Good morning, and welcome to The Kroger Co. second quarter earnings conference call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Cindy Holmes, Director of Investor Relations. Please go ahead.

Thank you, Laura. Good morning, and thank you for joining us. Before we begin, I want to remind you that today's discussion 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 may have a material effect on our business on an ongoing basis is contained in our SEC filings, but Kroger assumes no obligation to update that information. Both our second 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. [Operator Instructions] Please save the date for our 2015 investor conference, which we will hold at the New York Stock Exchange on October 27. Details will be coming soon, and we hope you can join us. I will now turn the call over to Kroger's Chairman and Chief Executive Officer, Rodney McMullen.

Thank you, Cindy. Good morning, everyone, and thank you for joining us today. With me to review Kroger's second quarter 2015 results is Mike Schlotman, Executive Vice President and Chief Financial Officer. And the next time you see Mike, please congratulate him on his well-deserved and well-earned promotion. We are pleased with our second quarter results. Our 5.3% identical supermarket sales growth, without fuel, allowed us to continue investing in our business and delivering on our aggressive growth plan. Strong fuel margins toward the end of the quarter allowed us to deliver results that exceeded our original expectations. During the second quarter, we achieved our 47th consecutive quarter of positive identical supermarket sales growth. We exceeded our goal to slightly expand FIFO operating margin, without fuel, on a rolling 4-quarter basis. We kept costs down, which, together with identical supermarket sales growth, allowed Kroger to leverage operating expenses at a rate of sales. And we continue to grow market share by improving our connection with customers, which fuels both our top and bottom lines and enables strategic Customer 1st investments. These consistently remarkable financial results are possible quarter after quarter because our business is built on the belief that serving customers is serving shareholders. Based on the strength of our second quarter results, we are raising our net earnings per diluted share and identical supermarket sales growth guidance for the year. While customers continue to feel optimistic about the economy throughout the second quarter, they also continue to tell us they want to spend less. More and more, they want retailers to help them save money with sales and coupons. We are well positioned with our everyday low prices and our weekly sales and digital offers to solve this for our customers. As you know, the food retail business is…

Thanks, Rodney, and good morning, everyone. First, I'd like to spend a few minutes discussing our results for the quarter in each of the key performance target areas for our long-term growth plan. Our first metric is identical supermarket sales without fuel. Our identical supermarket sales growth of 5.3% in the second quarter demonstrates the strength of our core business. Our identical supermarket sales growth was driven by a combination of strong tonnage growth and an increase in the number of households shopping with us in the second quarter. We also met our goal to grow the number of loyal households at an even faster rate than total household growth during the quarter. All geographies and supermarket departments had positive identical supermarket sales, excluding fuel, during the quarter. We continue to see outstanding double-digit identical sales growth in our natural foods department. Our meat, deli and pharmacy departments also posted strong sales. Rolling 4 quarters FIFO operating margin, excluding fuel, the 2014 and 2013 adjustment items and the contributions to the pension and foundation in the third and fourth quarters of 2014, I hope you got all that, increased by 20 basis points. This exceeded our commitment to grow the rate slightly over time on a rolling 4 quarters basis. Return on invested capital on a rolling 4 quarters basis was 14.24%. We are not presenting a comparative number this quarter because the last year's second quarter calculation does not include a full year of Harris Teeter assets and results. We continue to expect our return on invested capital for fiscal 2015 to increase slightly from fiscal 2014 results. This is an important metric as we continue to increase our capital investment to drive our future growth. Before I share our second quarter results in more detail, I'd like to…

Thanks, Mike. Kroger's business is strong. Our team of associates continues to drive our Customer 1st strategy by taking care of our customers in big and small ways, offering fresh foods and keeping costs down so that we can reinvest those savings in our associates, store experience, products and prices. As a result, we continue to earn customer loyalty and gain market share. We are investing to grow our business for the future while delivering on our promises today. Our stores are hiring to fill 20,000 new permanent jobs. We are expanding our digital and e-commerce offerings. Our confidence in Kroger has never been stronger. Now we look forward to your questions.

[Operator Instructions] And our first question will come from Karen Short of Deutsche Bank.

I just -- I don't want to sound negative here, but I guess, what I'm wondering, in terms of your ID guidance for the year, it definitely reflects a slow-down in the 2-year comp in the third quarter and fourth quarter, even though it looks like inflation is maybe getting a little bit better, maybe less of a headwind. So I guess, any color there. Is this you kind of being conservative? Any color you could give would be helpful.

Well, it's -- the guidance is always one of the hardest things to come up with what's the right estimate. As you know, we've always expected inflation to continue to slow down during the year, and we would expect that to continue. Now, we're working hard, as always, to make sure that we're at a good side of that. If you look at where we are so far this quarter, we continue to track within those -- within the guidance and kind of similar to where we were in the second quarter. So we feel good about where we are, but -- and we see exciting opportunities. I don't know, Mike, did you want to...

Yes, Karen, another thing to keep in mind is if you look at real growth, if you look at our current ID sales trend, and even what we would be projecting, and take away the relatively benign inflationary environment today, it's actually as strong of a real growth as we've had in quite some time, really, going all the way back to 3 or 4 years, actually 4 or 5 years. You really don't see a trend as strong as we have today when you look at it on an inflation-adjusted basis. Our tonnage growth is quite strong. And from our standpoint, as long as we continue to have the tonnage growth in many of the departments that we have, we'll be just fine, because that's the ultimate demonstration of the strength of your business is how many items are the customers buying on a weekly and monthly basis.

Okay, and that's helpful. And then, I guess, also just on your guidance, I'm -- just was wondering, on your updated pension guidance, you have some changes in both the company and the multiemployer. It's unclear to me on the multiemployer if your prior guidance just didn't include the $60 million that was previously accrued, but you definitely also increased the company-sponsored. So obviously, you're raising your guidance even with these -- those 2 headwinds?

Yes. The $60 million would have been accrued and expensed when it was accrued. Keep in mind that on the multiemployer plans, when you have a contractual obligation or actually put dollars in, you expense it, versus a company plan, we could put money in, and it may not translate to an -- a current expense. So they're quite different in how you account for the 2 calculations. I don't -- it's not a dramatic change in our expectations between the 2 plans, although somewhat...

More of a headwind? Okay, I'll get back in the queue.

It would be -- I mean, it would be a slight headwind compared to where we were earlier in the year, but nothing dramatic.

Our next question comes from Rupesh Parikh of Oppenheimer.

So I wanted to touch on your pharmacy business. We've seen some of your competitors call out some headwinds within their pharmacy business on the margin line. I just want to get a sense of whether you guys are also seeing some headwinds within your pharmacy business as well on the margin line.

As you know, one of the things that's so important for us is our total portfolio of businesses. And when you look, there's almost -- every year, you'll have something stronger and something else weaker. And if you look at the pharmacy business, what we would be experiencing would be pretty similar to what some of our competitors would talk about. We continue to have very strong growth on the number of scripts filled, and that has been true for a long period of time, and our pharmacy teams continue to do a great job on taking care of our customers. But in terms of financial, you -- it would be very similar to what some of the others have talked about. But it is the nice thing and the great thing about having a portfolio of businesses where some pieces are obviously growing well in excess of the total.

Okay, great. And then, switching topics to maybe expenses. So the leverage this quarter is much better than what we saw last quarter. Besides sales leverage, was there anything else that may have contributed to the better leverage this period?

I think it's really across-the-board good cost controls in many facets of the business. As we often say here at Kroger, sales are a beautiful thing. And when you can have north of 5% IDs, the sale leverage -- sales leverage on the expense line becomes quite enormous. And particularly if your ID sales start to exceed where your own expectations were, it gets a little tough to add hours as fast as the sales start to come, and it takes a while to catch up to that. So there was -- there could have been a bit of that as well. But I wouldn't say there is any one particular area that would stand out. It's really pretty strong across-the-board cost controls for many locations.

One of the other things that we mentioned on the first quarter, we were pretty aggressive on incrementally investing hours in some places. Some of that, you begin to get the flow of it and you understand, where does it make sense and where doesn't it make sense as well.

And next, we have a question from John Heinbockel of Guggenheim Securities.

So, guys, 2 things. Do you think -- when you look at the momentum the business has and the things you have to invest in, have we gotten to a point where it's really hard to keep ex fuel EBIT margin to just up slightly, right, without making investments that you don't think have a return? Or you think -- do you think we're just in a period here where timing of investments had been slower, and that's partly why you're getting the 20 basis points?

I -- when you look at the business overall, I would still feel that slightly improving is where -- is the right thing, long term, for the business and what creates the most sustainable long-term value for the business, and obviously, then, flow through to our shareholders. It's never as easy to be exactly precise every quarter in terms of where you invest and how do the margins flow through. So I feel good about where we are, but I certainly don't believe, as I look forward, to cause us to do anything to adjust what we -- the guidance we've provided. I don't know, Mike, any additional insight?

Yes, and one of the things to keep in mind, John, is we -- as you know, we have a portfolio of things we want to invest in over time. And these aren't promotional activities. To your point, we aren't going to go out and have crazy promotional activity that's not going to be sustainable and drive long-term growth. But we have a portfolio of things we want to continue to invest in. And frankly, some of the strength we're experiencing today is on the backs of some of the investments we made in the third and fourth quarter of last year. And you make a little bit of an investment, and then, several months later, you start to see the fruits of that investment. And that's one of the things that's leading to the strong IDs we've had in the first half. And we've tried to get into this rhythm where we're more diligent about when we invest, how we invest, balanced up against consistent results. And I think we're doing as good a job as we've ever done, and we still have that portfolio of areas where we would like to invest in.

And then, Rodney, you talked about the organizational structure, which is quite different than you've had as far back as I can remember. And you said sort of right for this time. Maybe more specifically, what do you think this structure gives you benefit-wise? And then, it does sound like every -- a lot of the guys will have more direct reports than they did before. What do you have to do, if anything, different in how you run the business tactically to account for that, that people would be overseeing more than they had previously?

Well, a big part of that is just the growth that the team has had. I feel very comfortable that the growth they've had as leaders will allow them to have a little broader span of control than they've had before. As you know, we're incredibly fortunate to have such a great depth of people, and we're incredibly fortunate that they've been at Kroger for a long time. So they really know our business well and they understand what we're trying to get done. For me, it really does eliminate one layer of decision-making, and it really does streamline this -- our ability to make decisions. And the team is working together so well as a team, and I'm just really excited about -- going forward, I think it'll just make it a lot smoother in terms of how the -- how we operate on a day-to-day basis.

And the next question is from Stephanie Chang of Crédit Suisse.

It's actually Ed Kelly here asking a question for Stephanie. So I guess, my first question for you -- well, my one question...

Your one question. Very good.

I have a follow-up. But so just related to IDs. I mean, your IDs are clearly exceeding expectations. You're raising the full-year guidance for the ID again this quarter. I would guess that the level of inflation is less than what you probably thought coming into the year. And Mike, you talked about it with tonnage, right, being the strongest that it's kind of been in some time. Could you just maybe help us understand how you're driving such strong growth in the business? And maybe even what's surprising you as you look at the top line performance today.

The -- it's a great question. And to me, the thing that is so important about what Kroger has been doing for a long period of time, not just in this quarter, is really focusing on multiple aspects of connecting with our customers and associates. So it's really -- we continue to improve the products that our customers have. We -- our merchandisers continue to find new ideas and new products. Our operators continue to improve execution and figuring out ways to take cost out of the business, and we continue to take that and invest in what the customers tell us is important. So it's really all of those things working together. The thing that you never know is how do -- how will competitors react to what you're doing and how -- customers continually change and how do you make sure that you're staying out in front of those changes. So far this year, we're incredibly delighted with how we've identified how the customer's evolving and changing and connecting with those customers in a deeper and deeper way. Our customers tell us, from the way that our associates serve them, the products we deliver, the prices, that we've continued to improve what we're doing, and it's really the combination of all those things working together.

Maybe just a quick follow-up here on inflation. I think I heard you guys say that you continue to expect inflation to slow throughout the rest of the year. We have, I think, heard from one of your smaller competitors yesterday about particularly produce and maybe produce bottoming and getting better. So could you just maybe provide a little color on some of the categories and how you see that progressing throughout the rest of the year?

Yes, Ed, as I said in my prepared comments, the produce picture, actually, the deflation slowed. And actually, if you were to look at the very end of the quarter, there was a slight bit of inflation in the last several weeks. Nothing to write home about, but it was deflationary for the quarter but got less, and actually turned a bit towards the end of the quarter. You continue to see other categories out there that have a mixed bag. Grocery is still, let's call it, just north of flat, just a little bit of inflation, and that's a big driving factor in it. The other one to keep out -- to keep in mind, as you think about inflation, is pharmacy is a big inflationary area that I spoke of as well. The generic costs continue to go up. It's -- on the earlier question on the headwinds from gross margin in pharmacy, it's one of the reasons why that headwind exists, because you can't pass that on as quickly as the cost of the underlying pills go up. So it continues to be a mixed bag. You're seeing some of the meat complex get less inflationary and, in fact, deflationary in some areas, but still some slight inflation in other areas. Seafood is a little deflationary right now, but it continues to be a little bit all over the board.

The next question is from Vincent Sinisi of Morgan Stanley.

Wanted to ask on the digital initiatives. You guys had said that a few more divisions now have the pick-up-at-store capabilities. Can you give us a little bit more color as to what you're seeing in terms of traction, usage there? What may be in the basket, and then maybe kind of some thoughts going forward for further rollout?

Well, the -- I -- to give you some insights, the -- it's -- what we find is some customers enjoy shopping that and -- in addition to still buying stuff in the store. So it's -- and you've heard us talk a long time about, on digital, we really do believe it's an and, and not an or. And all it is, is trying to offer one more way of a customer engaging with us so that they get engaged with us the way they want to versus the way they have to. And what we find is the customer feedback has been very positive for some customers, but it's not all customers. And the learnings that we were able to get from Harris Teeter is they really were able to accelerate teaching us how to do it, and then, our store associates are doing a great job of executing against that. In terms of specifics on going forward, the only thing, really, I would say is it continues to be something that we test, and will kind of -- the pace of which we go will really be driven by how fast the customers engage with us. And one of the things that we're trying to do as a company is pace things based on our ability to execute against it and the customer's connection with it. So I wouldn't be able to give you specifics right now because we really don't have specifics yet.

Okay. No, that is helpful. And maybe just as a follow-up, I'll stick with the digital initiatives. And I know you guys have said you're continuing to see some really nice growth in the loyal households. Have there been any changes on your end since the exclusivity with what was dunnhumby over the past couple of quarters has changed? Has there been any change in your approach to getting to know those loyal customers and who you -- who else maybe you are working with or not going forward?

The -- I wouldn't say there's been change. The thing that's probably the biggest difference is the leadership team at 84.51° is involved in every meeting now. And it's things when you're trying to make a decision on what you do, the folks are around the table, and they have great insights, so you're really having those insights as part of the decision at the front end rather than at the back end of the conversation. So the biggest thing is just the quality. To say that we get additional insights, I wouldn't say there's additional insight so far. I would say there's a lot of additional projects that we're working on that should help us going forward. That, I feel very confident in, that it just makes it a lot easier to get those things done rather than having to negotiate with a third party.

The next question is from Ken Goldman of JPMorgan.

There's been so much change in Southern California amongst some of your larger peers. And I realize it's not easy, maybe it's impossible to quantify, but can you give us a sense for how much those changes have either benefited you or created a more challenging competitive environment? Just thinking about some of the issues that Haggen has had, some of the changes that Albertsons put into place. If you can address that at all, I'd be appreciative.

Yes, the -- it's one of those where, obviously, it's a good question but hard to answer. When you look at our business in total in Southern California, we're very happy with where we are. But the thing -- the biggest thing that we think is driving it is our associates are doing a great job, and our leadership team there, in terms of improving how we serve our customers. Now whether it's things customers do -- or our competitors are doing that causes our customers to like what we're doing better, that I don't know. I think it's always important to remember that in Southern California, Costco is actually one of our biggest competitors. Whole Foods would be a huge competitor there. You have a ton of really high-quality independents there. So the competition there is very diverse and more than just the Safeway and Albertsons and their merger and Haggen. So I really -- it's hard to say a certain part is because of whatever somebody is doing. And we're really much more focused on how are the customers telling us we're delivering against what they're asking for. Mike, anything you would want to add to that?

No, I agree. It's -- when there's any kind of disruption in a market, we look at it as an opportunity from a positive standpoint, not a woe-is-me, oh, what's going to happen, how are we going to deal with this. And when you -- when names change on banners, when people may go to market differently, the opportunity all exists that folks may look for a different place to shop that didn't do that in the past, and we want to make sure that Dawn [ph] and her team continue to do what they're doing to excite our customers and our associates in Southern California.

And then, my follow-up, I just wanted to confirm that I heard correctly. You did say, I think, 3Q QTD ID sales, ex fuel, similar to what we saw in 2Q, right? [indiscernible]

[indiscernible] What I said is quarter-to-date, it's pretty similar to where we are in quarter 2.

And our next question is from William Kirk of RBC.

So I had a question on Simple Truth. I think it's in some of your convenience stores now. I was just wondering how the brand's performing in that channel and how many C-stores it is in, I guess.

I'm looking...

I've had C-stores for 2 days, and I already got it in there. Honestly, I don't know the answer to that question. How many it's in or how broad the...

Yes, on a few select items, it's in -- pretty broad in a lot of our convenience stores, but it's pretty narrow. It's early in the process, and we're really trying to learn how broad can the brand go and who all connects with it. As you know, historically, convenience stores isn't a place you go to for healthy offerings. And we are trying to make sure that the customer, if that's what they want, they can find what they want. So it's early in the process, but we are trying to learn how far the Simple Truth brand can go.

Okay. And then, on, I guess, the M&A opportunity environment. We saw repurchases come down in the quarter, leverage is back to about where it was pre-Harris Teeter. How are you feeling about the M&A environment or opportunities in the -- out there?

I would say our M&A appetite is the same as it's always been when the -- if the right opportunity comes along and it's the right set of stores, right sets of assets and right management team, we would think about it. There's not a lot that happens in the space that doesn't come across our desk. I wouldn't read anything into the share buyback coming down in the quarter to signal something on M&A activity. We were pretty upfront that we expected to front-end load our share repurchase program. And really, what you're seeing in the second quarter is the use of stock option proceeds and the tax benefit from that to repurchase shares to offset that dilution. And we're comfortable with our leverage where it is, and it allows us a lot of flexibility. And keep in mind, we are increasing capital, which consumes some cash as well.

The next question is from Kelly Bania of BMO Capital Markets.

I was curious if you could talk a little bit more about the HemisFares rollout. It sounds like that would be a premium quality, premium price point category. And just curious, in exactly which categories are you going to be launching that? How many stores? And really just stepping back and thinking about how does that come to fruition at Kroger? I mean, what's the idea process in terms of bringing that to market? Did -- was that born out of an 84.51° kind of data science project? Or just any color on how that comes to market.

Well, the biggest thing it's -- it's really our Corporate Brands team would use the insights from 84.51° plus other research they've done. We find customers are increasingly becoming foodies, and it's really trying to figure out how do you find great products that will satisfy that foodie need experience they want in a way that is actually a very affordable price. And if you look at the quality of this product, if you would go to a restaurant and eat food -- eat something of this quality, it would cost 4 or 5x as much as what it costs with us. So customers get to experience something that's very unique that's outstanding quality. And it's really the team searching across the world, finding items that are very, very unique and very regionally based. The initial items -- I actually don't know how broad it is. I can tell you, the ones I've tried would be more pasta- and sauce-based and olive oil and balsamic vinaigrette. Those types of items are the ones that I've tried. So the things I've tried are more based from Italy, but I'm sure there's others. It's just that's the ones I'm familiar with.

Yes, the whole idea of HemisFares is to allow our customers to take a journey of food experience around the globe without having to leave home. And it'll be very specific on the packaging where the product's from. The folks at our Corporate Brands who've procured this actually have met with and visited with and helped with the folks who manufacture this product or produce the product on-site in their home country. And some of this product, it's the first time that anybody's gone through the trouble of importing the product with some of the items in it into the U.S. that we have. So they've done a phenomenal job with this, and we're really excited about yet another great offering for our customers in the stores.

We would expect it to be in almost all of our stores. We think most customers will want to engage with it. On some of the items, there is a limited amount of production, so it's not something that you can just go out and produce 2x as much if it sells 2x as much.

That's very helpful. And then, just wanted to ask another question on deflation in some of the categories. I think you mentioned that all departments still comped positive, even though you had some deflation in dairy and produce and maybe seafood for the quarter. So just curious how you manage that. Do you do some incremental promotions in those categories in order to drive volume and increase the comps there when you experience deflation? Or how do you manage that so stably?

Well, a lot of times, it depends on what's driving the deflation. In some categories, you have deflation when the product is at its peak and tastes great. If you look at -- like produce. Usually, if there's deflation, that means there's tons of product available, and it's really great product, so you end up selling more. In other areas, when you have deflation, you're able to give such a great value for the customer for the item. So you end up promoting it more and the volume grows. So it's -- we would drive our promotions based on what our insights tell us that customers like and at what point they like versus trying to just make sure we have every department positive. But fortunately, every department was positive identicals. And I know, Mike, you were looking up some of the specific numbers.

No, it's -- I was just looking to -- when you look across the departments, the strength of whether you look at the -- just the IDs or the inflation-adjusted ID sales, it's really pretty remarkable how broad-based the strength of that -- of the momentum is in various departments. I mean, we even -- we had some departments that, even on an inflation-adjusted basis, were still double-digit IDs sales inside their department, and I'm excluding fuel and pharmacy from that. So it's -- at the end of the day, it's really fundamental that -- I spoke of it earlier, why we're so cognizant of what volume we're driving from a unit basis because that's, at the end of the day, what drives your business.

And next, we have a question from Robert Ohmes of Bank of America Merrill Lynch.

Just actually 2 kind of quick ones. Mike, I think you were alluding somewhat to the wage pressures. Can you kind of walk us through, is the wage pressures a lot more than normal for Kroger right now? And is that sort of a broader economic thing? And then, maybe tie into that some maybe more commentary on any changes you're seeing in your overall customer. HemisFares sounds like a more upscale, private-label launch. Are you seeing any change in the amount of trade-up going on? Or any changes in the different levels of your customers' behavior would be helpful.

Yes, the comments I made earlier weren't directly related to any wage pressures. It was actually the -- our own decision, and Rodney mentioned it as well, of certain departments, where we invested some incremental hours in those departments to drive a better customer experience. And it also happens to be departments where some of our tonnage has been very strong as well. So those hours would have ultimately got -- been in the stores anyway, but it was in advance of that. The wage pressures, I would say, aren't really any different than what we spoke of in the first quarter. There continues to be some out there. We're cognizant of trying to deliver the right overall package to our associates from a solid wage, a good health care package and a retirement plan as well. And we're a little different than a lot of our competitors, where we're balancing all 3 of those for all of our associates. As it relates to HemisFares, I would put that in the category of the Private Selection and Simple Truth range, where it is more of an upscale product and a very high-quality product and it's -- but it does wind up having fairly broad appeal to a lot of folks. Because when you really step back and dissect a lot of customers, there are many customers who, on some items, are a budget shopper, on other items, they wind up splurging on particular items. And these can be the kinds of items those folks wind up splurging on, while in other departments, they're perfectly happy with an entry-level price point or a banner brand that's a lower price point for them. I would say that the HemisFares, as it develops, and Private Selection and Simple Truth, as that mix shifts towards those, it is actually one of the things that's helping to drive our mix to be a little bit different than it has been historically as well.

The thing that's hot so hard to tell -- I don't think it's so much economy-based as customers clearly want high-quality food. So if you look at the areas -- natural and organics, Boar's Head, Starbucks, sushi, all of those areas all have strong, nice growth. So I really -- it really appears to be much different than just economy-based. When you talk to customers, they are definitely interested in saving money. There's no doubt about that.

And our next question comes from Alvin Concepcion of Citi.

I'll keep this to one question. Just wondering if you could talk about changes in the competitive promotional environment for both the overall business and the natural and organic part of the portfolio. Are you seeing anything different as the second quarter progressed and even third quarter-to-date?

Yes, as you know, when we look at competition, we always assume that competition is going to get more aggressive going forward than it's been in the past. And we always find that if that doesn't happen, then life's easier. It's just the way we've, years ago, learned to do our business plan. We wouldn't see anything that would be major in changes. There's always a certain promotion or some -- you'll see things that different customers -- competitors do. And you'll see it, even within weeks, changing. So there wasn't anything that I would say is a huge change in the second quarter versus first quarter.

The next question comes from Mark Wiltamuth of Jefferies.

Certainly had a nice bounce to the fuel margins here in recent months. If some of this persists, though, would you anticipate reinvesting that back into the business? Or do you think that would -- you'd let that flow through to the bottom line?

It's obviously a good question. It's one where I don't think I would really be able to answer at this point, because it really depends on what's going on in the marketplace and what do we think is the best use of that. So I -- at this point, I really wouldn't think it would be appropriate to answer it.

Okay. And then, just curious on your click-and-collect experience in those newer markets. Are the customers signing up for some of those longer-term fees like the monthly or annual fees? Or are they gravitating more to the pay-per-visit approach?

You actually have customers doing all 3. I would say, the most customers are on the 2 extremes. They do the yearly approach or the per-order approach. But it's not one of those things where you see 80% of the customers going one way or the other.

And can you tell if it's incremental in those new markets?

It's -- some of the basket would be incremental, but it's still so early that it's -- I -- the answer I gave you is what we're seeing, but I don't -- I wouldn't use a whole lot of basis off of it, because the sample size is still too small.

Yes, it's a data point, not a trend.

The next question comes from Andrew Wolf of BB&T Capital Markets.

Want to follow up on this volatility that you cited in the -- your product cost. First, on pharmacy inflation with generics, could you quantify or -- specifically or directionally how much that affected gross margin?

Yes, I wouldn't talk about a direct effect on gross margin, but I will tell you that pharmacy inflation in the quarter continued to be above 9%.

Okay. And again, that wasn't passed through due to the contracts and so forth?

Well, the -- you have contracts out there that you have to wait till you can pass it through. But also keep in mind, as generic inflation happens, we have the $4 30-day supply and $10 90-day supply, and we haven't changed those price points either.

Okay, that's helpful. And on -- when you talked about managing inflation and deflation, you had a good follow-up, I thought, on the pricing versus market share. So let me ask you about just on the inventory side. Does Kroger try to either go long -- commodities are inflating or be a little short those are -- that are deflating? Or is it -- when you talk about managing, is it much more about being sharp on pricing and managing it between -- using price to lever either market share or profitability?

Yes, the -- we do, do some things for our -- for consumption in our own manufacturing plants when we look at supply of products and the supply chain that is out there. We don't go overboard on hedges, and we really don't use hedges so much. It would be cash purchase contracts to lock in a price for a period of time. But we typically don't get too excited about doing those things unless the current prices and projected prices are trending below a 5-year rolling average because it's -- if you talk to people in the oil industry today, oil is only going to do one thing, and that's go down. And when oil prices are going up and you talk to somebody in the oil industry, they're only going to do one thing, and that's go up forever. And I would say most people in the commodities world has -- have that view. So we're very careful about how we do it. The amount we consume is actually pretty large, so we try not to be -- I use the term a lot internally, I'd rather be approximately correct than precisely wrong. And if I made too big a bet one way or the other, I'd probably be precisely wrong.

Just a last thing, so that -- what you just described is only for the vertically integrated part of the business, manufacturing, it doesn't permeate to retail at all? Or does it?

Yes, it -- so for example, I wouldn't go out, if I see something happening in produce, and try to hedge the apple crop this fall. Probably can't effectively do that anyway. But we do things with growers, trying to lock up fields and things like that, but that's more to make sure we have the exact product we want, not -- we do that regardless of the inflationary environment.

And that last question will come from Scott Mushkin of Wolfe Research.

This is actually Brian Cullinane on for Scott. Just wanted to talk broadly. Your business model is clearly unique and advantaged with the data technology that you guys have. Just wanted to touch on how you guys think about expanding and -- whether it's through square-footage growth and acquisitions or building more stores, getting your store and your offering to more consumers kind of in areas that you're not currently in.

Well, if you look in terms of going to territories that we are not in at all, as you know, historically, we've done that through mergers. And we're always, as Mike mentioned earlier, looking out for the right one to do something with. We're finding incredible opportunity on fill-ins, and we're -- the -- most of the incremental capital that Mike talked about is, what we're finding, is incremental project opportunities for great projects in existing markets. And right now, that's the highest focus. Now, that doesn't mean that we wouldn't go into a new territory de novo at some point.

Great. And any thoughts to -- you're spending more on capital, but to accelerate any of that with the success that you're having with some of the new stores and new projects?

Well, we feel like we already are, if you look at the incremental capital that we're spending, and we continue to push that. So you're always looking for opportunities to grow, but grow and make sure you execute, and we feel like we have started picking up that pace.

Yes. I prefer an environment where I have a bunch of division presidents upset with me that they have great projects that we haven't been able to fund because of our capital -- what they would call capital constraints, and spending $3.3 billion this year doesn't sound real constrained to me. So if they weren't clamoring for more dollars, I'd be nervous about our opportunities. But as long as they're clamoring, I feel good about where we are.

Before we end today's call, I'd like to take a moment to acknowledge that this morning is the 14th anniversary of the attacks of September 11. I know that many on the call today were personally affected by those events. We continue to mourn those we lost on that horrific day and to honor their memory through our support for police, firefighters and other first responders as well as the military and their families. The 9/11 -- I recently had a chance to go to the 9/11 memorial and museum, and it's incredibly touching, and I'm sure most people on the call have. But if you haven't, it's well worth seeing, and it really does make you appreciate all the things that the police, firefighters and other first responders did on that morning. Finally, I'd like to share some additional thoughts with our associates listening in today. One of the most exciting things about working for a growing and expanding company is the additional opportunities it creates for associates. Many of you would agree that Kroger is a place where you can come for a job and stay for a career. When I ask associates and managers why they stayed, most tell me they fell in love with working with people, our customers and associates, or they found a deep passion for food. Often, it's both. As I mentioned earlier, nearly 70% of our store managers started as hourly associates. I believe there are many young people working for us today who will become our future leaders and will be having Mike's role and other senior leaders' roles and mine. Our associates are people who care, who want to connect with something bigger and make a difference in our communities every day. We ask candidates to imagine you at Kroger, because whether you're looking for a flexible part-time job or for a lasting and rewarding career, you can find it here. And we're looking for friendly, bright people who want opportunities to learn and grow. This is such an exciting time to be at Kroger. Together, we do make a difference. That completes our call for today. Thanks for joining.

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