Kroger Company (KR) Q3 2018 Earnings Conference Call Transcript

Kroger Company (KR -2.28%)
Q3 2018 Earnings Conference Call
December 6, 2018, 10:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good morning and welcome to the Kroger Company third quarter earnings conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the * key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press * then 1 on your telephone keypad. To withdraw your question, please press * then 2. Please note this event is being recorded.

I would now like to turn the conference over to Rebekah Manis, Director of Investor Relations. Please go ahead.

Rebekah Manis -- Director, Investor Relations

Thank you, Laura. Good morning and thank you for joining us. Before we begin, I want to remind you that today's discussions will include forward-looking statements. We want to caution you that such statements are predictions and actual events or results can differ materially. A detailed discussion of the many factors that we believe will have a material effect on our ongoing business is contained in our SEC filings. Kroger assumes no obligation to update that information. Our third-quarter press release and our prepared remarks from this conference call will be available on our website at ir.kroger.com.

After our prepared remarks, we look forward to taking your questions. In order to cover a broad range of topics from as many of you as we can, we ask that you please limit yourself to one question and one follow-up question, if necessarily.

Thank you. I will now turn the call over to Kroger's Chairman and Chief Executive Officer Rodney McMullen.

Rodney McMullen -- Chairman & Chief Executive Officer

Thank you, Rebekah. Good morning, everyone and thank you for joining us. With me to review Kroger's third-quarter 2018 results is Executive Vice President and Chief Financial Officer Mike Schlotman.

At our investor conference at the end of October, we shared several big ideas. The defining idea is we are transforming our business model through Restock Kroger and then beyond. We will grow market share by both redefining Kroger customer experience and alternative profit streams through complementary businesses and partnerships.

Redefining the customer experience means offering customers incredibly physical and digital experiences, a fantastic offering, and friendly and caring associates, delivering an exceptional customer experience through their Kroger ecosystem creates incremental new profit streams, which in turn drives the economic model that makes a seamless experience possible. In this way, our new growth model will be a virtuous cycle.

This all means that Kroger is also reinventing our financial model. We're moving from a traditional grocer to a growth company with both a strong customer ecosystem that offers anything, anytime, anywhere and asset-light, high-margin alternative partnerships and services.

I will break it down in a bit more detail. Successful long-term businesses constantly explore new directions and adjacencies to grow their topline. At our investor conference, we highlighted one of the most successful to date Kroger Personal Finance, as well as several businesses under our 8451 portfolio, including our Kroger Precision Marketing Media offering.

Kroger Personal Finance delivered record year to date profit and is on track for the most profitable year ever. Our high-margin media business is strong and growing. Revenue for Kroger Precision Marketing, powered by 8451, is up more than 150% year to date. One service line, our boosted products and search business, where advertisers can influence how their products show on our site benefited advertisers with more than 700 million product impressions in the third quarter alone personalized to Kroger shoppers with click-to-conversion rates that are two to three times the industry standard.

We see tremendous potential in these asset-light, margin-rich businesses built off of a robust grocery supermarket experience, which is being redefined every day at Kroger.

Nowhere is this more obvious than digital. Our digital sales grew by over 60% in the third quarter. Our seamless coverage area now reaches more than 90% of Kroger households. This includes Kroger pickup and delivery. Kroger Ship is now available in all supermarket divisions. Ship customers can shop from a curated selection informed by 8451 data and insights of more than 50,000 grocery and household essentials that matter the most to our customers. Plus, there are 4,500 our brand products available only from Kroger.

We are aggressively investing to build digital platforms because they give our customers the ability to have anything, anywhere, anytime from Kroger and because they are catalysts to grow our business and improve margins in the future.

As we stated at our investor day, we expect to be able to cover not only 100% of our customers, but also the entire US population. Our brands continue to perform exceptionally well with customers and is one of the most profitable parts of our supermarket business.

Our brands made up 28.7% of unit sales and 26.6% of sales dollars, both of which are record third quarter results. Our Private Selection and Simple Truth brands saw strong sales, units, and gross margin gains in the third quarter. Simple Truth and Simple Truth organic is our fastest-growing brand, with sales up double digits again in this third quarter. As we've shared previously, our brands account for four of the top five items sold through Kroger Pickup and 41 of the top 50 items sold on Kroger Ship.

We have now been executing for three quarters our Restock Kroger plan to create shareholder value by redefining the grocery customer experience, partnering for customer value, developing talent, and living our purpose. We feel good about the progress and how everything is coming together. We are proactively investing for the future, in stores and online and in our customers and associates. We are using our assets, especially our love of people and our love of food to transform our business in ways to driver sustainable, competitive advantage.

Now, here is Mike to share more details on our third quarter results and share guidance for the fourth quarter of 2018. Mike?

Mike Schlotman -- Executive Vice President & Chief Financial Officer

Thanks, Rodney and good morning, everyone. We are pleased with our net adjusted operating earnings per diluted share result of $0.48 for the third quarter. Strong few margins and continued execution of Restock Kroger contributed to this result.

We continue to make several Restock Kroger investments in the third quarter. These included investments in price, especially in support of our brands and in space optimization, store remodels, and technology enhancements. Part of these investments will allow customers to buy anything, anytime, anywhere from Kroger.

As we discussed at our investor conference, space optimization is a massive undertaking and we continue to expect to end the year with 600 stores completed. Our ID sales for the third quarter were in line with our expectation. ID sales were led by natural foods, pharmacy, seafood, produce, and deli departments.

Looking at gross margin, we were pleased to see that our shrink rate continued to improve during the third quarter compared to the previous year. The gross margin rate reflects the timing and size of a company's price investments compared to a year ago. Rising transportation costs and growth of the specialty pharmacy business, which is a high sales, low-margin rate business that generates strong gross profit dollars.

Keep in mind that last year in the third quarter, our gross margin rate was higher than our typical run rate. For the third quarter in 2018, gross margin excluding fuel was actually higher than the second quarter of 2018. These fluctuations illustrate how results in the given quarter can vary based on the cadence of investments we make in the business. Part of our investments this year support the Our Brand strategy, where we continue to offer high-quality products at a great value.

The improvement in unit movement in the quarter demonstrates these investments are resonating with customers. We intended to continue investing in price to drive unit growth while also delivering on the bottom line for our shareholders. We are pleased that OG&A cost decreased by 20 basis points as a rate of sales. The significant improvements we are seeing from our focus on store associate turnover is contributing to this positive movement. We continue to focus on productivity in waste and improvements in our cost to fill prescriptions and increased adoption of self-scan contributed to this improvement.

Our investments in Restock Kroger in redefining the customer experience, partnering for customer value, and developing talent will be paid for by cost of goods savings, strong ID sales, and productivity gains. This will contribute to generating $400 million in incremental operating profit through 2020.

Now for an update on our retail fuel performance in the third quarter -- our cents per gallon fuel margin was approximately $0.261 compared to $0.249 in the last year's third quarter. The average retail price of fuel was $2.81 compared to $2.46 in the same quarter last year.

We expect our tax rate for 2018 to be approximately 23%, excluding the 2018 adjustment items, Kroger expects its factory to be approximately 21%. These rates reflect the third quarter adjustment related to regular IRS audit. The IRS audit resulted in a reduction in prior year tax deductions at pre-tax reform rates and future tax reductions at post-tax reform rates.

Our financial strategy is to use free cash flow to drive growth while also maintaining our current investment grade debt rating in returning capital to shareholders. We continually balance the use of cash flow to achieve these goals.

Over the last four quarters, we used cash to invest a combined $589 million in Ocado securities and Home Chef, contributed an incremental $185 million pre-tax to a company-sponsored pension plan, $467 million to satisfy withdraw obligations to the Central States Pension Fund, repurchased 91 million common shares for $2.3 billion, which includes $1.2 billion repurchased with after-tax proceeds in the sale of Kroger's convenience store business under an accelerated stock repurchase plan.

We pay $435 million in dividends and we invested $3 billion in capital, excluding mergers, acquisitions, and purchases, at least facilities. At the end of the third quarter, we had approximately $546 million remaining under the current share repurchase authorization.

We remain committed to generated the $6.5 billion of restock free cash flow by 2020 as part of our Restock Kroger plan. We have working capital improvements built into this guidance and off to a great start with $100 million improvement and net operating working capital so far this year.

Kroger's net total debt to adjusted EBITDA ratio on a 52-week basis is 2.72. Our net total debt to adjusted EBITDA ratio target is 2.3 to 2.5 times and we remain committed to bringing the leverage ratio back into he target range.

We are investing an incremental $500 million in our associates and wages, training, and development over the next three years through Restock Kroger. This will be in addition to our continued efforts to rebalance pay and benefits while also focusing on certifications and performance incentives, peer opportunities, and training.

In March, we also announced investing a portion of our tax savings and our Educational Assistance Program, Feed Your Future, and an increased 401(k) match for non-union associates. The average hourly rate for our store associates is more than $18.00 per hour when you factor in our comprehensive benefits that many of our competitors don't offer.

We recently ratified a new labor agreement with the UFCW, covering more than 13,000 Kroger associates in Columbus, Ohio. The agreement raised the starting wages and accelerates wage progressions after one year of service.

We are currently negotiating with the UFCW for contracts governing store associates at Smith's in Albuquerque and Fred Meyer in Portland. Our objective in every negotiation is to find a fair and reasonable balance between competitive costs and compensation packages that provide solid wages, good quality affordable healthcare, and retirement benefits for our associates.

We continue to strive to make our overall benefits package relevant to today's associates. Our financial results continue to be pressured by inefficient healthcare and pension costs, which some of our competitors do not face. We continue to communicate with our local unions and the international unions, which represent many of our associates, on importance of growing our business in a profitable way, which will help us create more jobs and career opportunities and enhance job security for our associates.

Turning now to guidance for the remainder of 2018 -- we continue to expect identical sales growth excluding fuel in the second half to be similar to the first half results. We updated our GAAP net earning guidance from $3.80 to $3.95 per diluted share for 2013 from the previous range of $3.88 to $4.03. The change in GAAP guidance is due to the third quarter market value adjustment of $0.09 per diluted share for Kroger's investment in Ocado shares and does not reflect any future changes in the market value of those shares because those could not be predicted.

On an adjusted basis, we maintained our net earnings guidance range of $2.00 to $2.15 per diluted share for 2018. Keep in mind that Fiscal 2017 included an extra week. We continue to expect capital investments, excluding mergers, acquisitions, and purchases of leased facilities to be approximately $3 billion for 2018. Now, I'll turn it back to Rodney.

Rodney McMullen -- Chairman & Chief Executive Officer

Thanks, Mike. We're not quite through our first year of executing Restock Kroger. We feel great about where we are. We are laser-focused on our customers and fulfilling their needs. We are clear on our vision to serve America through food inspiration and uplift. Our 2018 accomplishments and investments set us up well for 2019 and we are committed to delivering on our Restock Kroger financial targets by the end of 2020.

We have a clear path through both redefining the customer experience and growing alternative profit streams. Now, we look forward to your questions.

Questions and Answers:

Operator

We will now begin the question and answer session. To ask a question, you may press * then 1 on your touchstone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press * then 2. At this time, we will pause momentarily to assemble our roster.

Our first question today comes from Vincent Sinisi of Morgan Stanley.

Vincent Sinisi -- Morgan Stanley -- Analyst

Good morning, guys. Thanks for taking my question. I wanted to ask a bit further on the alternative revenue streams. Since your guys' investor day, we've been getting a lot of questions from investors. You called out the Kroger Personal Finance, seeing results there. Can you give us more color on that specifically and as a category, alternative revenue streams, what are some of the puts and takes? We know it's one of the more important components of your EBIT guide.

Rodney McMullen -- Chairman & Chief Executive Officer

If you look at the October meeting, we went through several different ones. We highlighted Kroger Personal Finance in October because we wanted everybody to see we had a great track record of identifying new business opportunities and having it grow in a meaningful way that's substantial to us.

One of the announcements that we made last year was the Kroger Precision Marketing, where we're using the insights from 8451. All of those things are really based on the traffic from our stores and our digital properties and creating a seamless experience for customers. All of those things that we're doing will help our customers shop at our stores easier. Like in the media experience, we'll allow our CPG partners and other people to target specific customers through our pipeline.

If you look at it over the last four years, the compounded annual growth from a profitability standpoint has been 16%. If you look at our expectations as you look at '18 through '20, we would expect that to accelerate to 28% growth per year. Certainly, the progress we're having in '18 would support the 16% that we've projected based on the historical four years. Mike, anything you want to add?

Mike Schlotman -- Executive Vice President & Chief Financial Officer

I think we also, Rodney, gave some color on the Kroger Precision Marketing, the fact that it's up 150% year to date. I think it's pretty impressive with the Boosted Search, with 700 million product impressions this third quarter and when you get click-to-conversion ratios two to three times industry standard, that's the kind of thing that keeps momentum going and keeps third parties interested in continuing to have that boosted search.

Vincent Sinisi -- Morgan Stanley -- Analyst

That's helpful. As a fast follow-up -- in the press release this morning, with some of the price investment commentary, is that normal cadence, nothing out of the ordinary or did you see any particular change or by category this quarter?

Rodney McMullen -- Chairman & Chief Executive Officer

I would say if you look at the overall strategy, it's executing the overall strategy that we started -- well, we talked about at the beginning of the year but we've been embarking upon for several years. I wouldn't say anything out of the ordinary, as Mike mentioned in his prepared comments, last year's third quarter was higher than trend line.

The other thing I think it's important to note is we did have a couple of new warehouses starting up and a warehouse conversion that also negatively affected the margins in the quarter and those are one-time -- it will take a couple of quarters for those to get started up in the transition but that also negatively affected the quarter.

Vincent Sinisi -- Morgan Stanley -- Analyst

That's helpful. Thank you.

Operator

Your next question will come from Karen Short of Barclays.

Karen Short -- Barclays -- Managing Director

Thanks very much. So, I just wanted to ask a question about full-year guidance and the implied fourth quarter. The range is pretty wide for 4Q, getting $0.38 to $0.53. I'm wondering if you could give a little color on that and the puts and takes to operating margin. I guess maybe comment on the guidance in light of the fact that gas margins seem pretty strong in the quarter to date. I know in the past when that has been the case, you've pulled forward expenses into the fourth quarter or into the quarter, whatever the quarter was where there were strong gas margins. A little color there would be helpful.

Rodney McMullen -- Chairman & Chief Executive Officer

The wide range, we all agree here at Kroger that the range for the fourth quarter is wide keeping it at $0.15. It's purely driven by what you zeroed in on and that's gasoline margins and where they wind up because they've been very volatile over the last several weeks while a very strong year, they can turn pretty quickly, both positively and negatively. If you think about what one margin and gallon means to earnings per share or $0.01 margin per gallon means to earnings per share, it equates almost to a penny a share, that volatility is what caused us to decide to keep the range fairly wide.

It has nothing to do with our view of how the business is going to operate in the fourth quarter. It's purely margins continue to be strong where they get weaker the next fire or six weeks or where exactly where they go. It's really you're unable to predict where those margins go on a weekly basis, so we decided to keep it a little wider, purely based on where gas margins my wind up in the fourth quarter.

Karen Short -- Barclays -- Managing Director

Is it fair to think if they remain strong you'll pull expenses into the fourth quarter or it's impossible to predict?

Rodney McMullen -- Chairman & Chief Executive Officer

I wouldn't predict pulling expenses into the fourth quarter. If you look where we're sitting here in early December, our promotional activity and our ads are pretty well-set over the holidays coming up and New Year's and even as we get into January, the college football playoffs and the Super Bowl, those big events, those plans are pretty well locked and loaded the supply chain is ready for those kinds of activities to come through.

So, to do a lot of other unusual things in the next eight weeks, eight and a half weeks would be pretty comfortable with the plans we have in place.

Karen Short -- Barclays -- Managing Director

Just a general question on the alternative revenue streams -- presumably, those are high gross margin and this quarter isn't really the quarter to see the flow through given the comparisons from last year -- any color on how to think of how alternative revenue streams will impact reported gross margin going forward?

Mike Schlotman -- Executive Vice President & Chief Financial Officer

Longer term, I wouldn't say we're in a position to start giving some of the detailed insight. Your hypothesis is correct in terms of the margins in our alternative profit streams are significantly higher than the core business, which is one of the reasons why we want to make sure we call it out and point it out.

The other thing, as you know, that's incredibly important is in that space, it's typically very asset-light. If you look at Kroger Personal Finance, we have an incredibly strong partnership with the bank. The asset that's used to grow that business is reasonably modest. If you look at Kroger Precision Marketing, it's using insights and data to create that revenue stream. It's easily scalable as long as you're producing the results for your customers. It's a piece that's incredibly exciting. In terms of some specifics, it's still a little too early for that.

Karen Short -- Barclays -- Managing Director

Thanks so much.

Operator

The next question will come from Edward Kelly of Wells Fargo.

Edward Kelly -- Wells Fargo -- Managing Director

Could we start with just the IDs? Could you talk about the cadence of IDs, what you're seeing so far in the current quarter and any update on the optimization drive? Obviously, your guidance implies Q4 will be better. I'm curious if you're seeing some of that yet.

Rodney McMullen -- Chairman & Chief Executive Officer

If you look at the cadence throughout the quarter, it was consistent throughout the quarter. So far this quarter, we would be in the same range that we ended the third quarter. When you look at space optimization and the fact that we're in the holiday season, we've been disciplined to not have stores disrupted during the holiday season, so, we would expect to see those stores start to perform better like we talked about at the investor conference.

We will start next year, space ops, we will start some storage in January after the holiday season. When you look at the slide I showed at the investor conference on space op, what we're seeing in ID sales for those stores is not materially different from what I showed back in October.

Edward Kelly -- Wells Fargo -- Managing Director

Then I wanted to ask about SG&A. Can you talk about your ability to drive 20 basis points of OpEx leverage this quarter? You've been talking about cost discipline. Is this starting to inflect into the P&L? I'm curious as we think about things going forward, how should we be thinking about this line item? How important is it to your $400 million over time? Any color would be good as to what this quarter means thinking about modeling going forward.

Mike Schlotman -- Executive Vice President & Chief Financial Officer

I think what it means is a lot of what you said. If you look at the areas I called out in the forward-looking comments, when you look at retention getting significantly better than it has, it does multiple things. One, you don't spend the dollars you have to spend to hire somebody, jus the hard cost of getting somebody into the system, whether you do a background check or other screenings on the individual, getting them through a training program and then getting them onto the sales floor at a productivity level lower than someone who has six to nine months' experience.

So, when you have more and more people who have that six to nine months' experience and start to get to 12 months' experience, that helps the productivity inside the store. More people then wind up staying, particularly the part-time workforce as they start to appreciate when they're here six months, they start to get the benefit of Feed Your Future, where they can get $3,500.00 a year toward furthering their education.

That cost, while it sounds expensive, actually will be offset by that person staying another 12 or 18 months versus having that person turn a couple of times and having lower productivity and training. So, you kind of create a virtuous cycle and better opening wage rates, more contemporary benefits, helping them with their college education or GED or English as a second language. We have lot of folks that work for Kroger in management positions that have decided to get their MBA and other advanced degree certifications. All of those help with that.

We continue to see improvement in our cost to fill in our pharmacies. Our pharmacy business continues to be a very strong piece. As we leverage that and are able to leverage down our cost to fill prescriptions, that certainly helps. Then the efforts we've had on our frontend transformation that we try to work in with space op. when possible of reconfiguring the self-checkout units so that it's an easier, more friendly experience for our customers and then the added benefit of the scan, bag, and go, all those help create productivity, which is a positive to it.

A lot of things I said there, I don't know that I would promise 20 basis points going forward, but certainly cost reduction as we've been talking, since we announced Restock Kroger in 2017 is a very important part of getting the $400 million of operating profit.

Rodney McMullen -- Chairman & Chief Executive Officer

I agree totally with everything that Mike said. I think the last part that Mike said is the important part. As you look at now through 2020, you should expect to see us reducing cost, how much cost it takes for us to operate our business. Mike gave several great examples, but really, our operations team is doing a great job working with our stores and technology team on some innovation ideas to improve processes and take costs out. It's really all of those pieces working together. But absolutely, as you look out through 2020, you should expect us to improve how much it costs us to operate our business.

Operator

The next question comes from Michael Lasser of UBS.

Michael Lasser -- UBS -- Analyst

In light of the fact that space optimization disruption should be less given the reacceleration of your price investment, should we expect that IDs are going to meaningfully accelerate over your fourth quarter?

Mike Schlotman -- Executive Vice President & Chief Financial Officer

I think the only place I would go on ID sales is we would expect the second half to be close to the first half. Our third quarter was close to the second quarter and our first quarter was a little better than the second quarter. We do have a little bit of ground to make up on that guidance. We said similar. We didn't say exactly equal to. We are expecting a little bit better fourth quarter. I think we have great plans in place.

Michael Lasser -- UBS -- Analyst

What would be the offset to some of those benefits -- industry factors, consumer pressures? What are your thoughts there?

Mike Schlotman -- Executive Vice President & Chief Financial Officer

What do you mean by offset?

Michael Lasser -- UBS -- Analyst

You're going to see less from space optimization and should get sales lift from the price investments you've been making. I'm wondering if there's offsetting drag.

Mike Schlotman -- Executive Vice President & Chief Financial Officer

I wouldn't point to any particular offsetting drag as it relates to the topline. Keep in mind, our fuel rewards program continues to be incredibly important to our customers and associates when they think about the totally value we give on a day in, day out basis. We reduce reported IDs for that because you have to buy groceries to get the lower fuel discount. Not all of our competitors account for it that way. We're selling more in the stores, but it actually slows how quickly ID sales grow because of the way we do our accounting. There are always puts and takes on that topline.

Michael Lasser -- UBS -- Analyst

My follow-up is on Kroger Personal Finance. You're seeing very healthy growth. What's been driving that? How much of that is the private label credit card?

Rodney McMullen -- Chairman & Chief Executive Officer

It's really all the portfolio products they offer. So, in the last two or three years, we've done a couple of mergers with Roundy's and Harris Teeter. So, there's good growth there. There's good growth in the existing business. Then the credit card business continues to be an incredible tie in for our loyalty Kroger customers. All pieces of that business continue to grow. Credit write-offs are low as well. That's a pretty small part of the overall impact of the profitability of that business.

Operator

The next question comes from Ken Goldman of J.P. Morgan.

Ken Goldman -- J.P. Morgan -- Analyst

Mike, at the investor day, you did say, "I think 2019 has to have some decent operating profit margin dollars." I wanted to see if you could elaborate in general for next year. Are there any unique tailwinds, headwinds we should be thinking about?

Mike Schlotman -- Executive Vice President & Chief Financial Officer

I won't go too far on 2019. If you go all the way back to 2017 and then the first order of this year when we talk about pulling forward some investments from '19 into '18, clearly, operating profit margin has to grow in 2019 over 2018 and start that march to the $400 million we're going to generate over the three years of the Restock Kroger plan.

I knew at some point we would get this question because we were pretty prescriptive this time last year on the call about what we expected for 2018. A lot of it had to do with the fact that we had a range of estimates out there at that point in time that were as low as the $1.40s and $1.50s and up to above $2.20 kind of range. It was a massive range.

What we were trying to do was rein in that range as we got into the end of the year. Knowing we were going to give guidance in March, we didn't want that wide of a range out there. I think today, people are understanding this is a three-year program we're undertaking. As we pull those investments from '19 into '18, they should start generating more in '19 and then even more in '20. So, it is a three-year growth to get to the $400 million but we continue to see a clear path to the $400 million.

Rodney McMullen -- Chairman & Chief Executive Officer

The other point I would add -- we talked about it in October -- if you look at digital, our digital business continues to be a significant investment for the future of the business. We would expect for '19 that to become less of a headwind than it was in '18. That is also an important part to remember as well.

Ken Goldman -- J.P. Morgan -- Analyst

A follow-up -- if I look at your SG&A dollars, they were down year on year. If I exclude the one-time pension contribution last year, some extra weeks, it actually was down for the first time in at least 22 years. I realize you're gaining efficiencies with store associates. I get that personal finance is a contra-SG&A item, but I'm still not 100% sure why that decline was so sudden. Your SG&A came in $200 million below where the Street was. Can you help us understand a little bit of what the big dramatic change was in the quarter? Maybe we're modeling it wrong and didn't see something.

Mike Schlotman -- Executive Vice President & Chief Financial Officer

From a dollar standpoint, Ken, don't forget that last year would have had the C-stores in our OG&A rate and they're disposed of now in our dollars.

Ken Goldman -- J.P. Morgan -- Analyst

But last quarter in 2Q, you still were up year over year with SG&A. I can follow-up offline. I don't want to hold everyone up on the call.

Mike Schlotman -- Executive Vice President & Chief Financial Officer

Hold on one second.

Ken Goldman -- J.P. Morgan -- Analyst

Sorry, I didn't mean to do this.

Mike Schlotman -- Executive Vice President & Chief Financial Officer

We were up a little bit in the second quarter. I would say the second quarter is probably more a function of in the prior year, we would have had some bonus accrual reductions because of where the year was heading that we didn't enjoy this year.

Ken Goldman -- J.P. Morgan -- Analyst

Thanks, guys.

Operator

The next question will come from Chris Mandeville of Jefferies.

Christopher Mandeville -- Jefferies -- Analyst

You guys are doing well on OG&A, but gross margins are lower than what we were all expecting. Mike, can you maybe help ballpark the impact on gross margins based on the noted items you called out? I know you don't like to guide to any one line item, but given the strength of the fuel margins we're seeing quarter to date and how that plays into overall earnings, can you give us a sense of how to think of gross margins ex-fuel in Q4?

Mike Schlotman -- Executive Vice President & Chief Financial Officer

If you think about that margin rate in Q4, I'm more comfortable doing that than listing out the effects in any one quarter of those things because one quarter is not an indication of where they go long-term. The one I did call out is Kroger Specialty Pharmacy. It's a very profitable business. It has a very low margin rate. But because of the individual cost of those prescriptions for the patients, it generates very strong gross margin dollars, which is why we're in that business. As that business continues to grow, it will be a headwind. That one alone was a double-digit basis point headwind. I won't give the exact amount.

When you think about the fourth quarter, you should probably think about the fourth quarter change in gross margin rate the way we talk about that basis point change being more similar to the second quarter than the third quarter.

Christopher Mandeville -- Jefferies -- Analyst

Over the last couple weeks now, we've seen several sizable product recalls. I think some was even specific to the Kroger brand in both meats and pet foods. I'm curious on what Kroger has been doing of late and what they plan to do with regards to the supply chain, improving sourcing, mitigate retail costs.

Rodney McMullen -- Chairman & Chief Executive Officer

If you look, food safety is something Kroger has been incredibly proud of for many years. We have a team of folks here that that is their only responsibility, to make sure products are safe through the food channel. We will do routine audits of our suppliers as part of that process.

One of the things we are incredibly proud of is in the unfortunate situation where there is a recall, we reach out to our customers and let them know there is a recall on products they bought so we try to get that customer to get the product back to us as quick as possible to make it easy on them to let them know.

It's something we review with our board on a regular basis. If you look at severity of incidents, over the last five or six years, there's been a decline on severity of incidents. If you look at overall recalls, it continues to increase just because I think the overall food safety chain in the US continues to improve.

Christopher Mandeville -- Jefferies -- Analyst

A few quick housekeeping questions -- what was inflation/deflation in the quarter and was there any notable call out from hurricane impacts on the comp?

Mike Schlotman -- Executive Vice President & Chief Financial Officer

If you look at the hurricane impacts, it would have been a little bit of a headwind to ID sales. We didn't necessarily call it out primarily because it wasn't that dramatic. It was several basis points of a headwind. More than a couple, but not like 20 or 30 basis points. It was meaningful, but not directionally going to change. If you look at your question on inflation/deflation, I'm looking at my chart here -- I have 30-year olds that make a chart for their eyes, not my eyes.

If you look at inflation/deflation without fuel and pharmacy on a cost basis, we had about 11 basis points of inflation. If you put pharmacy back in the mix, we had about 22 basis points of inflation, a very benign environment. It ranges around the categories around who had some inflation and deflation. There were some categories that had a little bit of inflation and others that had a fair amount of deflation.

Operator

Our next question comes from Rupesh Parikh of Oppenheimer.

Rupesh Parikh -- Oppenheimer & Co. -- Managing Director

Good morning. So, on capital allocation, I was curious how quickly you anticipate being back to that 2.3 to 2.5 leverage ratio. I'm just curious if you have any initial thoughts as to whether you'd paid that down or refinanced that debt.

Mike Schlotman -- Executive Vice President & Chief Financial Officer

We actually have about $1.1 billion of long-term debt that is now classified as current coming due in the next 60 days, some this month, some next month. We would anticipate refinancing that in the market. We have forward starting swaps against the types of debt we would wind up expecting to issue at very favorable rates. The 30-year is almost 100 basis points below where the 30-year is today and the 10-year is hedged not quite that strongly.

We haven't decided what we will do with the term loan. Some of our banks like the business, some don't like the business, but we would have enough capacity to be able to use commercial paper to pay off the term loan if we chose to. We always have a financial policy committee meeting with our board in January and we'll discuss our plans of how much flexibility we want.

Relative to the net solo debt to EBITDA range, we are always in contact with the rating agencies. They understand what our program is. They are executing against a program. We've described to them relative to them keeping our ratings where they are.

Rodney McMullen -- Chairman & Chief Executive Officer

It's important for us to get back into the range.

Operator

The next question will come from Judah Frommer of Credit Suisse.

Judah Frommer -- Credit Suisse -- Analyst

Just to follow-up on the price investment first -- can you give us some insight as to how internally the decisions are made around seeing better fuel profitability and how quickly you can turn that in to pull forward price investment and then how should we think about that pull forward. Does it offset investments you may have made next year or since the environment is so competitive, is there just a race to the bottom with everybody?

Mike Schlotman -- Executive Vice President & Chief Financial Officer

It's obvious from some of the questions out there that there's this notion that when fuel profitability is very strong, we invest more in price and that's driving our gross margin down. I actually don't think that's true for this particular calendar year. We had a price program in place as part of restock Kroger. We knew what we wanted to invest this year.

Washington gave us a Tax Reform Act that lowered our cash taxes. We elected to pull some of our investments from '19 into '18 to get that expense behind us in the first year of the lower taxes, start to drive better growth in those categories as we get into '19. I wouldn't say that we've made any big moves on pricing as a result of strong fuel margin. It's where everything shakes out.

Rodney McMullen -- Chairman & Chief Executive Officer

The other thing I think is important to remember when we go to market, our fabulous associates in terms of the great experience they deliver and fresh product is also important. So, for us, it's the overall shopping experience we're trying to create for the customer and we're aggressively investing in the anything, any time, anywhere, so they can do it any way they want to, whether that's digital, delivery, pick up, or physically in the store and have the same great experience and great fresh product and all those together.

Judah Frommer -- Credit Suisse -- Analyst

A quick follow-up on the OG&A line -- I would say historically, your unionization was thought of as a knock on the business. Today, I would say the expansion into online and digital is seen as needing incremental investment in OG&A, but would you say we're at a point where the unionization may be helping you in some ways given the tightness of the labor environment and is there anything you can to dispel online grocery necessarily adding meaningfully to SG&A or bringing down the margin there?

Mike Schlotman -- Executive Vice President & Chief Financial Officer

I think when you look at our workforce overall, whether you're unionized or non-unionized -- not 100% of Kroger is unionized -- when I look at overall results in a unionized market versus a non-unionized market, whether it's at the end of the day, the OG&A rate and what you pay associates to perform their jobs, when you look at your employee relations, employee satisfaction, there's really not a tremendous difference between those particularly in the wages.

But we offer all of our associates a great healthcare option and if they're in a union, they're in amore defined benefit plan. If they're not in a union, some of them would be in a defined benefit plan, but some are in a defined contribution plan. It's really a mix of benefits inside those.

When I look at some of the home delivery and the online stuff that you refer to, there are a lot of costs in that system that everybody can point to and say how are you going to do it. It's one of the reasons we joined up with Ocado to build the fulfillment centers we're going to start building and we announced the first one here in Cincinnati.

While there are certain costs that will add and a part of the total supply chain for the customer, there are other parts of that cost that will come out the supply chain more efficient picking because it's done robotically, it's done significant faster on a 50-item order compared to how long it takes a 50-item order inside the store.

I don't take product from the manufacturer to the warehouse, to the store, I take it from the manufacturer to the Ocado warehouse and then it goes right from there to the customer. So, there are different efficiencies, which is overall why we think that's going to offset some of the costs people are worried about.

Operator

Your next question Paul Trussell of Deutsche Bank.

Paul Trussell -- Deutsche Bank -- Managing Director

Could you speak to any additional color around your digital business? I know you mentioned up 60%, just kind of what you're seeing out of Kroger Ship versus Pickup and Home Chef. In addition, if you could speak to the new pilot with Walgreens.

Rodney McMullen -- Chairman & Chief Executive Officer

There's a whole host of questions.

Mike Schlotman -- Executive Vice President & Chief Financial Officer

That was a good one question.

Rodney McMullen -- Chairman & Chief Executive Officer

I'll try to organize it in a way that makes sense. Our digital business, as you mentioned, grew 60%. All piece of the digital business continues to grow. If you look at what was the biggest drivers of the growth, it would certainly be continuing to add locations where customers can pick up and get delivery from an online standpoint and the stores that already had a year ago their continued growth and then Home Chef as well -- Home Chef would be pretty much exactly where we thought it would be from a growth standpoint, where Pat and his team thought they would be and we were part of it.

If you look at Ship and some of the other pieces, it's still pretty early in the process. We would have had a lot more expenses in terms of setting up where all the system worked versus so much of a sales driver, but obviously, over time, you would expect that to become more of a sales driver. That is very early in the ramp.

The relationship with Walgreens, both of us are very excited about what it can be, but it's one of the things where you have to start small and learn from it. That's really the prioritization is let's take baby steps and see if we can identify something that works for a Walgreens customer and a Kroger customer in some way that both of us can grow our business and make money. The thing I'm most excited about is when I spend time with our combined teams and their openness and aggressiveness in trying to identify something great for both of our customers is so exciting. It's pretty early to be giving more specifics than that.

Paul Trussell -- Deutsche Bank -- Managing Director

To circle back on inflation or lack thereof, it's clearly a benign environment in terms of the impact to your third quarter results -- I just wanted to circle back on your outlook as you think about what's to come over the next few months, any change in your outlook on inflation-deflation impact to your results?

Mike Schlotman -- Executive Vice President & Chief Financial Officer

I would say no. I don't really see a lot out there. I know there is a lot of noise in the marketplace about CPG companies pushing price increases through and the like. Over time, we'll see where that goes and how everybody winds up reacting to it. Keep in mind, when we talk about inflation-deflation, it's relative to Kroger and not marketplace forces, necessarily. So, it's our cost of goods this year versus our cost of goods last year.

As everybody knows our key component of driving the $400 million of operating profit over the next three years is continued improvement in cost of goods. So, some of that deflation is actually doing things to get better pricing inside Kroger and that may not be something that's replicated at other places.

Rodney McMullen -- Chairman & Chief Executive Officer

The other thing I think is always important to remember is I always think it's a dangerous thing for CPGs to raise their costs more than the economic cost of something increasing. What we find over time when somebody does that, our own brands will pick up a disproportionate amount of share whenever somebody does that. To me, it's a fine balance we're all doing to find that optimal price point.

Operator

The final question will come from Robbie Holmes of Bank of America Merrill Lynch.

Robert Holmes -- Bank of America, Merrill Lynch -- Analyst

Good morning, guys. Thanks for making me last. Just a couple of quick ones, sorry if I missed this -- Mike, can you give us traffic versus ticket in the quarter? I'm just curious the tone of the customer through the quarter -- were there any variances there? Are you seeing trade up when you look at what they're doing? Again, sorry if I missed this, but loyal households, was that still growing similar to previous quarters?

Mike Schlotman -- Executive Vice President & Chief Financial Officer

When you look at overall, the basket value grew a little bit in the quarter. That's primarily a result of mix of what's going inside the basket. When you look at transactions in the quarter, when you add in all of the entities, it was up a little bit in the quarter as well.

Rodney McMullen -- Chairman & Chief Executive Officer

The tone of the customer, they continue to -- the economy still feels very good. People continue to buy wine, anything that makes their life easier, they will aggressively buy. It wouldn't be anything. Then from a household standpoint, we did continue to have a slight growth in households as well.

Robert Holmes -- Bank of America, Merrill Lynch -- Analyst

Terrific. Thanks so much.

Rodney McMullen -- Chairman & Chief Executive Officer

We are incredibly confident about the future of Kroger, especially with Restock Kroger. One of the exciting things about our earnings call is that many of our associates listen in to better understand and gain insights into our business. Of course, many of our associates are shareholders as well. So, as always, before we end today's call, I'd like to share a few final comments directed toward them.

Last week, we celebrated Giving Tuesday. In conjunction with our partner, Feeding America, we set a goal to raise enough money to provide 5 million meals to those in need during this holiday season. Together with our customers, we raised enough to serve almost 6 million meals, helping us move closer to our zero hunger, zero waste goal of eliminating hunger in our communities.

Last Friday, a major earthquake rattled Alaska. We operate seven Fred Meyer stores that were affected and thankfully, all of our associates and customers inside our stores were safe. I'm so proud of the awesome job that Fred Meyer and Kroger team did. Under the leadership of Joe Grieshaber and our teams, everybody worked together to get all our stores opened within one day.

Each holiday season, I'm reminded of our privilege to serve more than 9 million customers who shop with us every day. Every celebration or tradition is as unique as the customer who walks through our door. Among the hustle and bustle of the season, you welcome our customers and help to make their celebrations brighter. We lift our customers' spirits and they uplift our spirits as well.

These are just a few examples of what it means to live our purpose to feed the human spirit. It's an amazing thing of what we can do together. Thank you for all you do for our customers, communities, and each other. Merry Christmas, happy holidays, and Happy New Year to you and your family, and all those listening in.

That completes our call today. Thanks for joining.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

Duration: 61 minutes

Call participants:

Rebekah Manis -- Director, Investor Relations

Rodney McMullen -- Chairman & Chief Executive Officer

Mike Schlotman -- Executive Vice President & Chief Financial Officer

Vincent Sinisi -- Morgan Stanley -- Analyst

Karen Short -- Barclays -- Managing Director

Edward Kelly -- Wells Fargo -- Managing Director

Michael Lasser -- UBS -- Analyst

Ken Goldman -- J.P. Morgan -- Analyst

Christopher Mandeville -- Jefferies -- Analyst

Rupesh Parikh -- Oppenheimer & Co. -- Managing Director

Judah Frommer -- Credit Suisse -- Analyst

Paul Trussell -- Deutsche Bank -- Managing Director

Robert Holmes -- Bank of America, Merrill Lynch -- Analyst

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