784 convenience stores, 319 fine jewelry stores and an online retailer.  All 114 of our fine jewelry stores located in malls are operated in leased locations.  In addition, 69 convenience stores were operated by franchisees through franchise agreements.  Approximately 56% 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 fuel.

 

SEGMENTS

 

We operate supermarkets, multi-department stores, jewelry stores, and convenience stores throughout the United States.  Our retail operations, which represent over 98% of our consolidated sales and earnings before interest, taxes and depreciation and amortization (“EBITDA”), is our only reportable segment.  We aggregate our operating divisions into one reportable segment due to the operating divisions having similar economic characteristics with similar long-term financial performance.  In addition, our operating divisions offer customers similar products,  have similar distribution methods, operate in similar regulatory environments, purchase the majority of the merchandise for retail sale from similar (and in many cases identical) vendors on a coordinated basis from a centralized location, serve similar types of customers, and are allocated capital from a centralized location. Our operating divisions are organized primarily on a geographical basis so that the operating division management team can be responsive to local needs of the operating division and can execute company strategic plans and initiatives throughout the locations in their operating division. This geographical separation is the primary differentiation between these retail operating divisions.  The geographical basis of organization reflects how the business is managed and how our Chief Executive Officer, who acts as our chief operating decision maker, assesses performance internally.  All of our operations are domestic.  Revenues, profits and losses and total assets are shown in our Consolidated Financial Statements set forth in Item 8 below.

 

MERCHANDISING AND MANUFACTURING

 

Corporate brand products play an important role in our merchandising strategy.  Our supermarkets, on average, stock over 14,000 private label items.  Our corporate brand products are primarily produced and sold in three “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®, Fred Meyer®, King Soopers®, etc.), which represents the majority of our private label items, is designed to satisfy customers with quality products.  Before we will carry a “banner brand” product we must be satisfied that the product quality meets our customers’ expectations in taste and efficacy, and we guarantee it.  P$$T…®, Check This Out… and Heritage Farm™ are the three value brands, designed to deliver good quality at a very affordable price.   In addition, we continue to grow our other brands, including Simple Truth® and Simple Truth Organic®.  Both Simple Truth and Simple Truth Organic are Free From 101+ artificial preservatives and ingredients that customers have told us they do not want in their food, and the Simple Truth Organic products are USDA certified organic.

 

Approximately 35% of the corporate brand units sold in our supermarkets are produced in our food production plants; the remaining corporate brand items are produced to our strict specifications by outside manufacturers. This percentage has declined recently due to an expanded portfolio of non-grocery corporate brand units produced by outside manufacturers.  Our food production plants produced 45% of our grocery category corporate brand units sold in our supermarkets, which is consistent with our historical trend.  We perform a “make or buy” analysis on corporate brand products and decisions are based upon a comparison of market-based transfer prices versus open market purchases.  As of January 28, 2017, we operated 38 food production plants. These plants consisted of 17 dairies, ten deli or bakery plants, five grocery product plants, two beverage plants, two meat plants and two cheese plants.

 

SEASONALITY

 

The majority of our revenues are generally not seasonal in nature.  However, revenues tend to be higher during the major holidays throughout the year.  Additionally, significant inclement weather systems, particularly winter storms, tend to affect our sales trends.

 

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.

 

COMPETITIVE ENVIRONMENT

 

For the disclosure related to our competitive environment, see Item 1A under the heading “Competitive Environment.”

 

ITEM 1A.RISK FACTORS.

 

There are risks and uncertainties that can affect our business.  The significant risk factors are discussed below.  The following information should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the “Outlook” section in Item 7 of this Form 10-K, which include forward-looking statements and factors that could cause us not to realize our goals or meet our expectations.

 

COMPETITIVE ENVIRONMENT

 

The operating environment for the food retailing industry continues to be characterized by intense price competition, aggressive expansion, increasing fragmentation of retail and online formats, entry of non-traditional competitors and market consolidation.  We have developed a strategic plan that we believe provides a balanced approach that will enable us 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 have been, and could continue to be, adversely affected by changes in the overall economic environment that affect consumer spending, including discretionary spending.

 

PRODUCT SAFETY

 

Customers count on Kroger to provide them with safe food and drugs and other merchandise.  Concerns regarding the safety of the products that we sell could cause shoppers to avoid purchasing certain products from us, or to seek alternative sources of supply 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.  Any issue regarding the safety of items we sell, regardless of the cause, could have a substantial and adverse effect on our reputation, financial condition, results of operations, or cash flows.

 

LABOR RELATIONS

 

A majority of our employees are covered by collective bargaining agreements with unions, and our relationship with those unions, including a prolonged work stoppage affecting a substantial number of locations, could have a material adverse effect on our results.

 

We are a party to approximately 366 collective bargaining agreements.  Upon the expiration of our collective bargaining agreements, work stoppages by the affected workers could occur if we are unable to negotiate new contracts with labor unions.  A prolonged work stoppage affecting a substantial number of locations could have a material adverse effect on our results.  Further, if we are unable to control health care, pension and wage costs, or if we have insufficient operational flexibility under our collective bargaining agreements, we may experience increased operating costs and an adverse effect on our financial condition, results of operations, or cash flows.

 

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 or operating existing systems or implementing new systems, we could incur significant losses due to disruptions in our operations.

 

Through our sales and marketing activities, we collect and store some personal information that our customers provide to us. We also gather and retain information about our associates in the normal course of business. Under certain circumstances, we may share information with vendors that assist us in conducting our business, as required by law, or otherwise in accordance with our privacy policy. Although we have implemented procedures to protect our information, we cannot be certain that all of our systems are entirely free from vulnerability to attack. Computer hackers may attempt to penetrate our or our vendors’ network security and, if successful, misappropriate confidential customer or business information. In addition, a Kroger associate, a contractor or other third party with whom we do business may attempt to circumvent our security measures in order to obtain information or may inadvertently cause a breach involving information. Loss of customer or business information could disrupt our operations, damage our reputation, and expose us to claims from customers, financial institutions, regulatory authorities, payment card associations, associates, and other persons, any of which could have an adverse effect on our business, financial condition and results of operations. In addition, compliance with tougher privacy and information security laws and standards may result in significant expense due to increased investment in technology and the development of new operational processes.

 

Additionally, on October 1, 2015, the payment card industry shifted liability for certain transactions to retailers who are not able to accept Europay, MasterCard, Visa (EMV) transactions. We completed the implementation of the EMV technology for more than the majority of our supermarket transactions in 2016 with plans to complete them in 2017, and have a plan in place to complete implementation for our fuel centers prior to the liability shift for fuel centers.

 

INDEBTEDNESS

 

Our indebtedness could reduce our ability to obtain additional financing for working capital, mergers and acquisitions or other purposes and could make us vulnerable to future economic downturns as well as 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.

 

LEGAL PROCEEDINGS AND INSURANCE

 

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.  Other legal proceedings purport to be brought as class actions on behalf of similarly situated parties.  Some of these proceedings could result in a substantial loss to Kroger.  We estimate our exposure to these legal proceedings and establish accruals for the estimated liabilities, where it is reasonably possible to estimate and where an adverse outcome is probable.  Assessing and predicting the outcome of these matters involves substantial uncertainties.  Adverse 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 and the “Litigation” section in Note 13 to the Consolidated Financial Statements.

 

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 claims, 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, insolvency of insurance carriers, and changes in discount rates could all affect our financial condition, results of operations, or cash flows.

 

MULTI-EMPLOYER PENSION OBLIGATIONS

 

As discussed in more detail below in “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies-Multi-Employer Pension 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.  We believe that the present value of actuarially accrued liabilities in most of these multi-employer plans substantially exceeds the value of the assets held in trust to pay benefits, and we expect that Kroger’s contributions to those funds will increase over the next few years.  A significant increase to those funding requirements could adversely affect our financial condition, results of operations, or cash flows.  Despite the fact that the pension obligations of these funds are not the liability or responsibility of the Company, except as noted below, there is a risk that the agencies that rate our outstanding debt instruments could view the underfunded nature of these plans unfavorably when determining their ratings on our debt securities.  Any downgrading of our debt ratings likely would adversely affect our cost of borrowing and access to capital.

 

We also currently bear the investment risk of one of the larger multi-employer pension plans in which we participate.  In addition, we have been designated as the named fiduciary of this fund with sole investment authority of the assets of the fund.  If investment results fail to meet our expectations, we could be  required to make additional contributions to fund a portion of or the entire shortfall, which could have an adverse effect on our business, financial condition, results of operations, or cash flows.

 

INTEGRATION OF NEW BUSINESS

 

We enter into mergers and acquisitions with expected benefits including, among other things, operating efficiencies, procurement savings, innovation, sharing of best practices and increased market share that may allow for future growth.  Achieving the anticipated benefits may be subject to a number of significant challenges and uncertainties, including, without limitation, whether unique corporate cultures will work collaboratively in an efficient and effective manner, the coordination of geographically separate organizations, the possibility of imprecise assumptions underlying expectations regarding potential synergies and the integration process, unforeseen expenses and delays, and competitive factors in the marketplace.  We could also encounter unforeseen transaction and integration-related costs or other circumstances such as unforeseen liabilities or other issues.  Many of these potential circumstances are outside of our control and any of them could result in increased costs, decreased revenue, decreased synergies and the diversion of management time and attention.  If we are unable to achieve our objectives within the anticipated time frame, or at all, the expected benefits may not be realized fully or at all, or may take longer to realize than expected, which could have an adverse effect on our business, financial condition and results of operations, or cash flows.

 

FUEL

 

We sell a significant amount of fuel, which could face increased regulation and demand could be affected by concerns about the effect of emissions on the environment as well as retail price increases.  We are unable to predict future regulations, environmental effects, political unrest, acts of terrorism and other matters that may affect the cost and availability of fuel, and how our customers will react, which could adversely affect our financial condition, results of operations, or cash flows.

 

ECONOMIC CONDITIONS

 

Our operating results could be materially impacted by changes in overall economic conditions that impact consumer confidence and spending, including discretionary spending.  Future economic conditions affecting disposable consumer income such as employment levels, business conditions, changes in housing market conditions, the availability of credit, interest rates, tax rates, the impact of natural disasters or acts of terrorism, and other matters could reduce consumer spending.  Increased fuel prices could also have an effect on consumer spending and on our costs of producing and procuring products that we sell.  We are unable to predict how the global economy and financial markets will perform.  If the global economy and financial markets do not perform as we expect, it could adversely affect our financial condition, results of operations, or cash flows.

 

WEATHER AND NATURAL DISASTERS

 

A large number of our stores and distribution facilities are geographically located in areas that are susceptible to hurricanes, tornadoes, floods, droughts and earthquakes.  Weather conditions and natural disasters could disrupt our operations at one or more of our facilities, interrupt the delivery of products to our stores, substantially increase the cost of products, including supplies and materials and substantially increase the cost of energy needed to operate our facilities or deliver products to our facilities.  Adverse weather and natural disasters could materially affect our financial condition, results of operations, or cash flows.

 

GOVERNMENT REGULATION

 

Our stores are subject to various laws, regulations, and administrative practices that affect our business. We must comply with numerous provisions regulating, among other things, health and sanitation standards, food labeling and safety, equal employment opportunity, minimum wages, and licensing for the sale of food, drugs, and alcoholic beverages. We cannot predict future laws, regulations, interpretations, administrative orders, or applications, or the effect they will have on our operations. They could, however, significantly increase the cost of doing business.  They also could require the reformulation of some of the products that we sell (or manufacture for sale to third parties) to meet new standards.  We also could be required to recall or discontinue the sale of products that cannot be reformulated.  These changes could result in additional record keeping, expanded documentation of the properties of certain products, expanded or different labeling, or scientific substantiation.  Any or all of these requirements could have an adverse effect on our financial condition, results of operations, or cash flows.

 

ITEM 1B.UNRESOLVED STAFF COMMENTS.

 

None.

 

ITEM 2.PROPERTIES.

 

As of January 28, 2017, we operated approximately 4,000 owned or leased supermarkets, convenience stores, fine jewelry stores, distribution warehouses and food production plants through divisions, subsidiaries or affiliates. These facilities are located throughout the United States. While our current strategy emphasizes ownership of store real estate, a majority of the properties used to conduct our business are leased.

 

We generally own store equipment, fixtures and leasehold improvements, as well as processing and food production equipment. The total cost of our owned assets and capitalized leases at January 28, 2017, was $40.6 billion while the accumulated depreciation was $19.6 billion.

 

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 the 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, food production and miscellaneous facilities generally are payable monthly at stated amounts.  For additional information on lease obligations, see Note 10 to the Consolidated Financial Statements.

ITEM 3.LEGAL PROCEEDINGS.

 

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, as well as product liability cases, 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, we believe that any resulting liability will not have a material adverse effect on our financial position, results of operations, or cash flows.

 

We continually evaluate our exposure to loss contingencies arising from pending or threatened litigation and believe we have made provisions where it is reasonably possible to estimate and where an adverse outcome is probable.  Nonetheless, assessing and predicting the outcomes of these matters involves substantial uncertainties.  We currently believe that the aggregate range of loss for our exposures is not material.  It remains possible that despite our current belief, material differences in actual outcomes or changes in our evaluation or predictions could arise that could have a material adverse effect on our financial condition, results of operations, or cash flows.

 

ITEM 4.MINE SAFETY DISCLOSURES.

 

Not applicable.

 

PART II

 

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

 

(a)

 

The following table sets forth the high and low sales prices for our common shares on the New York Stock Exchange for each full quarterly period of the two most recently completed fiscal years.  All share and per share amounts presented are reflective of the two-for-one stock split that began trading at the split adjusted price on July 14, 2015.

 

COMMON SHARE PRICE RANGE

 

 

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

 

Number of shareholders of record at fiscal year-end 2016:28,351

 

Number of shareholders of record at March 22, 2017:28,252

 

During 2016, we paid two quarterly cash dividends of $0.105 per share and two quarterly cash dividends of $0.12 per share.  During 2015, we paid two quarterly cash dividends of $0.0925 per share and two quarterly cash dividends of $0.105 per share.  On March 1, 2017, we paid a quarterly cash dividend of $0.12 per share.  On March 9, 2017, we announced that our Board of Directors declared a quarterly cash dividend of $0.12 per share, payable on June 1, 2017, to shareholders of record at the close of business on May 15, 2017.  We currently expect to continue to pay comparable cash dividends on a quarterly basis depending on our earnings and other factors, including approval by our Board.

 

For information on securities authorized for issuance under our existing equity compensation plans, see Item 12 under the heading “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”

 

PERFORMANCE GRAPH

 

Set forth below is a line graph comparing the five-year cumulative total shareholder return on our common shares, based on the market price of the common shares and assuming reinvestment of dividends, with the cumulative total return of companies in the Standard & Poor’s 500 Stock Index and a peer group composed of food and drug companies.

 

 

 

Kroger’s fiscal year ends on the Saturday closest to January 31.

 

Data supplied by Standard & Poor’s.

 

The foregoing Performance Graph will not be deemed incorporated by reference into any other filing, absent an express reference thereto.

*     Total assumes $100 invested on January 29, 2012, in The Kroger Co., S&P 500 Index, and the Peer Group, with reinvestment of dividends.

 

**   The Peer Group consists of Costco Wholesale Corp., CVS Caremark Corp, Etablissements Delhaize Freres Et Cie Le Lion (“Groupe Delhaize”, which is included through July 22, 2016 when it merged with Koninklijke Ahold), Great Atlantic & Pacific Tea Company, Inc. (included through March 13, 2012 when it became private after emerging from bankruptcy), Koninklijke Ahold Delhaize NV (changed name from Koninklijke Ahold after merger with Groupe Delhaize), Safeway, Inc. (included through January 29, 2015 when it was acquired by AB Acquisition LLC), Supervalu Inc., Target Corp., Tesco Plc (included through November 27, 2013 when it sold its U.S. business), Wal-Mart Stores Inc., Walgreens Boots Alliance Inc. (formerly, Walgreen Co.), Whole Foods Market Inc. and Winn-Dixie Stores, Inc. (included through March 9, 2012 when it became a wholly-owned subsidiary of Bi-Lo Holdings).

(c)

 

The following table presents information on our purchases of our common shares during the fourth quarter of 2016.

 

ISSUER PURCHASES OF EQUITY SECURITIES

 

 

 

 

 

ITEM 6.SELECTED FINANCIAL DATA.

 

The following table presents our selected consolidated financial data for each of the last five fiscal years.  Refer to Note 2 of the Consolidated Financial Statements for disclosure of business combinations and their effect on each of the last three fiscal years’ Consolidated Statements of Operations and the last two fiscal years’ Consolidated Balance Sheets.  All share and per share amounts presented are reflective of the two-for-one stock split that began trading at the split adjusted price on July 14, 2015.

 

 

 

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

 

The following discussion and analysis of financial condition and results of operations of The Kroger Co. should be read in conjunction with the “Forward-looking Statements” section set forth in Part I, the “Risk Factors” section set forth in Item 1A of Part I and the “Outlook” section below.

 

OUR BUSINESS

 

The Kroger Co. was founded in 1883 and incorporated in 1902.  Kroger is one of the world’s largest retailers, as measured by revenue, operating 2,796 supermarkets under a variety of local banner names in 35 states and the District of Columbia.  Of these stores, 2,255 have pharmacies and 1,445 have fuel centers.  We also offer ClickList™ and Harris Teeter ExpressLane — personalized, order online, pick up at the store services —  at 637 of our supermarkets, and operate 784 convenience stores, either directly or through franchisees, 319 fine jewelry stores and an online retailer.

 

We operate 38 food production plants, primarily bakeries and dairies, which supply approximately 35% of the corporate brand units sold in our supermarkets; the remaining corporate brand items are produced to our strict specifications by outside manufacturers. This percentage has declined recently due to an expanded portfolio of non-grocery corporate brand units produced by outside manufacturers.  Our food production plants produced 45% of our grocery category corporate brand units sold in our supermarkets, which is consistent with our historical trend. 

 

Our revenues are earned and cash is generated as consumer products are sold to customers in our stores, fuel centers and via our online platforms.  We earn income predominately by selling products at price levels that produce revenues in excess of the costs we incur to make these products available to our customers.  Such costs include procurement and distribution costs, facility occupancy and operational costs, and overhead expenses.  Our retail operations, which represent over 98% of our consolidated sales and EBITDA, is our only reportable segment.

 

On September 2, 2016, we closed our merger with Modern HC Holdings, Inc. (“ModernHEALTH”) by purchasing 100% of the outstanding shares of ModernHEALTH for $407 million.  ModernHEALTH is included in our ending Consolidated Balance Sheet for 2016 and in our Consolidated Statements of Operations from September 2, 2016 through January 28, 2017.

 

On December 18, 2015, we closed our merger with Roundy’s, Inc. (“Roundy’s”) by purchasing 100% of Roundy’s® outstanding common stock for $3.60 per share and assuming Roundy’s outstanding debt, for a purchase price of $866 million.  Roundy’s is included in our ending Consolidated Balance Sheets for 2015 and 2016 and in our Consolidated Statements of Operations for the last six weeks of 2015 and all periods in 2016. 

 

On August 18, 2014, we closed our merger with Vitacost.com® by purchasing 100% of the Vitacost.com outstanding common stock for $8.00 per share or $287 million.  Vitacost.com is included in our ending Consolidated Balance Sheets for 2015 and 2016 and in our Consolidated Statements of Operations for all periods succeeding the merger. 

 

See Note 2 to the Consolidated Financial Statements for more information related to our mergers with ModernHEALTH, Roundy’s and Vitacost.com.

   

USE OF NON-GAAP FINANCIAL MEASURES 

   

The accompanying Consolidated Financial Statements, including the related notes, set forth in Part II, Item 8 of this Form 10-K are presented in accordance with generally accepted accounting principles (“GAAP”). We provide non-GAAP measures, including First-In, First-Out (“FIFO”) gross margin, FIFO operating profit, adjusted net earnings and adjusted net earnings per diluted share because management believes these metrics are useful to investors and analysts.  These non-GAAP financial measures should not be considered as an alternative to gross margin, operating profit, net earnings and net earnings per diluted share or any other GAAP measure of performance.  These measures should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP.  Our calculation and reasons these are useful metrics to investors and analysts are explained below.

   

We calculate FIFO gross margin as sales less merchandise costs, including advertising, warehousing, and transportation expenses, but excluding the Last-In, First-Out (“LIFO”) charge.  Merchandise costs exclude depreciation and rent expenses.  FIFO gross margin is an important measure used by management to evaluate merchandising and operational effectiveness.  Management believes FIFO gross margin is a useful metric to investors and analysts because it measures our day-to-day merchandising and operational effectiveness.

   

We calculate FIFO operating profit as operating profit excluding the LIFO charge.  FIFO operating profit is an important measure used by management to evaluate operational effectiveness.  Management believes FIFO operating profit is a useful metric to investors and analysts because it measures our day-to-day operational effectiveness. 

   

We believe the adjusted net earnings per diluted share metric presents more accurate year-over-year comparisons for our net earnings per diluted share because adjusted items are not the result of our normal operations. 

   

OVERVIEW 

   

Notable items for 2016 are:

   

 

   

 

   

 

 

 

   

The following table provides a reconciliation of net earnings attributable to The Kroger Co. to adjusted net earnings attributable to The Kroger Co. and a reconciliation of net earnings attributable to The Kroger Co. per diluted common share to adjusted net earnings attributable to The Kroger Co. per diluted common share, excluding the 2016 and 2014 Adjusted Items.  In 2015, we did not have any adjustment items that affect net earnings or net earnings per diluted share.

 

Net Earnings per Diluted Share excluding the Adjusted Items

($ in millions, except per share amounts)

 

 

RESULTS OF OPERATIONS

 

Sales

 

Total Sales

($ in millions)

 

Total sales increased in 2016, compared to 2015, by 5.0%.  This increase was primarily due to our increase in total supermarket sales, without fuel, and our merger with ModernHEALTH, partially offset by a decrease in fuel sales due to a 9.4% decrease in the average retail fuel price.  The increase in total supermarket sales without fuel for 2016, compared to 2015, was primarily due to our merger with Roundy’s, an increase in supermarket square footage and our identical supermarket sales increase, excluding fuel, of 1.0%.  Identical supermarket sales, excluding fuel, for 2016, compared to 2015, increased primarily due to an increase in the number of households shopping with us, partially offset by product cost deflation of 0.8%.  Excluding mergers, acquisitions and operational closings, total supermarket square footage at the end of 2016 increased 3.4% over 2015.  Total fuel sales decreased 5.6% in 2016, compared to 2015, primarily due to a decrease in the average retail fuel price of 9.4%, partially offset by an increase in fuel gallons sold of 4.2%.  The decrease in the average retail fuel price was caused by a decrease in the product cost of fuel.

 

Total sales increased in 2015, compared to 2014, by 1.3%.  This increase in 2015 total sales, compared to 2014, was primarily due to an increase in identical supermarket sales, excluding fuel, of 5.0%.  Total sales also increased due to the inclusion of Roundy’s sales, due to our merger, for the period of December 18, 2015 to January 30, 2016.  Identical supermarket sales, excluding fuel, for 2015, compared to 2014, increased primarily due to an increase in the number of households shopping with us, an increase in visits per household, changes in product mix and product cost inflation.  Total fuel sales decreased in 2015, compared to 2014, primarily due to a 26.7% decrease in the average retail fuel price, partially offset by an increase in fuel gallons sold of 7.1%.

 

We define a supermarket as identical when it has been in operation without expansion or relocation for five full quarters.  Although identical supermarket sales is a relatively standard term, numerous methods exist for calculating identical supermarket sales growth.  As a result, the method used by our management to calculate identical supermarket sales may differ from methods other companies use to calculate identical supermarket sales.  We urge you to understand the methods used by other companies to calculate identical supermarket sales before comparing our identical supermarket sales to those of other such companies.  Fuel discounts received at our fuel centers and earned based on in-store purchases are included in all of the identical supermarket sales results calculations as illustrated in the following table and reduce our identical supermarket sales results.  Differences between total supermarket sales and identical supermarket sales primarily relate to changes in supermarket square footage.  Identical supermarket sales include sales from all departments at identical multi-department stores and Roundy’s stores that are identical as if they were part of the Company in the prior year.  Our identical supermarket sales results are summarized in the following table.  We used the identical supermarket dollar figures presented below to calculate percentage changes for 2016 and 2015.

 

Identical Supermarket Sales

(dollars in millions)

 

 

Gross Margin, LIFO and FIFO Gross Margin

 

Our gross margin rates, as a percentage of sales, were 22.40% in 2016, 22.16% in 2015 and 21.16% in 2014.  The increase in 2016, compared to 2015, resulted primarily from lower fuel sales, a lower LIFO charge and our merger with Roundy’s due to its historically higher gross margin rate, partially offset by continued investments in lower prices for our customers, unfavorable pricing and cost effects due to transitioning to a deflationary operating environment, our merger with ModernHEALTH due to its historically lower gross margin rate and increased warehousing and shrink costs, as a percentage of sales.  The increase in 2015, compared to 2014, resulted primarily from lower fuel sales, reductions in transportation costs and a lower LIFO charge, partially offset by continued investments in lower prices for our customers and increased shrink costs, as a percentage of sales. Lower fuel sales increase our gross margin rate, as a percentage of sales, due to the very low gross margin rate, as a percentage of sales, on fuel sales compared to non-fuel sales.

 

Our LIFO charge was $19 million in 2016, $28 million in 2015 and $147 million in 2014.  In 2016, our LIFO charge primarily resulted from annualized product cost inflation related to pharmacy, and was partially offset by annualized product cost deflation in other departments.  In 2015, we experienced lower product cost inflation, compared to 2014, which resulted in a lower LIFO charge. In 2015, our LIFO charge primarily resulted from annualized product cost inflation related to pharmacy, and was partially offset by annualized product cost deflation related to meat and dairy.  In 2014, our LIFO charge primarily resulted from annualized product cost inflation related to pharmacy, grocery, deli, meat and seafood. 

 

Our FIFO gross margin rates, as a percentage of sales, were 22.42% in 2016, 22.18% in 2015 and 21.30% in 2014.  Excluding the effect of fuel and our mergers with Roundy’s and ModernHEALTH (“recent mergers”), our FIFO gross margin rate decreased seven basis points in 2016, compared to 2015.  This decrease resulted primarily from continued investments in lower prices for our customers, unfavorable pricing and cost effects due to transitioning to a deflationary operating environment and increased warehousing and shrink costs, as a percentage of sales.   Excluding the effect of fuel, our FIFO gross margin rate decreased four basis points in 2015, compared to 2014.  This decrease resulted primarily from continued investments in lower prices for our customers and increased shrink costs, partially offset by a reduction in transportation costs, as a percentage of sales. 

 

Operating, General and Administrative Expenses

 

OG&A expenses consist primarily of employee-related costs such as wages, health care benefits and retirement plan costs, utility and credit card fees.  Rent expense, depreciation and amortization expense and interest expense are not included in OG&A.

 

OG&A expenses, as a percentage of sales, were 16.63% in 2016, 16.34% in 2015 and 15.82% in 2014.  OG&A expenses, as a percentage of sales, increased 29 basis points to 16.63% in 2016 from 16.34% in 2015.  This increase resulted primarily from a decrease in fuel sales, the loss of sales leverage due to transitioning to a deflationary operating environment, the 2016 Adjusted Items, our recent mergers due to their historically higher OG&A rate, compared to our other divisions, and increases in healthcare benefit and credit card costs, partially offset by increased supermarket sales, productivity improvements, effective cost controls, $110 million United Food and Commercial Workers International Union (“UFCW”) contributions made during 2015 (“2015 UFCW Contributions”) and decreases in incentive plans, company-sponsored pension plans and utility costs, as a percentage of sales.  Our fuel sales lower our OG&A rate, as a percentage of sales, due to the very low OG&A rate, as a percentage of sales, of fuel sales compared to non-fuel sales.  Excluding the effect of fuel, the 2016 Adjusted Items, recent mergers and the 2015 UFCW Contributions, our OG&A rate decreased five basis points in 2016, compared to 2015.  This decrease resulted primarily from increased supermarket sales, productivity improvements, effective cost controls and decreases in incentive plans, company-sponsored pension plans and utility costs, partially offset by the loss of sales leverage due to transitioning to a deflationary operating environment and increases in healthcare benefit and credit card costs, as a percentage of sales.

 

OG&A expenses, as a percentage of sales, increased 52 basis points to 16.34% in 2015 from 15.82% in 2014.  This increase resulted primarily from a decrease in fuel sales, increases in EMV chargebacks, company-sponsored pension, healthcare and incentive plan costs, partially offset by increased supermarket sales, the 2014 Multi-Employer Pension Plan Obligation, lower charges for total contributions to The Kroger Foundation and UFCW Consolidated Pension Plan (“2014 Contributions”), compared to the 2015 UFCW Contributions, productivity improvements and effective cost controls at the store level.  Excluding fuel, the 2015 UFCW Contributions, the 2014 Contributions and the 2014 Multi-Employer Pension Plan Obligation, our OG&A rate decreased nine basis points, compared to 2014.  The decrease resulted primarily from increased supermarket sales, productivity improvements and effective cost controls at the store level, partially offset by increases in EMV chargebacks , company-sponsored pension, healthcare and incentive plan costs, as a percentage of sales. 

 

Rent Expense

 

Rent expense increased on a total dollars and percentage of sales basis in 2016, compared to 2015, due to:

   

 

Rent expense increased in 2015, compared to 2014, due to our merger with Roundy’s,  partially offset by our continued emphasis to own rather than lease, whenever possible.  Rent expense, as a percentage of sales, in 2015 was consistent with 2014, due to the effect of our merger with Roundy’s being offset by our continued emphasis to own rather than lease, whenever possible, and the benefit of increased sales.

 

Depreciation and Amortization Expense

 

Depreciation and amortization expense increased on a total dollars and percentage of sales basis in 2016, compared to 2015, due to:

 

 

Depreciation and amortization expense increased on a total dollars and percentage of sales basis in 2015, compared to 2014, due to:

 

 

Operating Profit and FIFO Operating Profit

 

Operating profit was $3.4 billion in 2016, $3.6 billion in 2015 and $3.1 billion in 2014.  Operating profit, as a percentage of sales, decreased 28 basis points in 2016, compared to 2015, due to increased OG&A, depreciation and amortization and rent expenses, partially offset by higher gross margin and a lower LIFO charge, as a percentage of sales.  Operating profit, as a percentage of sales, increased 37 basis points in 2015, compared to 2014, due to higher gross margin and a lower LIFO charge, partially offset by increased OG&A, depreciation and amortization and rent expenses, as a percentage of sales.  Specific factors of these operating trends are discussed earlier in this section.

 

FIFO operating profit was $3.5 billion in 2016, $3.6 billion in 2015 and $3.3 billion in 2014.  FIFO operating profit, as a percentage of sales, was 3.00% in 2016, 3.28% in 2015 and 3.03% in 2014.  Fuel sales lower our operating profit rate due to the very low operating profit rate, as a percentage of sales, of fuel sales compared to non-fuel sales.  FIFO operating profit, as a percentage of sales excluding fuel, the 2016 Adjusted Items, the effects of our recent mergers and the 2015 UFCW Contributions, decreased 14 basis points in 2016, compared to 2015.  This decrease was due to lower gross margin, higher depreciation and amortization, partially offset by decreased OG&A and rent expenses, as a percentage of sales.  FIFO operating profit, as a percentage of sales excluding fuel, the effects of our Roundy’s merger, the 2015 UFCW Contributions, the 2014 Contributions and the 2014 Multi-Employer Pension Plan Obligation, increased 8 basis points in 2015, compared to 2014.  This increase was primarily due to decreased OG&A and rent, partially offset by lower gross margin and increased depreciation and amortization, as a percentage of sales.  Specific factors of these operating trends are discussed earlier in this section. 

 

Interest Expense

 

Interest expense totaled $522 million in 2016, $482 million in 2015 and $488 million in 2014.  The increase in interest expense in 2016, compared to 2015, resulted primarily from additional borrowings used for share repurchases, mergers and a higher weighted average interest rate.  The decrease in interest expense in 2015, compared to 2014, resulted primarily from the timing of debt principal payments and debt issuances, partially offset by an increase in interest expense associated with our commercial paper program. 

 

Income Taxes

 

Our effective income tax rate was 32.8% in 2016, 33.8% in 2015 and 34.1% in 2014.  The 2016 tax rate differed from the federal statutory rate primarily as a result of the recognition of excess tax benefits related to share-based payments after the adoption of ASU 2016-09, the utilization of tax credits, the Domestic Manufacturing Deduction and other changes, partially offset by the effect of state income taxes.  The 2015 and 2014 tax rate differed from the federal statutory rate primarily as a result of the utilization of tax credits, the Domestic Manufacturing Deduction and other changes, partially offset by the effect of state income taxes.

 

Net Earnings and Net Earnings Per Diluted Share

 

Our net earnings are based on the factors discussed in the Results of Operations section.

 

Net earnings of $2.05 per diluted share in 2016 represented a decrease of 0.5% from net earnings of $2.06 per diluted share in 2015.  Excluding the 2016 Adjusted Items, net earnings of $2.12 per diluted share in 2016 represented an increase of 2.9% from net earnings of $2.06 per diluted share in 2015.  The net earnings of 2015 do not include any adjusted items.  The 2.9% increase resulted primarily from a lower LIFO charge, lower income tax expense and lower weighted average common shares outstanding due to common share repurchases, partially offset by lower non-fuel FIFO operating profit and lower fuel earnings.

 

Net earnings of $2.06 per diluted share in 2015 represented a increase of 19.8% from net earnings of $1.72 per diluted share in 2014.  Excluding the 2014 Adjusted Items, net earnings of $2.06 per diluted share in 2015 represented an increase of 17.0% from net earnings of $1.76 per diluted share in 2014.  The net earnings of 2015 do not include any adjusted items.  The 17.0% increase resulted primarily from higher non-fuel FIFO operating profit, a lower LIFO charge and lower weighted average common shares outstanding due to common share repurchases, partially offset by lower fuel earnings and higher income tax expense.

 

COMMON SHARE REPURCHASE PROGRAMS

 

We maintain share repurchase programs that comply with Rule 10b5-1 of the Securities Exchange Act of 1934 and allow for the orderly repurchase of our common shares, from time to time.  We made open market purchases of our common shares totaling $1.7 billion in 2016, $500 million in 2015 and $1.1 billion in 2014 under these repurchase programs.  In addition to these repurchase programs, we also repurchase common shares to reduce dilution resulting from our employee stock option plans.  This program is solely funded by proceeds from stock option exercises, and the tax benefit from these exercises.  We repurchased approximately $105 million in 2016, $203 million in 2015 and $155 million in 2014 of our common shares under the stock option program.

 

The following Board of Director authorizations created repurchase programs to reacquire shares via open market purchases:

 

 

During the first quarter through March 28, 2017, the Company used an additional $341 million of cash to repurchase 11 million common shares at an average price of $31.09 per share.  As of March 28, 2017, we have exhausted the September 2016 program and have $498 million remaining under the March 2017 program.

 

CAPITAL INVESTMENTS

 

Capital investments, including changes in construction-in-progress payables and excluding mergers and the purchase of leased facilities, totaled $3.7 billion in 2016, $3.3 billion in 2015 and $2.7 billion in 2014.  Capital investments for mergers totaled $401 million in 2016, $168 million in 2015 and $252 million in 2014.  We merged with ModernHEALTH in 2016, Roundy’s in 2015 and Vitacost.com in 2014.  Refer to Note 2 to the Consolidated Financial Statements for more information on these mergers. Capital investments for the purchase of leased facilities totaled $5 million in 2016, $35 million in 2015 and $135 million in 2014.  The table below shows our supermarket storing activity and our total supermarket square footage:

 

Supermarket Storing Activity

 

 

RETURN ON INVESTED CAPITAL

 

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

 

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

 

The following table provides a calculation of ROIC for 2016 and 2015.  The January 30, 2016 calculation of ROIC excludes the financial position and results for the Roundy's merger.

 

 

CRITICAL ACCOUNTING POLICIES

 

We have chosen accounting policies that we believe are appropriate to report accurately and fairly our operating results and financial position, and we apply those accounting policies in a consistent manner.  Our significant accounting policies are summarized in Note 1 to the Consolidated Financial Statements.

 

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

 

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

 

Self-Insurance Costs

 

We primarily are self-insured for costs related to workers’ compensation and general liability claims.  The liabilities represent our best estimate, using generally accepted actuarial reserving methods, of the ultimate obligations for reported claims plus those incurred but not reported for all claims incurred through January 28, 2017.  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 $2 million.  General liability claims are not discounted.

 

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

 

We monitor the carrying value of long-lived assets for potential impairment each quarter based on whether certain triggering events have occurred.  These events include current period losses combined with a history of losses or a projection of continuing losses or a significant decrease in the market value of an asset.  When a triggering event occurs, we perform an impairment calculation, comparing projected undiscounted cash flows, utilizing current cash flow information and expected growth rates related to specific stores, to the carrying value for those stores.  If we identify impairment for long-lived assets to be held and used, we compare the assets’ current carrying value to the assets’ fair value.  Fair value is determined based on market values or discounted future cash flows.  We record impairment when the carrying value exceeds fair market value.  With respect to owned property and equipment held for disposal, we adjust the value of the property and equipment to reflect recoverable values based on our previous efforts to dispose of similar assets and current economic conditions.  We recognize impairment for the excess of the carrying value over the estimated fair market value, reduced by estimated direct costs of disposal.  We recorded asset impairments in the normal course of business totaling $26 million in 2016, $46 million in 2015 and $37 million in 2014.  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 level, could produce significantly different results.

 

Goodwill

 

Our goodwill totaled $3.0 billion as of January 28, 2017.  We review goodwill for impairment in the fourth quarter of each year, and also upon the occurrence of triggering events.  We perform reviews of each of our operating divisions and variable interest entities (collectively, “reporting units”) that have goodwill balances.  Fair value is determined using a multiple of earnings, or discounted projected future cash flows, and we compare fair value to the carrying value of a reporting unit for purposes of identifying potential impairment.  We base projected future cash flows on management’s knowledge of the current operating environment and expectations for the future.  If we identify potential for impairment, we measure the fair value of a reporting unit against the fair value of its underlying assets and liabilities, excluding goodwill, to estimate an implied fair value of the reporting unit’s goodwill.  We recognize goodwill impairment for any excess of the carrying value of the reporting unit’s goodwill over the implied fair value.

 

The annual evaluation of goodwill performed for our reporting units during the fourth quarter of 2016, 2015 and 2014 did not result in impairment.  Based on current and future expected cash flows, we believe goodwill impairments are not reasonably likely.  A 10% reduction in fair value of our reporting units would not indicate a potential for impairment of our goodwill balance.

 

For additional information relating to our results of the goodwill impairment reviews performed during 2016, 2015 and 2014 see Note 3 to the Consolidated Financial Statements.

 

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

 

Store Closing Costs

 

We provide for closed store liabilities on the basis of the present value of the estimated remaining non-cancellable 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 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

 

We account for our defined benefit pension plans using the recognition and disclosure provisions of GAAP, 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.

 

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 15 to the Consolidated Financial Statements and include, among others, the discount rate, the expected long-term rate of return on plan assets, mortality 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 15 to the Consolidated Financial Statements also 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 assumptions was intended to reflect the rates 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 rates was to match the plan’s cash flows to that of a hypothetical bond portfolio whose cash flow from coupons and maturities match the plan’s projected benefit cash flows.  The discount rates are the single rates that produce the same present value of cash flows.  The selection of the 4.25% and 4.18% discount rates as of year-end 2016 for pension and other benefits, respectively, represents the hypothetical bond portfolio using bonds with an AA or better rating constructed with the assistance of an outside consultant.  We utilized a discount rate of 4.62% and 4.44% as of year-end 2015 for pension and other benefits, respectively.  A 100 basis point increase in the discount rate would decrease the projected pension benefit obligation as of January 28, 2017, by approximately $510 million.

 

To determine the expected rate of return on pension plan assets held by Kroger for 2016, we considered current and forecasted plan asset allocations as well as historical and forecasted rates of return on various asset categories.  In 2016, our assumed pension plan investment return rate was 7.40% compared to 7.44% in 2015 and 2014.  During 2016, Kroger began managing the assets for the Harris Teeter and Roundy’s pension plans, and our expected rate of return reflects implementing a similar investment management strategy for the Harris Teeter and Roundy’s plans’ assets.  Historically, the Kroger pension plans’ average rate of return was 5.81% for the 10 calendar years ended December 31, 2016, net of all investment management fees and expenses.  The value of all investments in our Company-sponsored defined benefit pension plans during the calendar year ending December 31, 2016, net of investment management fees and expenses, increased 6.90%.  For the past 20 years, the Kroger pension plans’ average annual rate of return has been 7.77%.  Based on the above information and forward looking assumptions for investments made in a manner consistent with our target allocations, we believe a 7.40% rate of return assumption is reasonable for 2016.  See Note 15 to the Consolidated Financial Statements for more information on the asset allocations of pension plan assets.

 

On January 31, 2015, we adopted new industry specific mortality tables based on mortality experience and assumptions for generational mortality improvement in determining our benefit obligations. On January 28, 2017, we adopted an updated assumption for generational mortality improvement, based on additional years of published mortality experience.

 

Sensitivity to changes in the major assumptions used in the calculation of Kroger’s pension plan liabilities is illustrated below (in millions).

 

 

In 2016, we contributed $3 million to our Company-sponsored defined benefit plans and are not required to make any contributions to these plans in 2017.  We contributed $5 million to our Company-sponsored defined benefit plans in 2015 and did not make contributions in 2014.  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 contributions.

 

We contributed and expensed $215 million in 2016, $196 million in 2015 and $177 million in 2014 to employee 401(k) retirement savings accounts.  The increase in 2016, compared to 2015, is primarily due to our recent mergers. The increase in 2015, compared to 2014, is due to a higher employee savings rate.  The 401(k) retirement savings account plans provide to eligible employees both matching contributions and automatic contributions from the Company based on participant contributions, plan compensation and length of service.

 

Multi-Employer Pension Plans

 

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

 

We recognize expense in connection with these plans as contributions are funded or when commitments are probable and reasonably estimable, in accordance with GAAP.  We made cash contributions to these plans of $289 million in 2016, $426 million in 2015 and $297 million in 2014.

 

We continue to evaluate and address our potential exposure to under-funded multi-employer pension plans as it relates to our associates who are beneficiaries of these plans.  These under-fundings are not our liability.  When an opportunity arises that is economically feasible and beneficial to us and our associates, we may negotiate the restructuring of under-funded multi-employer pension plan obligations to help stabilize associates’ future benefits and become the fiduciary of the restructured multi-employer pension plan.  The commitments from these restructurings do not change our debt profile as it relates to our credit rating.  We are currently designated as the named fiduciary of the UFCW Consolidated Pension Plan and have sole investment authority over these assets.  Significant effects of these restructuring agreements recorded in our Consolidated Financial Statements are:

 

 

 

 

As we continue to work to find solutions to under-funded multi-employer pension plans, it is possible we could incur withdrawal liabilities for certain funds.  Two locations have initiated a withdrawal process, in the first quarter of 2017, resulting in an estimated withdrawal liability of less than $100 million, after-tax.

 

Based on the most recent information available to us, we believe that the present value of actuarially accrued liabilities in most of the multi-employer plans to which we contribute substantially exceeds the value of the assets held in trust to pay benefits.  We have attempted to estimate the amount by which these liabilities exceed the assets, (i.e., the amount of underfunding), as of December 31, 2016.  Because we are only one of a number of employers contributing to these plans, we also have attempted to estimate the ratio of our contributions to the total of all contributions to these plans in a year as a way of assessing our “share” of the underfunding.  Nonetheless, the underfunding is not a direct obligation or liability of ours or of any employer.  As of December 31, 2016, we estimate that our share of the underfunding of multi-employer pension plans to which we contribute, or as it relates to certain funds, an estimated withdrawal liability, was approximately $3.0 billion, pre-tax, or $1.8 billion, after-tax.  This represents an increase in the estimated amount of underfunding of approximately $100 million, pre-tax, or approximately $40 million, after-tax, as of December 31, 2016, compared to December 31, 2015.  The increase in the amount of underfunding is attributable to lower than expected returns on the assets held in the multi-employer pension plans during 2016 and changes in mortality rate assumptions.  Our estimate is based on the most current information available to us including actuarial evaluations and other data (that include the estimates of others), and such information may be outdated or otherwise unreliable.

 

We have made and disclosed this estimate not because, except as noted above, this underfunding is a direct liability of ours.  Rather, we believe the underfunding is likely to have important consequences.  In 2017, we expect to contribute approximately $360 million to multi-employer pension plans, which excludes any additional multi-employer pension plan restructurings that could occur. Of this amount, $35 million has been accrued for as of January 28, 2017.  We expect increases in expense as a result of increases in multi-employer pension plan contributions over the next few years.  Finally, underfunding means that, in the event we were to exit certain markets or otherwise cease making contributions to these plans, we could trigger a substantial withdrawal liability. Any adjustment for withdrawal liability will be recorded when it is probable that a liability exists and can be reasonably estimated, in accordance with GAAP. 

 

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

 

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

 

Uncertain Tax Positions

 

We review the tax positions taken or expected to be taken on tax returns to determine whether and to what extent a benefit can be recognized in our Consolidated Financial Statements.  Refer to Note 5 to the Consolidated Financial Statements for the amount of unrecognized tax benefits and other disclosures related to uncertain tax positions.

 

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 an allowance has been established, is audited and fully resolved.  As of January 28, 2017, the Internal Revenue Service had concluded its examination of our 2012 and 2013 federal tax returns. 

 

The assessment of our tax position relies on the judgment of management to estimate the exposures associated with our various filing positions.

Share-Based Compensation Expense

 

We account for stock options under the fair value recognition provisions of GAAP.  Under this method, we recognize compensation expense for all share-based payments granted.  We recognize share-based compensation expense, net of an estimated forfeiture rate, over the requisite service period of the award.  In addition, we record expense for restricted stock awards in an amount equal to the fair market value of the underlying stock on the grant date of the award, over the period the award restrictions lapse.  As described in Note 17 to the Consolidated Financial Statements, we adopted a new share-based compensation standard during 2016, which requires recognition of excess tax benefits related to share-based payments in our provision for income taxes. Excess tax benefits were historically recorded in additional paid-in capital.

 

Inventories

 

Inventories are stated at the lower of cost (principally on a LIFO basis) or market.  In total, approximately 89% and 95% of inventories were valued using the LIFO method in 2016 and 2015, respectively.  Cost for the balance of the inventories, including substantially all fuel inventories, was determined using the FIFO method.  Replacement cost was higher than the carrying amount by $1.3 billion at January 28, 2017 and January 31, 2016.  We follow the Link-Chain, Dollar-Value LIFO method for purposes of calculating our LIFO charge or credit.

 

We follow the 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.  In addition, substantially all of our inventory consists of finished goods and is recorded at actual purchase costs (net of vendor allowances and cash discounts). 

 

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.

 

Vendor Allowances

 

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 cost 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 $7.8 billion in 2016, $7.3 billion in 2015 and $6.9 billion in 2014 of vendor allowances as a reduction in merchandise costs.  We recognized approximately 92% of all vendor allowances in the item cost with the remainder being based on inventory turns.

 

RECENTLY ADOPTED ACCOUNTING STANDARDS

 

In September 2015, the FASB issued Accounting Standards Update (“ASU”) 2015-16, “Business Combinations (Topic 805): Simplifying the Accounting for Measurement-Period Adjustments.” This amendment eliminates the requirement to retrospectively account for adjustments made to provisional amounts recognized in a business combination. This amendment became effective for us beginning January 31, 2016, and was adopted prospectively in accordance with the standard. The adoption of this amendment did not have an effect on our Consolidated Balance Sheets or Consolidated Statements of Operations.

   

During the second quarter of 2016, we adopted ASU 2016-09, “Compensation-Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting.”  This amendment addresses several aspects of the accounting for share-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities and classification on the statement of cash flows. As a result of the adoption, we recognized $49 million of excess tax benefits related to share-based payments in our provision for income taxes in 2016. These items were historically recorded in additional paid-in capital. In addition, for 2016, cash flows related to excess tax benefits are classified as an operating activity. Cash paid on employees’ behalf related to shares withheld for tax

purposes is classified as a financing activity. Retrospective application of the cash flow presentation requirements resulted in increases to both “Net cash provided by operating activities” and “Net cash used by financing activities” of $59 million for 2016, $84 million for 2015 and $52 for 2014.  Our stock compensation expense continues to reflect estimated forfeitures.

 

During 2016, we adopted ASU 2014-15, “Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (Topic 205)”. This standard requires us to evaluate, for each annual and interim reporting period, whether there are conditions and events, considered in the aggregate, that raise substantial doubt about our ability to continue as a going concern within one year after the date the  Consolidated Financial Statements are issued or are available to be issued. If substantial doubt is raised, additional disclosures around our plan to alleviate these doubts are required. The adoption of this standard did not affect our Consolidated Financial Statements.

 

During 2016, we adopted ASU 2015-07, “Fair Value Measurement - Disclosures for Investments in Certain Entities that Calculate Net Asset Value per Share (or Its Equivalent) (Topic 820)”.  This standard requires us to disclose which assets we value using net asset value as a practical expedient, and ends the requirement to classify these assets within the GAAP fair value hierarchy.  See Note 15 of our Consolidated Financial Statements for disclosures of assets we value using net asset value as a practical expedient. 

 

RECENTLY ISSUED ACCOUNTING STANDARDS

 

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers,” as amended by several subsequent ASUs, which provides guidance for revenue recognition. The standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services.  Per ASU 2015-14, “Deferral of Effective Date,” this guidance will be effective for us in the first quarter of our fiscal year ending February 2, 2019.  Early adoption is permitted as of the first quarter of our fiscal year ending February 3, 2018.  We are currently in the process of evaluating the effect of adoption of this ASU on our Consolidated Financial Statements.

   

In November 2015, the FASB issued ASU 2015-17, “Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes.” This amendment requires deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. This guidance will be effective for our fiscal year ending February 3, 2018. Early adoption is permitted. The implementation of this amendment will not have an effect on our Consolidated Statements of Operations and will not have a significant effect on our Consolidated Balance Sheets.

   

In February 2016, the FASB issued ASU 2016-02, “Leases”, which provides guidance for the recognition of lease agreements.  The standard’s core principle is that a company will now recognize most leases on its balance sheet as lease liabilities with corresponding right-of-use assets.  This guidance will be effective for us in the first quarter of fiscal year ending February 1, 2020.  Early adoption is permitted.  The adoption of this ASU will result in a significant increase to our Consolidated Balance Sheets for lease liabilities and right-of-use assets, and we are currently evaluating the other effects of adoption of this ASU on our Consolidated Financial Statements.  We believe our current off-balance sheet leasing commitments are reflected in our investment grade debt rating.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Cash Flow Information

 

Net cash provided by operating activities

 

We generated $4.3 billion of cash from operations in 2016, compared to $4.9 billion in 2015 and $4.2 billion in 2014.  The cash provided by operating activities came from net earnings including non-controlling interests adjusted primarily for non-cash expenses of depreciation and amortization, stock compensation, expense for Company-sponsored pension plans and the LIFO charge.  Changes in working capital created a net cash outflow in 2016, and net cash inflows for 2015 and 2014.

 

The decrease in net cash provided by operating activities in 2016, compared to 2015, resulted primarily due to a decrease in net earnings including noncontrolling interests and changes in working capital, partially offset by an increase in non-cash expenses, deferred taxes and lower payments on long-term liabilities.  

The increase in net cash provided by operating activities in 2015, compared to 2014, resulted primarily due to an increase in net earnings including non-controlling interests, an increase in non-cash items and changes in working capital.  The increase in non-cash items in 2015, as compared to 2014, was primarily due to increases in depreciation and amortization expense and expense for Company-sponsored pension plans, partially offset by a lower LIFO charge.

 

Cash provided (used) by operating activities for changes in working capital was ($492) million in 2016, compared to $180 million in 2015 and $3 million in 2014.  The decrease in cash provided by operating activities for changes in working capital in 2016, compared to 2015, was primarily due to the net effect of the following:

 

The increase in cash provided by operating activities for changes in working capital in 2015, compared to 2014, was primarily due to an increase in cash provided by trade accounts payables and store deposits in transit, partially offset by a decrease in cash provided by income taxes receivable and payable. 

 

Net cash used by investing activities

 

Cash used by investing activities was $3.9 billion in 2016, compared to $3.6 billion in 2015 and $3.1 billion in 2014.  The amount of cash used by investing activities increased in 2016, compared to 2015, primarily due to increased cash payments for capital investments and our merger with ModernHEALTH. The amount of cash used by investing activities increased in 2015, compared to 2014, due to increased payments for capital investments, partially offset by lower payments for mergers.

 

Net cash provided (used) by financing activities

 

Financing activities used cash of $352 million in 2016, $1.3 billion in 2015 and $1.2 billion in 2014.  The decrease in the amount of cash used for financing activities in 2016, compared to 2015, was primarily due to higher treasury stock purchases, partially offset by higher long-term and commercial paper borrowings.  The increase in the amount of cash used for financing activities in 2015, compared to 2014, was primarily related to increased payments on long-term debt and commercial paper, partially offset by higher proceeds from issuances of long-term debt and decreased treasury stock purchases. 

 

Debt Management

 

Total debt, including both the current and long-term portions of capital lease and lease-financing obligations, increased $2.0 billion to $14.1 billion as of year-end 2016, compared to 2015.  The increase in 2016, compared to 2015, resulted from the issuance of (i) $1.0 billion of senior notes bearing an interest rate of 4.45%, (ii) 750 million of senior notes bearing an interest rate of 2.65%, (iii) $500 million of senior notes bearing an interest rate of 3.875%, (iv) $500 million of senior notes bearing an interest rate of 1.5%, (v) increases in commercial paper borrowings and  (vi) increases in capital lease obligations due to additional leased locations, partially offset by payments of $1.4 billion on maturing long-term debt obligations.

 

Total debt, including both the current and long-term portions of capital lease and lease-financing obligations, increased $481 million to $12.1 billion as of year-end 2015, compared to 2014.  The increase in 2015, compared to 2014, resulted primarily from the issuance of (i) $300 million of senior notes bearing an interest rate of 2.00%, (ii) $300 million of senior notes bearing an interest rate of 2.60%, (iii) $500 million of senior notes bearing an interest rate of 3.50% and (iv) an increase in capital lease obligations due to our merger with Roundy’s and various leased locations, partially offset by payments of $678 million on long-term debt obligations assumed as part of our merger with Roundy’s and $500 million of payments at maturity of senior notes bearing an interest rate of 3.90%.  The increase in financing obligations was due to partially funding our merger with Roundy’s.

 

Liquidity Needs

 

We estimate our liquidity needs over the next twelve-month period to range from $5.9 to $6.4 billion, which includes anticipated requirements for working capital, capital investments, interest payments and scheduled principal payments of debt and commercial paper, offset by cash and temporary cash investments on hand at the end of 2016.  We generally operate with a working capital deficit due to our efficient use of cash in funding operations and because we have consistent access to the capital markets.  Based on current operating trends, we believe that cash flows from operating activities and other sources of liquidity, including borrowings under our commercial paper program and bank credit facility, will be adequate to meet our liquidity needs for the next twelve months and for the foreseeable future beyond the next twelve months.  We have approximately $1.4 billion of commercial paper and $600 million of senior notes maturing in the next twelve months, which is included in the range of $5.9 to $6.4 billion in estimated liquidity needs.  We expect to refinance this debt, in 2017, by issuing additional senior notes or commercial paper on favorable terms based on our past experience.  We also currently plan to continue repurchases of common shares under the Company’s share repurchase programs and a growing dividend.  We believe we have adequate coverage of our debt covenants to continue to maintain our current debt ratings and to respond effectively to competitive conditions.

 

Factors Affecting Liquidity

 

We can currently borrow on a daily basis approximately $2.75 billion under our commercial paper  program.  At January 28, 2017, we had $1.4 billion of commercial paper borrowings outstanding.  Commercial paper borrowings are backed by our credit facility, and reduce the amount we can borrow under the credit facility.  If our short-term credit ratings fall, the ability to borrow under our current commercial paper program could be adversely affected for a period of time and increase our interest cost on daily borrowings under our commercial paper program.  This could require us to borrow additional funds under the credit facility, under which we believe we have sufficient capacity.  However, in the event of a ratings decline, we do not anticipate that our borrowing capacity under our commercial paper program would be any lower than $500 million on a daily basis.  Although our ability to borrow under the credit facility is not affected by our credit rating, the interest cost on borrowings under the credit facility could be affected by an increase in our Leverage Ratio.  As of March 22, 2017, we had $956 million of commercial paper borrowings outstanding. 

 

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

 

 

 

Our credit facility is more fully described in Note 6 to the Consolidated Financial Statements.  We were in compliance with our financial covenants at year-end 2016.

 

The tables below illustrate our significant contractual obligations and other commercial commitments, based on year of maturity or settlement, as of January 28, 2017 (in millions of dollars):

 

 

As of January 28, 2017, we maintained a $2.75 billion (with the ability to increase by $750 million), unsecured revolving credit facility that, unless extended, terminates on June 30, 2019.  Outstanding borrowings under the credit facility and commercial paper borrowings, and some outstanding letters of credit, reduce funds available under the credit facility.  As of January 28, 2017, we had $1.4 billion of borrowings of commercial paper and no borrowings under our credit facility.  The outstanding letters of credit that reduce funds available under our credit facility totaled $13 million as of January 28, 2017.

 

In addition to the available credit mentioned above, as of January 28, 2017, we had authorized for issuance $4 billion of securities under a shelf registration statement filed with the SEC and effective on December 14, 2016.

 

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

 

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

 

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

 

OUTLOOK

 

This discussion and analysis contains certain forward-looking statements about our future performance.  These statements are based on management’s assumptions and beliefs in light of the information currently available to it.  Such statements are indicated by words such as “comfortable,” “committed,” “will,” “expect,” “goal,” “should,” “intend,” “target,” “believe,” “anticipate,” “plan,” 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 21E 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 actual results to differ materially from those contained in the forward-looking statements.  These include:

 

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We cannot fully foresee the effects of changes in economic conditions on our business. We have assumed economic and competitive situations will not change significantly in 2017.

 

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.  We undertake no obligation to update the forward-looking information contained in this filing.

 

 

ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

 

Financial Risk Management

 

We use derivative financial instruments primarily to manage our exposure to fluctuations in interest rates.  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 our commercial paper program, 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 January 28, 2017, we maintained two interest rate swap agreements, with an aggregate notional amount totaling $100 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 in December 2018, and coincide with our scheduled debt maturities.  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 January 28, 2017, we maintained 25 forward-starting interest rate swap agreements with maturity dates of August 15, 2027, January 15, 2029, January 15, 2049 and January 15, 2050 with an aggregate notional amount totaling $1.6 billion.  A forward-starting interest rate swap is an agreement that effectively hedges the variability in future benchmark interest payments attributable to changes in interest rates on the forecasted issuance of fixed-rate debt.  We entered into these forward-starting interest rate swaps in order to lock in fixed interest rates on our forecasted issuances of debt in fiscal years 2017, 2018 and 2019.  The fixed interest rates for these forward-starting interest rate swaps range from 2.07% to 3.00%.  The variable rate component on the forward-starting interest rate swaps is 3 month LIBOR.  Accordingly, the forward-starting interest rate swaps were designated as cash-flow hedges as defined by GAAP.  As of January 28, 2017, the fair value of the interest rate swaps was recorded in other assets for $67 million, other long-term liabilities for $7 million and accumulated other comprehensive income for $38 million, net of tax.

 

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

 

The tables below provide information about our interest rate derivatives classified as fair value hedges and underlying debt portfolio as of January 28, 2017 and January 30, 2016.  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 classified as fair value hedges as of January 28, 2017 and January 30, 2016.  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 January 28, 2017 and January 30, 2016.  The Fair Value column includes the fair value of our debt instruments and interest rate derivatives

classified as fair value hedges as of January 28, 2017 and January 30, 2016.  See Notes 6, 7 and 8 to the Consolidated Financial Statements.

 

 

 

 

 

Based on our year-end 2016 variable rate debt levels, a 10 percent change in interest rates would be immaterial.  See Note 7 to the Consolidated Financial Statements for further discussion of derivatives and hedging policies.