Edgar Filing: KROGER CO

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended August 16, 2014

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

For the transition period from to

Commission file number 1-303

(Exact name of registrant as specified in its charter)

Ohio		31-0345740
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

1014 Vine Street, Cincinnati, OH 45202

(Address of principal executive offices)

(Zip Code)

(513) 762-4000

(Registrant’s telephone number, including area code)

Unchanged

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer x		Accelerated filer o

Non-accelerated filer o		Smaller reporting company o
(do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x.

There were 491,090,776 shares of Common Stock ($1 par value) outstanding as of September 19, 2014.

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements.

THE KROGER CO.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in millions, except per share amounts)

(unaudited)

	Second Quarter Ended				Two Quarters Ended
	August 16, 2014		August 17, 2013		August 16, 2014		August 17, 2013
Sales	$	25,310	$	22,686	$	58,271	$	52,683
Merchandise costs, including advertising, warehousing, and transportation, excluding items shown separately below	20,136		18,059		46,201		41,876
Operating, general and administrative	3,920		3,506		9,088		8,099
Rent	166		139		383		328
Depreciation	444		387		1,025		906
Operating profit	644		595		1,574		1,474
Interest expense	112		99		259		228
Earnings before income tax expense	532		496		1,315		1,246
Income tax expense	182		176		456		442
Net earnings including noncontrolling interests	350		320		859		804
Net earnings attributable to noncontrolling interests	3		3		11		6
Net earnings attributable to The Kroger Co.	$	347	$	317	$	848	$	798

Net earnings attributable to The Kroger Co. per basic common share	$	0.71	$	0.61	$	1.70	$	1.54

Average number of common shares used in basic calculation	485		515		494		515

Net earnings attributable to The Kroger Co. per diluted common share	$	0.70	$	0.60	$	1.68	$	1.52

Average number of common shares used in diluted calculation	491		521		500		520

Dividends declared per common share	$	0.165	$	0.150	$	0.330	$	0.300

The accompanying Notes are an integral part of the Consolidated Financial Statements.

THE KROGER CO.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(in millions and unaudited)

	Second Quarter Ended				Two Quarters Ended
	August 16, 2014		August 17, 2013		August 16, 2014		August 17, 2013
Net earnings including noncontrolling interests	$	350	$	320	$	859	$	804

Other comprehensive income
Unrealized gain on available for sale securities, net of income tax(1)	3		1		2		4
Amortization of amounts included in net periodic pension expense, net of income tax(2)	5		14		13		33
Unrealized gains and losses on cash flow hedging activities, net of income tax(3)	—		10		—		(9		)
Amortization of unrealized gains and losses on cash flow hedging activities, net of income tax	—		—		—		1

Total other comprehensive income	8		25		15		29

Comprehensive income	358		345		874		833
Comprehensive income attributable to noncontrolling interests	3		3		11		6
Comprehensive income attributable to The Kroger Co.	$	355	$	342	$	863	$	827

(1) Amount is net of tax of $1 for the second quarter of 2014. Amount is net of tax of $2 for the first two quarters of 2013.

(2) Amount is net of tax of $4 for the second quarter of 2014 and $9 for the second quarter of 2013. Amount is net of tax of $8 for the first two quarters of 2014 and $20 for the first two quarters of 2013.

(3) Amount is net of tax of $7 for the second quarter of 2013. Amount is net of tax of $(5) for the first two quarters of 2013.

The accompanying Notes are an integral part of the Consolidated Financial Statements.

THE KROGER CO.

CONSOLIDATED BALANCE SHEETS

(in millions, except per share amounts)

(unaudited)

	August 16,			February 1,
	2014			2014
ASSETS
Current assets
Cash and temporary cash investments	$	248		$	401
Store deposits in-transit	956			958
Receivables	1,174			1,116
FIFO inventory	6,646			6,801
LIFO reserve	(1,151		)	(1,150		)
Prepaid and other current assets	422			704
Total current assets	8,295			8,830

Property, plant and equipment, net	17,263			16,893
Intangibles, net	695			702
Goodwill	2,135			2,135
Other assets	691			721

Total Assets	$	29,079		$	29,281

LIABILITIES
Current liabilities
Current portion of long-term debt including obligations under capital leases and financing obligations	$	1,494		$	1,657
Trade accounts payable	5,076			4,881
Accrued salaries and wages	1,128			1,150
Deferred income taxes	248			248
Other current liabilities	2,894			2,769
Total current liabilities	10,840			10,705

Long-term debt including obligations under capital leases and financing obligations
Face-value of long-term debt including obligations under capital leases and financing obligations	9,707			9,654
Adjustment to reflect fair-value interest rate hedges	(1		)	(1		)
Long-term debt including obligations under capital leases and financing obligations	9,706			9,653

Deferred income taxes	1,280			1,381
Pension and postretirement benefit obligations	899			901
Other long-term liabilities	1,332			1,246

Total Liabilities	24,057			23,886

Commitments and contingencies (see Note 9)

SHAREOWNERS’ EQUITY

Preferred shares, $100 per share, 5 shares authorized and unissued	¾			¾
Common shares, $1 par per share, 1,000 shares authorized; 959 shares issued in 2014 and 2013	959			959
Additional paid-in capital	3,605			3,549
Accumulated other comprehensive loss	(449		)	(464		)
Accumulated earnings	11,667			10,981
Common shares in treasury, at cost, 473 shares in 2014 and 451 shares in 2013	(10,785		)	(9,641		)

Total Shareowners’ Equity — The Kroger Co.	4,997			5,384
Noncontrolling interests	25			11

Total Equity	5,022			5,395

Total Liabilities and Equity	$	29,079		$	29,281

The accompanying Notes are an integral part of the Consolidated Financial Statements.

THE KROGER CO.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in millions and unaudited)

	Two Quarters Ended
	August 16, 2014			August 17, 2013
Cash Flows from Operating Activities:
Net earnings including noncontrolling interests	$	859		$	804
Adjustments to reconcile net earnings including noncontrolling interests to net cash provided by operating activities:
Depreciation	1,025			906
LIFO charge	54			30
Stock-based employee compensation	76			47
Expense for Company-sponsored pension plans	21			40
Deferred income taxes	(103		)	(16		)
Other	53			40
Changes in operating assets and liabilities net of effects from acquisitions of businesses:
Store deposits in-transit	2			105
Receivables	(47		)	107
Inventories	102			162
Prepaid expenses	274			246
Trade accounts payable	354			180
Accrued expenses	60			1
Income taxes receivable and payable	(47		)	82
Other	67			(121		)

Net cash provided by operating activities	2,750			2,613

Cash Flows from Investing Activities:
Payments for property and equipment, including payments for lease buyouts	(1,347		)	(1,110		)
Proceeds from sale of assets	18			7
Other	16			(34		)

Net cash used by investing activities	(1,313		)	(1,137		)

Cash Flows from Financing Activities:
Proceeds from issuance of long-term debt	48			1,011
Dividends paid	(166		)	(155		)
Payments on long-term debt	(26		)	(419		)
Net payments on commercial paper	(160		)	(1,595		)
Excess tax benefits on stock-based awards	32			20
Proceeds from issuance of capital stock	66			155
Treasury stock purchases	(1,221		)	(236		)
Net decrease in book overdrafts	(158		)	(40		)
Other	(5		)	(15		)

Net cash used by financing activities	(1,590		)	(1,274		)

Net increase (decrease) in cash and temporary cash investments	(153		)	202

Cash and temporary cash investments:
Beginning of year	401			238
End of quarter	$	248		$	440

Reconciliation of capital investments:
Payments for property and equipment, including payments for lease buyouts	$	(1,347	)	$	(1,110	)
Payments for lease buyouts	28			19
Changes in construction-in-progress payables	(63		)	(56		)
Total capital investments, excluding lease buyouts	$	(1,382	)	$	(1,147	)

Disclosure of cash flow information:
Cash paid during the year for interest	$	282		$	225
Cash paid during the year for income taxes	$	582		$	349

The accompanying Notes are an integral part of the Consolidated Financial Statements.

THE KROGER CO.

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREOWNERS’ EQUITY

(in millions, except per share amounts)

(unaudited)

												Accumulated
				Additional								Other
	Common Stock			Paid-In			Treasury Stock					Comprehensive			Accumulated			Noncontrolling
	Shares	Amount		Capital			Shares		Amount			Gain (Loss)			Earnings			Interest			Total
Balances at February 2, 2013	959	$	959	$	3,451		445		$	(9,237	)	$	(753	)	$	9,787		$	7		$	4,214
Issuance of common stock:
Stock options exercised	—	—		—			(7	)	155			—			—			—			155
Restricted stock issued	—	—		(57		)	(2	)	25			—			—			—			(32		)
Treasury stock activity:
Treasury stock purchases, at cost	—	—		—			1		(21		)	—			—			—			(21		)
Stock options exchanged	—	—		—			6		(215		)	—			—			—			(215		)
Share-based employee compensation	—	—		47			—		—			—			—			—			47
Other comprehensive gain net of income tax of $17	—	—		—			—		—			29			—			—			29
Other	—	—		41			—		(16		)	—			—			(3		)	22
Cash dividends declared ($0.30 per common share)	—	—		—			—		—			—			(155		)	—			(155		)
Net earnings including noncontrolling interests	—	—		—			—		—			—			798			6			804

Balances at August 17, 2013	959	$	959	$	3,482		443		$	(9,309	)	$	(724	)	$	10,430		$	10		$	4,848

Balances at February 1, 2014	959	$	959	$	3,549		451		$	(9,641	)	$	(464	)	$	10,981		$	11		$	5,395
Issuance of common stock:
Stock options exercised	—	—		—			(3	)	66			—			—			—			66
Restricted stock issued	—	—		(83		)	(2	)	37			—			—			—			(46		)
Treasury stock activity:
Treasury stock purchases, at cost	—	—		—			25		(1,129		)	—			—			—			(1,129		)
Stock options exchanged	—	—		—			2		(92		)	—			—			—			(92		)
Share-based employee compensation	—	—		76			—		—			—			—			—			76
Other comprehensive gain net of income tax of $8	—	—		—			—		—			15			—			—			15
Other	—	—		63			—		(26		)	—			—			3			40
Cash dividends declared ($0.33 per common share)	—	—		—			—		—			—			(162		)	—			(162		)
Net earnings including noncontrolling interests	—	—		—			—		—			—			848			11			859

Balances at August 16, 2014	959	$	959	$	3,605		473		$	(10,785	)	$	(449	)	$	11,667		$	25		$	5,022

The accompanying Notes are an integral part of the Consolidated Financial Statements.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

All amounts in the Notes to Consolidated Financial Statements are in millions except per share amounts.

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

1. ACCOUNTING POLICIES

Basis of Presentation and Principles of Consolidation

The accompanying financial statements include the consolidated accounts of The Kroger Co., its wholly-owned subsidiaries, and the Variable Interest Entities (“VIEs”) in which the Company is the primary beneficiary. The February 1, 2014 Consolidated Balance Sheet was derived from audited financial statements and, due to its summary nature, does not include all disclosures required by generally accepted accounting principles (“GAAP”). Significant intercompany transactions and balances have been eliminated. References to the “Company” in these Consolidated Financial Statements mean the consolidated company.

In the opinion of management, the accompanying unaudited Consolidated Financial Statements include all normal, recurring adjustments that are necessary for a fair presentation of results of operations for such periods but should not be considered as indicative of results for a full year. The financial statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been omitted, pursuant to SEC regulations. Accordingly, the accompanying Consolidated Financial Statements should be read in conjunction with the financial statements in the Annual Report on Form 10-K of The Kroger Co. for the fiscal year ended February 1, 2014.

The unaudited information in the Consolidated Financial Statements for the second quarter and the two quarters ended August 16, 2014 and August 17, 2013, includes the results of operations of the Company for the 12 and 28-week periods then ended.

Certain revenue transactions previously reported in sales and merchandise costs in the Consolidated Statements of Operations are now reported net within sales. Also, certain expense transactions previously reported in operating, general and administrative in the Consolidated Statements of Operations are now reported within merchandise costs. Prior quarter amounts have been revised or reclassified to conform to the current year presentation. These amounts were not material to the prior periods.

2. MERGER

On January 28, 2014, the Company closed its merger with Harris Teeter Supermarkets, Inc. (“Harris Teeter”) and there have not been any changes in the Company’s preliminary purchase price allocation in the first two quarters of 2014.

As of August 16, 2014, the fair value step up adjustment to Harris Teeter inventory as of the merger date is recorded in the LIFO reserve. This resulted in a $53 decrease in LIFO reserve.

Pro forma results of operations, assuming the transaction had taken place at the beginning of 2012, are included in the following table. The pro forma information includes historical results of operations of Harris Teeter and adjustments for interest expense that would have been incurred due to financing the acquisition, depreciation and amortization of the assets acquired and excludes the pre-acquisition transaction related expenses incurred by Harris Teeter and the Company. The pro forma information does not include efficiencies, cost reductions, synergies and investments in lower prices for our customers expected to result from the merger. The unaudited pro forma financial information is not necessarily indicative of the results that actually would have occurred had the merger been completed at the beginning of 2012.

	Second Quarter Ended August 17, 2013		Two Quarters Ended August 17, 2013
Sales	$	23,787	$	55,129
Net earnings including noncontrolling interests	347		865
Net earnings attributable to noncontrolling interests	3		6

Net earnings attributable to The Kroger Co.	$	344	$	859

3. STOCK OPTION PLANS

The Company recognized total share-based compensation of $36 and $23 in the second quarters ended August 16, 2014 and August 17, 2013, respectively. The Company recognized total share-based compensation of $76 and $47 in the first two quarters of 2014 and 2013, respectively. These costs were recognized as operating, general and administrative costs in the Company’s Consolidated Statements of Operations.

The Company grants options for common shares (“stock options”) to employees, as well as to its non-employee directors, under various plans at an option price equal to the fair market value of the shares at the date of grant. In addition to stock options, the Company awards restricted stock to employees and its non-employee directors under various plans. Equity awards may be made once each quarter on a predetermined date. It has been the Company’s practice to make a general annual grant to employees, which occurred in the second quarter of 2014. Special grants may be made in the other three quarters. Grants to non-employee directors occur on the same date that the general annual grant to employees occurs.

Stock options granted in the first two quarters of 2014 expire 10 years from the date of grant and vest between one year and five years from the date of grant. Restricted stock awards granted in the first two quarters of 2014 have restrictions that lapse between one year and five years from the date of the awards. All grants and awards become immediately exercisable, in the case of options, and restrictions lapse, in the case of restricted stock, upon certain changes in control of the Company.

Changes in equity awards outstanding under the plans are summarized below.

Stock Options

	Shares subject to option		Weighted-average exercise price
Outstanding, February 1, 2014	21.7		$	25.66
Granted	4.1		$	49.21
Exercised	(3.2	)	$	22.75
Canceled or Expired	(0.2	)	$	28.70

Outstanding, August 16, 2014	22.4		$	30.40

Restricted Stock

	Restricted shares outstanding		Weighted-average grant-date fair value
Outstanding, February 1, 2014	4.8		$	32.31
Granted	2.8		$	48.99
Vested	(2.3	)	$	32.84
Forfeited	(0.1	)	$	35.35

Outstanding, August 16, 2014	5.2		$	41.14

The weighted-average grant date fair value of stock options granted during the first two quarters of 2014 and 2013, was $11.96 and $8.97, respectively. The fair value of each stock option grant was estimated on the date of grant using the Black-Scholes option-pricing model, based on the assumptions shown in the table below. The Black-Scholes model utilizes accounting judgment and financial estimates, including the term option holders are expected to retain their stock options before exercising them, the volatility of the Company’s share price over that expected term, the dividend yield over the term, and the number of awards expected to be forfeited before they vest. Using alternative assumptions in the calculation of fair value would produce fair values for stock option grants that could be different than those used to record stock-based compensation expense in the Consolidated Statements of Operations. The increase in the fair value of the stock options granted during the first two quarters of 2014, compared to the first two quarters of 2013, resulted primarily from an increase in the Company’s share price, which decreased the expected dividend yield, and an increase in the weighted average risk-free interest rate.

The following table reflects the weighted-average assumptions used for grants awarded to option holders:

	2014	2013
Risk-free interest rate	2.06%	1.87%
Expected dividend yield	1.51%	1.82%
Expected volatility	25.29%	26.34%
Expected term	6.6 Years	6.8 Years

4. DEBT OBLIGATIONS

Long-term debt consists of:

	August 16,			February 1,
	2014			2014
0.76% to 8.00% Senior Notes due through 2043	$	9,083		$	9,083
5.00% to 12.75% Mortgages due in varying amounts through 2034	61			64
0.27% Commercial paper borrowings due through September 2014	1,090			1,250
Other	427			383

Total debt, excluding capital leases and financing obligations	10,661			10,780

Less current portion	(1,451		)	(1,616		)

Total long-term debt, excluding capital leases and financing obligations	$	9,210		$	9,164

On June 30, 2014, the Company amended, extended and restated its $2,000 unsecured revolving credit facility. The Company entered into the amended credit facility to amend, extend and restate the Company’s existing credit facility that would have terminated on January 25, 2017. The amended credit facility provides for a $2,750 unsecured revolving credit facility (the “Credit Agreement”), with a termination date of June 30, 2019, unless extended as permitted under the Credit Agreement. The Company has the ability to increase the size of the Credit Agreement by up to an additional $750, subject to certain conditions.

Borrowings under the Credit Agreement bear interest at the Company’s option, at either (i) LIBOR plus a market rate spread, based on the Company’s Leverage Ratio or (ii) the base rate, defined as the highest of (a) the Federal Funds Rate plus 0.5%, (b) the Bank of America prime rate, and (c) one-month LIBOR plus 1.0%, plus a market rate spread based on the Company’s Leverage Ratio. The Company will also pay a Commitment Fee based on the Leverage Ratio and Letter of Credit fees equal to a market rate spread based on the Company’s Leverage Ratio. The Credit Agreement contains covenants, which, among other things, require the maintenance of a Leverage Ratio of not greater than 3.50:1.00 and a Fixed Charge Coverage Ratio of not less than 1.70:1.00. The Company may repay the Credit Agreement in whole or in part at any time without premium or penalty. The Credit Agreement is not guaranteed by the Company’s subsidiaries.

5. BENEFIT PLANS

The following table provides the components of net periodic benefit cost for the Company-sponsored defined benefit pension plans and other post-retirement benefit plans for the second quarters of 2014 and 2013.

	Second Quarter Ended
	Pension Benefits						Other Benefits
	August 16, 2014			August 17, 2013			August 16, 2014			August 17, 2013
Components of net periodic benefit cost:
Service cost	$	10		$	8		$	2		$	4
Interest cost	42			35			3			4
Expected return on plan assets	(56		)	(52		)	—			—
Amortization of:
Prior service cost	—			—			(2		)	(1		)
Actuarial loss	12			24			(1		)	—

Net periodic benefit cost	$	8		$	15		$	2		$	7

	Two Quarters Ended
	Pension Benefits						Other Benefits
	August 16, 2014			August 17, 2013			August 16, 2014			August 17, 2013
Components of net periodic benefit cost:
Service cost	$	24		$	23		$	6		$	9
Interest cost	98			83			7			9
Expected return on plan assets	(130		)	(121		)	—			—
Amortization of:
Prior service cost	—			—			(4		)	(2		)
Actuarial loss	28			55			(3		)	—

Net periodic benefit cost	$	20		$	40		$	6		$	16

The Company is not required and does not expect to make any contributions to the Company-sponsored defined benefit pension plans in 2014.

The Company contributed $98 and $80 to employee 401(k) retirement savings accounts in the first two quarters of 2014 and 2013, respectively.

The Company also contributes to various multi-employer pension plans based on obligations arising from most of its collective bargaining agreements. These plans provide retirement benefits to participants based on their service to contributing employers. The Company recognizes expense in connection with these plans as contributions are funded.

During the first quarter of 2014, the Company incurred a charge of $56 (after-tax) due to commitments and withdrawal liabilities arising from the restructuring of certain multi-employer pension plan obligations.

6. EARNINGS PER COMMON SHARE

Net earnings attributable to The Kroger Co. per basic common share equal net earnings attributable to The Kroger Co. less income allocated to participating securities divided by the weighted-average number of common shares outstanding. Net earnings attributable to The Kroger Co. per diluted common share equal net earnings attributable to The Kroger Co. less income allocated to participating securities divided by the weighted-average number of common shares outstanding, after giving effect to dilutive stock options. The following table provides a reconciliation of net earnings attributable to The Kroger Co. and shares used in calculating net earnings attributable to The Kroger Co. per basic common share to those used in calculating net earnings attributable to The Kroger Co. per diluted common share:

	Second Quarter Ended					Second Quarter Ended
	August 16, 2014					August 17, 2013
	Earnings (Numerator)		Shares (Denominator)	Per Share Amount		Earnings (Numerator)		Shares (Denominator)	Per Share Amount
Net earnings attributable to The Kroger Co. per basic common share	$	343	485	$	0.71	$	315	515	$	0.61
Dilutive effect of stock options			6					6

Net earnings attributable to The Kroger Co. per diluted common share	$	343	491	$	0.70	$	315	521	$	0.60

	Two Quarters Ended					Two Quarters Ended
	August 16, 2014					August 17, 2013
	Earnings (Numerator)		Shares (Denominator)	Per Share Amount		Earnings (Numerator)		Shares (Denominator)	Per Share Amount
Net earnings attributable to The Kroger Co. per basic common share	$	840	494	$	1.70	$	791	515	$	1.54
Dilutive effect of stock options			6					5

Net earnings attributable to The Kroger Co. per diluted common share	$	840	500	$	1.68	$	791	520	$	1.52

The Company had combined undistributed and distributed earnings to participating securities totaling $4 in the second quarter of 2014 and $2 in the second quarter of 2013. For the first two quarters of 2014 and 2013, the Company had combined undistributed and distributed earnings to participating securities of $8 and $7, respectively.

The Company had options outstanding for approximately 2 shares during the second quarters of 2014 and 2013 that were excluded from the computations of earnings per diluted common share because their inclusion would have had an anti-dilutive effect on earnings per share. The Company had options outstanding for approximately 2 shares in the first two quarters of 2014 and 1 shares in the first two quarters of 2013 that were excluded from the computations of earnings per diluted common share because their inclusion would have had an anti-dilutive effect on earnings per share.

7. RECENTLY ADOPTED ACCOUNTING STANDARDS

In July 2013, the Financial Accounting Standards Board (“FASB”) amended Accounting Standards Codification (“ASC”) 740, “Income Taxes.” The amendment provides guidance on the financial statement presentation of an unrecognized tax benefit, as either a reduction of a deferred tax asset or as a liability, when a net operating loss carryforward, similar tax loss, or a tax credit carryforward exists. This amendment became effective for the Company beginning February 2, 2014, and was adopted prospectively in accordance with the standard. The adoption of this amendment did not have an effect on net income and did not have a significant effect on the Company’s Consolidated Balance Sheet.

8. RECENTLY ISSUED ACCOUNTING STANDARDS

In May 2014, FASB issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers”, which provides guidance for revenue recognition. The standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. This guidance will be effective for the Company in the first quarter of its fiscal year ending January 27, 2018. Early adoption is not permitted. The Company is currently in the process of evaluating the effect of adoption of this ASU on the Company’s Consolidated Financial Statements.

9. COMMITMENTS AND CONTINGENCIES

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

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

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

The Company continually evaluates its exposure to loss contingencies arising from pending or threatened litigation and believes it has made provisions where it is reasonably possible to estimate and where an adverse outcome is probable. Nonetheless, assessing and predicting the outcomes of these matters involve substantial uncertainties. Management currently believes that the aggregate range of loss for the Company’s exposure is not material to the Company. It remains possible that despite management’s current belief, material differences in actual outcomes or changes in management’s evaluation or predictions could arise that could have a material adverse effect on the Company’s financial condition, results of operations, or cash flows.

10. FAIR VALUE MEASUREMENTS

GAAP establishes a fair value hierarchy that prioritizes the inputs used to measure fair value. The three levels of the fair value hierarchy defined in the standards are as follows:

Level 1 — Quoted prices are available in active markets for identical assets or liabilities;

Level 2 — Pricing inputs are other than quoted prices in active markets included in Level 1, which are either directly or indirectly observable;

Level 3 — Unobservable pricing inputs in which little or no market activity exists, therefore requiring an entity to develop its own assumptions about the assumptions that market participants would use in pricing an asset or liability.

For items carried at (or adjusted to) fair value in the Consolidated Financial Statements, the following tables summarize the fair value of these instruments at August 16, 2014 and February 1, 2014:

August 16, 2014 Fair Value Measurements Using

	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Total
Trading Securities	$	46	$	—		$	—	$	46
Available-for-Sale Securities	31		—			—		31
Warrants	—		19			—		19
Long-Lived Assets	—		—			10		10
Interest Rate Hedges	—		(2		)	—		(2		)
Total	$	77	$	17		$	10	$	104

The table above includes Harris Teeter assets at fair value as of August 16, 2014.

February 1, 2014 Fair Value Measurements Using

	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Total
Available-for-Sale Securities	$	36	$	—		$	—	$	36
Warrants	—		16			—		16
Long-Lived Assets	—		—			29		29
Interest Rate Hedges	—		(2		)	—		(2		)
Total	$	36	$	14		$	29	$	79

In the first two quarters of 2014, unrealized gains on the Level 1 available-for-sale securities totaled $2.

The Company values warrants using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model is classified as a Level 2 input.

The Company values interest rate hedges using observable forward yield curves. These forward yield curves are classified as Level 2 inputs.

Fair value measurements of non-financial assets and non-financial liabilities are primarily used in the impairment analysis of goodwill, other intangible assets, and long-lived assets, and in the valuation of store lease exit costs. The Company reviews goodwill and other intangible assets for impairment annually, during the fourth quarter of each fiscal year, and as circumstances indicate the possibility of impairment. See Note 3 to the Consolidated Financial Statements in the Annual Report on Form 10-K for the fiscal year ended February 1, 2014 for further discussion related to the Company’s carrying value of goodwill. Long-lived assets and store lease exit costs were measured at fair value on a nonrecurring basis using Level 3 inputs as defined in the fair value hierarchy. See Note 1 to the Consolidated Financial Statements in the Annual Report on Form 10-K for the fiscal year ended February 1, 2014 for further discussion of the Company’s policies regarding the valuation of long-lived assets and store lease exit costs. For the first two quarters of 2014, long-lived assets with a carrying amount of $27 were written down to their fair value of $10 resulting in an impairment charge of $17. For the first two quarters of 2013, long-lived assets with a carrying amount of $35 were written down to their fair value of $10 resulting in an impairment charge of $25. In fiscal year 2013, long-lived assets with a carrying amount of $68 were written down to their fair value of $29, resulting in an impairment charge of $39.

Fair Value of Other Financial Instruments

Current and Long-term Debt

The fair value of the Company’s long-term debt, including current maturities, was estimated based on the quoted market prices for the same or similar issues adjusted for illiquidity based on available market evidence. If quoted market prices were not available, the fair value was based on the net present value of the future cash flow using the forward interest rate yield curve in effect at August 16, 2014 and February 1, 2014, which is a Level 2 measurement technique. At August 16, 2014, the fair value of total debt was $11,667 compared to a carrying value of $10,661. At February 1, 2014, the fair value of total debt was $11,547 compared to a carrying value of $10,780.

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

The carrying amounts of these items approximated fair value.

Other Assets

The fair values of these investments were estimated based on quoted market prices for those or similar investments, or estimated cash flows, if appropriate. At August 16, 2014 and February 1, 2014, the carrying and fair value of long-term investments for which fair value is determinable was $112 and $51, respectively. The increase in fair value of long-term investments for which fair value is determinable is mainly due to the Company’s merger with Harris Teeter. At August 16, 2014 and February 1, 2014, the carrying value of notes receivable for which fair value is determinable was $99 and $87, respectively.

11. OTHER COMPREHENSIVE INCOME (LOSS)

The following table represents the changes in AOCI by component for the first two quarters of 2013 and 2014:

	Cash Flow Hedging Activities(1)			Available for sale Securities(1)		Pension and Postretirement Defined Benefit Plans(1)			Total(1)
Balance at February 2, 2013	$	(14	)	$	7	$	(746	)	$	(753	)
OCI before reclassifications(2)	(9		)	4		—			(5		)
Amounts reclassified out of AOCI	1			—		33			34
Net current-period OCI	(8		)	4		33			29
Balance at August 17, 2013	$	(22	)	$	11	$	(713	)	$	(724	)

Balance at February 1, 2014	$	(25	)	$	12	$	(451	)	$	(464	)
OCI before reclassifications	—			2		—			2
Amounts reclassified out of AOCI	—			—		13			13
Net current-period OCI	—			2		13			15
Balance at August 16, 2014	$	(25	)	$	14	$	(438	)	$	(449	)

(1) All amounts are net of tax.

(2) Net of tax of $(5) and $2 for cash flow hedging activities and available for sale securities, respectively, for the first two quarters of 2013.

The following table represents the items reclassified out of AOCI and the related tax effects for the second quarter and first two quarters of 2014 and 2013:

	Second Quarter Ended						Two Quarters Ended
	August 16, 2014			August 17, 2013			August 16, 2014			August 17, 2013
Gains on cash flow hedging activities
Amortization of unrealized gains and losses on cash flow hedging activities(1)	$	—		$	—		$	—		$	1
Tax (expense) / benefit	—			—			—			—
Net of tax	—			—			—			1

Pension and postretirement defined benefit plan items
Amortization of amounts included in net periodic pension expense(2)	9			23			21			53
Tax expense	(4		)	(9		)	(8		)	(20		)
Net of tax	5			14			13			33
Total reclassifications, net of tax	$	5		$	14		$	13		$	34

(1) Reclassified from AOCI into interest expense.

(2) Reclassified from AOCI into merchandise costs and operating, general and administrative expense. These components are included in the computation of net periodic pension expense (see Note 5 to the Company’s Consolidated Financial Statements for additional details).

12. INCOME TAXES

The effective income tax rate was 34.2% in the second quarter of 2014, compared to 35.5% for the second quarter of 2013. The effective income tax rate was 34.7% for the first two quarters of 2014, compared to 35.5% for the first two quarters of 2013. The effective income tax rate for the second quarter of 2014 and the first two quarters of 2014 differed from the federal statutory rate primarily due to the utilization of tax credits and deductions, partially offset by the effect of state income taxes. The effective income tax rate for the second quarter of 2013 and the first two quarters of 2013 differed from the federal statutory rate primarily due to the effect of state income taxes, partially offset by the utilization of tax credits and deductions.

13. SUBSEQUENT EVENT

On August 18, 2014, the Company acquired all of the outstanding common stock of Vitacost.com, Inc. (“Vitacost.com”) for $8.00 per share in cash or approximately $280 in total. Vitacost.com is a leading online retailer of health and wellness products, which are sold directly to consumers through the website vitacost.com. This merger affords the Company access to Vitacost.com’s extensive e-commerce platform, which can be combined with the Company’s customer insights and loyal customer base, to create new levels of personalization and convenience for customers. Vitacost.com’s annual revenue, for the year ended December 31, 2013, was approximately $383 with a net loss of approximately $(14). The merger will be accounted for under the purchase method of accounting and was financed through the issuance of commercial paper.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following analysis should be read in conjunction with the Consolidated Financial Statements.

OVERVIEW

Second quarter 2014 total sales were $25.3 billion compared with $22.7 billion for the same period of 2013. This increase was attributable to increased sales due to our merger with Harris Teeter Supermarkets, Inc. (“Harris Teeter”), which closed on January 28, 2014, identical supermarket sales increases, increased fuel gallon sales and an increase in the average retail fuel price. Identical supermarket sales without fuel increased 4.8% in the second quarter of 2014, compared to the second quarter of 2013, primarily due to an increase in the number of households shopping with us, an increase in the average sale per customer and product cost inflation. Every supermarket store department and operating division had positive identical sales. This marks our 43rd consecutive quarter of positive identical supermarket sales growth. Total sales for the first two quarters of 2014 were $58.3 billion compared to $52.7 billion for the same period of 2013. This increase was attributable to our merger with Harris Teeter, identical supermarket sales increases and increased fuel gallon sales, offset partially by a decrease in the average retail fuel price. Identical supermarket sales without fuel increased 4.7% in the first two quarters of 2014, compared to the same period in 2013, primarily due to an increase in the number of households shopping with us, an increase in the average sale per customer and product cost inflation. Our Customer 1st strategy continues to deliver solid results.

For the second quarter of 2014, net earnings totaled $347 million, or $0.70 per diluted share, compared to $317 million, or $0.60 per diluted share for the same period of 2013. The increase in net earnings for the second quarter of 2014, compared to the second quarter of 2013, resulted primarily from an increase in non-fuel First-In, First Out (“FIFO”) operating profit and an increase in earnings from our fuel operations, offset partially by increases in interest expense and the last-in, first-out (“LIFO”) charge. For the first two quarters of 2014, net earnings totaled $848 million, or $1.68 per diluted share, compared to $798 million, or $1.52 per diluted share for the same period of 2013. This includes a $0.11 per diluted share charge due to the commitments and withdrawal liabilities arising from the restructuring of certain multi-employer pension plan obligations to help stabilize associates’ future benefits (“pension plan agreements”). Excluding the pension plan agreements, net earnings totaled $904 million, or $1.79 per diluted share, for the first two quarters of 2014. The pension plan agreements resulted in an increase in operating, general and administrative expense of $87 million ($56 million after-tax) in the first two quarters of 2014. We believe the adjusted net earnings per diluted share figure presents a more accurate year-over-year comparison of our financial results because the pension plan agreements were not the result of our normal operations. The increase in adjusted net earnings for the first two quarters of 2014, compared to the first two quarters of 2013, resulted primarily from an increase in non-fuel FIFO operating profit and an increase in earnings from our fuel operations, partially offset by increases in interest expense, income tax expense and the LIFO charge.

Based on the strength of our results for the first two quarters of 2014, we have increased both the lower and upper ranges of our guidance for adjusted net earnings per diluted share and identical supermarket sales for fiscal year 2014. Please refer to the “Outlook” section for more information on our expectations.

RESULTS OF OPERATIONS

Net Earnings

Net earnings totaled $347 million for the second quarter of 2014, an increase of 9.5% from net earnings of $317 million for the second quarter of 2013. The increase in our net earnings for the second quarter of 2014, compared to the second quarter of 2013, resulted primarily from an increase in non-fuel FIFO operating profit and an increase in earnings from our fuel operations, offset partially by increases in interest expense and the LIFO charge. The increase in non-fuel FIFO operating profit for the second quarter of 2014, compared to the second quarter of 2013, resulted primarily from the benefit of increased supermarket sales, the merger with Harris Teeter, productivity improvements and cost controls, offset partially by continued investments in lower prices for our customers, increases in the workers compensation and general liability reserves and increases in credit card and incentive plan costs. The increase in net earnings from our fuel operations for the second quarter of 2014, compared to the second quarter of 2013, resulted primarily from an increase in the average margin per gallon of fuel sold and an increase in fuel gallons sold.

Net earnings totaled $848 million for the first two quarters of 2014, an increase of 6.3% from net earnings of $798 million for the first two quarters of 2013. Adjusted net earnings for the first two quarters of 2014 totaled $904 million, excluding the pension plan agreements, an increase of 13.3% compared to net earnings for the first two quarters of 2013. The increase in our adjusted net earnings for the first two quarters of 2014, compared to the same period in 2013, resulted primarily from an increase in non-fuel FIFO operating profit and an increase in earnings from our fuel operations, offset partially by increases in interest expense and the LIFO charge. The increase in non-fuel FIFO operating profit for the first two quarters of 2014, compared to the same period in 2013, resulted primarily from the benefit of increased supermarket sales, the merger with Harris Teeter, productivity improvements and cost controls, offset partially by continued investments in lower prices for our customers, increases in the workers compensation and general liability reserves and increases in credit card and incentive plan costs. The increase in net earnings from our fuel operations for the first two quarters of 2014, compared to the first two quarters of 2013, resulted primarily from an increase in the average margin per gallon of fuel sold and an increase in fuel gallons sold.

Net earnings of $0.70 per diluted share for the second quarter of 2014 represented an increase of 16.7% over net earnings of $0.60 per diluted share for the second quarter of 2013. Net earnings per diluted share increased in the second quarter of 2014, compared to the second quarter of 2013, due to increased net earnings and the repurchase of common shares resulting in a lower weighted average shares outstanding.

Net earnings of $1.68 per diluted share for the first two quarters of 2014 represented an increase of 10.5% over net earnings of $1.52 per diluted share for the first two quarters of 2013. Adjusted net earnings for the first two quarters of 2014 of $1.79 per diluted share, excluding the pension plan agreements, represented an increase of 17.8% over the first two quarters of 2013. Adjusted net earnings per diluted share increased in the first two quarters of 2014, compared to the first two quarters of 2013, due to increased net earnings and the repurchase of common shares resulting in a lower weighted average shares outstanding.

Management believes adjusted net earnings (and adjusted net earnings per diluted share) are useful metrics to investors and analysts because they more accurately reflect our day-to-day business operations than do the generally accepted accounting principle (“GAAP”) measures of net earnings and net earnings per diluted share. Adjusted net earnings (and adjusted net earnings per diluted share) are non-generally accepted accounting principle (“non-GAAP”) financial measures and should not be considered alternatives to net earnings (and net earnings per diluted share) or any other GAAP measure of performance. Adjusted net earnings (and adjusted net earnings per diluted share) should not be viewed in isolation or considered substitutes for our financial results as reported in accordance with GAAP. Management uses adjusted net earnings (and adjusted net earnings per diluted share) in evaluating our results of operations as it believes these measures are more meaningful indicators of operating performance since, as adjusted, those earnings relate more directly to our day-to-day operations. Management also uses adjusted net earnings (and adjusted net earnings per diluted share) as a performance metric for management incentive programs, and to measure our progress against internal budgets and targets.

The following table provides a reconciliation of net earnings attributable to The Kroger Co. to net earnings attributable to The Kroger Co. excluding the pension plan agreements and a reconciliation of net earnings attributable to The Kroger Co. per diluted common share to net earnings attributable to The Kroger Co. per diluted common share excluding the pension plan agreements, for the second quarters and the first two quarters of 2014 and 2013 ($ in millions):

	Second Quarter Ended				Two Quarters Ended
	August 16, 2014		August 17, 2013		August 16, 2014		August 17, 2013
Net earnings attributable to The Kroger Co.	$	347	$	317	$	848	$	798
Adjustment for pension plan agreements(1)(2)	—		—		56		—

Net earnings attributable to The Kroger Co. excluding the adjustment item above	$	347	$	317	$	904	$	798

Net earnings attributable to The Kroger Co. per diluted common share	$	0.70	$	0.60	$	1.68	$	1.52
Adjustment for pension plan agreements(3)	—		—		0.11		—

Net earnings attributable to The Kroger Co. per diluted common share excluding the adjustment item above	$	0.70	$	0.60	$	1.79	$	1.52

Average number of common shares used in diluted calculation	491		521		500		520

(1)	The amount presented represents the after-tax effect of the adjustment.
(2)	The pre-tax adjustment for the pension plan agreements was $87.
(3)	The amount presented represents the net earnings per diluted common share effect of the adjustment.

Sales

Total Sales

($ in millions)

	Second Quarter Ended								Two Quarters Ended
	August 16, 2014		Percentage Increase		August 17, 2013		Percentage Increase(2)		August 16, 2014		Percentage Increase		August 17, 2013		Percentage Increase(3)
Total supermarket sales without fuel	$	19,629	12.4	%	$	17,468	3.6	%	$	45,487	11.8	%	$	40,694	3.6	%
Fuel sales	4,936		8.1	%	4,565		7.4	%	11,119		5.6	%	10,532		4.1	%
Other sales(1)	745		14.1	%	653		11.2	%	1,665		14.3	%	1,457		10.5	%

Total sales	$	25,310	11.6	%	$	22,686	4.6	%	$	58,271	10.6	%	$	52,683	3.9	%

(1)	Other sales primarily relate to sales by convenience stores, excluding fuel; jewelry stores; manufacturing plants to outside customers; variable interest entities; and in-store health clinics.
(2)	This column represents the percentage increase in the second quarter of 2013, compared to the second quarter of 2012.
(3)	This column represents the percentage increase in the first two quarters of 2013, compared to the first two quarters of 2012.

The increase in total sales and total supermarket sales without fuel for the second quarter of 2014, compared to the second quarter of 2013, was primarily due to our merger with Harris Teeter, which closed on January 28, 2014, and an increase in identical supermarket sales, excluding fuel, of 4.8%. Identical supermarket sales, excluding fuel for the second quarter of 2014, compared to the second quarter of 2013, increased primarily due to an increase in the number of households shopping with us, an increase in transaction count and product cost inflation. Total fuel sales increased 8.1% in the second quarter of 2014, compared to the second quarter of 2013, primarily due to an increase in fuel gallons sold of 7.1% and an increase in the average retail fuel price of 0.9%. The increase in the average retail fuel price was caused by an increase in the product cost of fuel.

The increase in total sales and total supermarket sales without fuel for the first two quarters of 2014, compared to the same period of 2013, was primarily due to our merger with Harris Teeter, which closed on January 28, 2014, and an increase in identical supermarket sales, excluding fuel, of 4.7%. Identical supermarket sales, excluding fuel for the first two quarters of 2014, compared to the first two quarters of 2013, increased primarily due to an increase in the number of households shopping with us, an increase in transaction count and product cost inflation. Total fuel sales increased 5.6% in the first two quarters of 2014, compared to the first two quarters of 2013, primarily due to an increase in fuel gallons sold of 6.3% offset by a decrease in the average retail fuel price of 0.7%. The decrease in the average retail fuel price was caused by a decrease in the product cost of fuel.

We define a supermarket as identical when it has been in operation without expansion or relocation for five full quarters. Fuel discounts received at our fuel centers and earned based on in-store purchases are included in all of the identical supermarket sales results calculations illustrated below and reduce our identical supermarket sales results. Differences between total supermarket sales and identical supermarket sales primarily relate to changes in supermarket square footage. Identical supermarket sales include sales from all departments at identical Fred Meyer multi-department stores and include Harris Teeter sales for stores that are identical as if they were part of the Company in our prior year. Our identical supermarket sales results are summarized in the table below. We used the identical supermarket dollar figures presented below to calculate percentage changes for the second quarter and the first two quarters of 2014.

Identical Supermarket Sales

($ in millions)

	Second Quarter
	August 16, 2014		Percentage Increase		August 17, 2013		Percentage Increase(1)
Including fuel centers	$	22,621	5.3	%	$	21,492	4.0	%
Excluding fuel centers	$	18,875	4.8	%	$	18,009	3.3	%

(1)	This column represents the percentage increase in identical supermarket sales in the second quarter of 2013, compared to the second quarter of 2012.

Identical Supermarket Sales

($ in millions)

	Two Quarters Ended
	August 16, 2014		Percentage Increase		August 17, 2013		Percentage Increase(1)
Including fuel centers	$	52,287	4.7	%	$	49,950	3.3	%
Excluding fuel centers	$	43,824	4.7	%	$	41,864	3.3	%

(1)	This column represents the percentage increase in identical supermarket sales in the first two quarters of 2013, compared to the first two quarters of 2012.

Gross Margin and FIFO Gross Margin

Our gross margin rate, as a percentage of sales, was 20.44% for the second quarter of 2014, as compared to 20.40% for the second quarter of 2013. The increase in the second quarter of 2014, compared to the second quarter of 2013, resulted primarily from the effect of our merger with Harris Teeter and an increase in fuel gross margin rate, as a percentage of sales, partially offset by continued investments in lower prices for our customers and an increase in our LIFO charge, as a percentage of sales. The merger with Harris Teeter, which closed late in fiscal year 2013, had a positive effect on our gross margin rates in the second quarter of 2014 since Harris Teeter has higher gross margin rates as compared to the total Company without Harris Teeter.

Our gross margin rate, as a percentage of sales, was 20.71% for the first two quarters of 2014, as compared to 20.51% for the first two quarters of 2013. The increase in the first two quarters of 2014, compared to the first two quarters of 2013, resulted primarily from the effect of our merger with Harris Teeter and an increase in fuel gross margin rate, as a percentage of sales, partially offset by continued investments in lower prices for our customers and an increase in our LIFO charge, as a percentage of sales. The merger with Harris Teeter, which closed late in fiscal year 2013, had a positive effect on our gross margin rates in the second quarter of 2014 since Harris Teeter has higher gross margin rates as compared to the total Company without Harris Teeter.

We calculate FIFO gross margin as sales minus merchandise costs, including advertising, warehousing, and transportation expenses, but excluding the LIFO charge. Merchandise costs exclude depreciation and rent expenses. Our LIFO charge was $26 million for the second quarter of 2014 and $13 million for the second quarter of 2013. Our LIFO charge was $54 million for the first two quarters of 2014 and $30 million for the first two quarters of 2013. FIFO gross margin is a non-GAAP financial measure and should not be considered as an alternative to gross margin or any other GAAP measure of performance. FIFO gross margin should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. FIFO gross margin is an important measure used by management to evaluate merchandising and operational effectiveness. Management believes FIFO gross margin is a useful metric to investors and analysts because it measures our day-to-day merchandising and operational effectiveness.

Our FIFO gross margin rate was 20.54% for the second quarter of 2014, as compared to 20.45% for the second quarter of 2013. Retail fuel sales lower our FIFO gross margin rate, as a percentage of sales, due to the very low FIFO gross margin on retail fuel sales as compared to non-fuel sales. Excluding the effect of retail fuel operations, our second quarter 2014 FIFO gross margin rate decreased 12 basis points, as a percentage of sales, compared to the second quarter of 2013. This decrease in the second quarter of 2014, compared to the second quarter of 2013, was primarily due to continued investments in lower prices for our customers, offset partially by the effect of our merger with Harris Teeter.

Our FIFO gross margin rate was 20.81% for the first two quarters of 2014, as compared to 20.57% for the first two quarters of 2013. Excluding the effect of retail fuel operations, as a percentage of sales, our FIFO gross margin rate decreased 5 basis points for the first two quarters of 2014, compared to the first two quarters of 2013. This decrease in the first two quarters of 2014, compared to the first two quarters of 2013, was primarily due to continued investments in lower prices for our customers, offset partially by the effect of our merger with Harris Teeter.

LIFO Charge

The LIFO charge was $26 million in the second quarter of 2014 and $13 million in the second quarter of 2013. The LIFO charge increased in the second quarter of 2014, compared to the second quarter of 2013, due to our higher expected year-end product cost of inflation in most major categories for fiscal 2014 compared to fiscal 2013.

The LIFO charge was $54 million in the first two quarters of 2014 and $30 million in the first two quarters of 2013. The LIFO charge increased in the first two quarters of 2014, compared to the first two quarters of 2013, due to our higher expected year end product cost of inflation in most major categories for 2014 compared to 2013. As of August 16, 2014, the fair value step up adjustment to Harris Teeter inventory as of the merger date is recorded in LIFO reserve. This resulted in a $53 million decrease in the LIFO reserve.

Operating, General and Administrative Expenses

Operating, general and administrative (“OG&A”) expenses consist primarily of employee-related costs such as wages, health care benefit costs and retirement plan costs, utilities, and credit card fees. Rent expense, depreciation and amortization expense, and interest expense are not included in OG&A.

OG&A expenses, as a percentage of sales, increased 3 basis points to 15.49% for the second quarter of 2014 from 15.46% for the second quarter of 2013. The OG&A rate increased primarily due to the effect of our merger with Harris Teeter, increases in workers compensation and general liability reserves and increases in credit card fees and incentive plan costs, as a percentage of sales, partially offset by the benefit of increased supermarket sales and fuel sales, productivity improvements and effective cost controls. The merger with Harris Teeter, which closed late in fiscal year 2013, increased our OG&A rate, as a percentage of sales, in the second quarter of 2014 since Harris Teeter has a higher OG&A rate as compared to the total Company without Harris Teeter. Retail fuel sales lower our OG&A rate due to the very low OG&A rate, as a percentage of sales, of retail fuel sales compared to non-fuel sales. OG&A expenses, as a percentage of sales excluding fuel, decreased nine basis points in the second quarter of 2014, compared to the second quarter of 2013. This decrease in our OG&A rate, as a percentage of sales excluding the effect of fuel, resulted primarily from increased supermarket sales, productivity improvements and effective cost controls, offset partially by the effect of our merger with Harris Teeter, increases in workers compensation and general liability reserves and increases in credit card fees and incentive plan costs, as a percentage of sales.

OG&A expenses, as a percentage of sales, increased 22 basis points to 15.60% for the first two quarters of 2014 from 15.38% for the first two quarters of 2013. The OG&A rate increased primarily due to the pension plan agreements, the effect of our merger with Harris Teeter, increases in workers compensation and general liability reserves and increases in credit card fees and incentive plan costs, as a percentage of sales, partially offset by the benefit of increased supermarket sales and fuel sales, productivity improvements and effective cost controls. The merger with Harris Teeter, which closed late in fiscal year 2013, increased our OG&A rate, as a percentage of sales, in the first two quarters of 2014 since Harris Teeter has a higher OG&A rate as compared to the total Company without Harris Teeter. Retail fuel sales lower our OG&A rate due to the very low OG&A rate, as a percentage of sales, of retail fuel sales compared to non-fuel sales. OG&A rate, excluding the pension plan agreements and fuel, decreased 11 basis points in the first two quarters of 2014, compared to the first two quarters of 2013. This decrease in our OG&A rate, as a percentage of sales excluding the pension plan agreements and fuel, resulted primarily from increased supermarket sales, productivity improvements and effective cost controls, offset partially by the effect of our merger with Harris Teeter, increases in workers compensation and general liability reserves and increases in credit card fees and incentive plan costs, as a percentage of sales.

Rent Expense

Rent expense was $166 million, or 0.65% of sales, for the second quarter of 2014, compared to $139 million, or 0.61% of sales, for the second quarter of 2013. For the first two quarters of 2014, rent expense was $383 million, or 0.66% of sales, compared to $328 million, or 0.62% of sales, in the first two quarters of 2013. Rent expense, as a percentage of sales excluding fuel, increased four basis points in the second quarter of 2014 compared to the second quarter of 2013. Rent expense, as a percentage of sales excluding fuel, increased 3 basis points in the first two quarters of 2014 compared to the first two quarters of 2013. These increases in rent expense, as a percentage of sales both including and excluding fuel, is due to the effect of our merger with Harris Teeter, partially offset by our continued emphasis on owning rather than leasing, whenever possible, and the benefit of increased supermarket sales. The merger with Harris Teeter, which closed late in fiscal year 2013, increased rent expense, as a percentage of sales excluding fuel, since Harris Teeter has a higher rent expense rate as compared to the total Company without Harris Teeter.

Depreciation Expense

Depreciation expense was $444 million, or 1.76% of total sales, for the second quarter of 2014 compared to $387 million, or 1.71% of total sales, for the second quarter of 2013. The increase in our depreciation expense for the second quarter of 2014, compared to the second quarter of 2013, in total dollars, was the result of additional depreciation on capital investments, including acquisitions and lease buyouts, of $4.0 billion, during the rolling four quarter period ending with the second quarter of 2014. Excluding the effect of retail fuel operations, depreciation, as a percentage of sales, increased five basis points in the second quarter of 2014, compared to the same period of 2013. The increase in depreciation expense, as a percentage of sales excluding fuel, is due to the effect of our merger with Harris Teeter, partially offset by increased supermarket sales. The merger with Harris Teeter, which closed late in fiscal year 2013, increased our depreciation expense, as a percentage of sales excluding fuel, in the second quarter of 2014 since Harris Teeter has a higher depreciation expense rate as compared to the total Company without Harris Teeter.

Depreciation expense was $1.0 billion, or 1.76% of total sales, for the first two quarters of 2014 compared to $906 million, or 1.72% of total sales, for the first two quarters of 2013. The increase in our depreciation expense for the first two quarters of 2014, compared to the first two quarters of 2013, in total dollars, was the result of additional depreciation on capital investments, including acquisitions and lease buyouts, of $4.0 billion, during the rolling four quarter period ending with the second quarter of 2014. Excluding the effect of retail fuel operations, depreciation, as a percentage of sales, increased three basis points in the first two quarters of 2014, compared to the same period of 2013. The increase in depreciation expense, as a percentage of sales excluding fuel, is due to the effect of our merger with Harris Teeter, partially offset by increased supermarket sales. The merger with Harris Teeter, which closed late in fiscal year 2013, increased our depreciation expense, as a percentage of sales excluding fuel, in the first two quarters of 2014 since Harris Teeter has a higher depreciation expense rate as compared to the total Company without Harris Teeter.

Operating Profit and FIFO Operating Profit

Operating profit was $644 million, or 2.54% of sales, for the second quarter of 2014, compared to $595 million, or 2.62% of sales, for the second quarter of 2013. Operating profit was $1.6 billion, or 2.70% of sales, for the first two quarters of 2014, compared to $1.5 billion, or 2.80% of sales, for the first two quarters of 2013. Operating profit, as a percentage of sales, decreased eight basis points in the second quarter of 2014, compared to the second quarter of 2013, primarily due to continued investments in lower prices for our customers, increased LIFO expense, increases in workers compensation and general liability reserves and increases in credit card and incentive plan costs, as a percentage of sales, partially offset by the benefit of increased supermarket sales, an increase in fuel operating profit, the effect of our merger with Harris Teeter, productivity improvements and cost controls. Operating profit, as a percentage of sales, decreased 10 basis points in the first two quarters of 2014, compared to the first two quarters of 2013, primarily due to the pension plan agreements, continued investments in lower prices for our customers, increased LIFO expense, increases in workers compensation and general liability reserves and increases in credit card and incentive plan costs, as a percentage of sales, partially offset by the benefit of increased supermarket sales, an increase in fuel operating profit, the effect of our merger with Harris Teeter, productivity improvements and cost controls.

We calculate FIFO operating profit as operating profit excluding the LIFO charge. FIFO operating profit is a non-GAAP financial measure and should not be considered as an alternative to operating profit or any other GAAP measure of performance. FIFO operating profit should not be reviewed in isolation or considered as a substitute for our financial results as reported in accordance with GAAP. FIFO operating profit is an important measure used by management to evaluate operational effectiveness. Management believes FIFO operating profit is a useful metric to investors and analysts because it measures our day-to-day operational effectiveness. Since fuel discounts are earned based on in-store purchases, fuel operating profit does not include fuel discounts, which are allocated to our non-fuel supermarket departments. We also derive operating, general and administrative expenses, rent and depreciation and amortization through the use of estimated allocations in the calculation of fuel operating profit.

FIFO operating profit was $670 million, or 2.65% of sales, for the second quarter of 2014, compared to $608 million, or 2.68% of sales, for the second quarter of 2013. Retail fuel sales lower our FIFO operating profit rate due to the very low FIFO operating profit rate, as a percentage of sales, of retail fuel sales compared to non-fuel sales. FIFO operating profit, excluding fuel, was $559 million, or 2.74% of sales, for the second quarter of 2014, compared to $519 million, or 2.86% of sales, for the second quarter of 2013. FIFO operating profit, as a percentage of sales excluding fuel, decreased 12 basis points in the second quarter of 2014, compared to the second quarter of 2013 primarily due to continued investments in lower prices for our customers, increases in workers compensation and general liability reserves and increases in credit card and incentive plan costs, as a percentage of sales, partially offset by the benefit of increased supermarket sales, the effect of our merger with Harris Teeter, productivity improvements and cost controls.

FIFO operating profit was $1.6 billion, or 2.79% of sales, for the first two quarters of 2014, compared to $1.5 billion, or 2.85% of sales, for the first two quarters of 2013. Retail fuel sales lower our FIFO operating profit rate due to the very low FIFO operating profit rate, as a percentage of sales, of retail fuel sales compared to non-fuel sales. FIFO operating profit, excluding fuel and the pension plan agreements, was $1.6 billion, or 3.30% of sales, for the first two quarters of 2014, compared to $1.4 billion, or 3.30% of sales, for the first two quarters of 2013. FIFO operating profit, as a percentage of sales excluding fuel and the pension plan agreements, remained flat for the first two quarters of 2014, compared to the first two quarters of 2013 primarily due to continued investments in lower prices for our customers, increased workers compensation and general liability reserves and increases in credit card and incentive plan costs, as a percentage of sales, partially offset by the benefit of increased supermarket sales, the effect of our merger with Harris Teeter, productivity improvements and cost controls.

The following table provides a reconciliation of operating profit to FIFO operating profit and FIFO operating profit, excluding fuel, for the second quarters and first two quarters of 2014 and 2013 ($ in millions):

	Second Quarter Ended								Two Quarters Ended
	August 16, 2014		2014 Percentage of Sales		August 17, 2013		2013 Percentage of Sales		August 16, 2014		2014 Percentage of Sales		August 17, 2013		2013 Percentage of Sales
Sales	$	25,310			$	22,686			$	58,271			$	52,683
Fuel sales	4,936				4,565				11,119				10,532

Sales excluding fuel	$	20,374			$	18,121			$	47,152			$	42,151

Operating profit	$	644	2.54	%	$	595	2.62	%	$	1,574	2.70	%	$	1,474	2.80	%
LIFO charge	26		0.10	%	13		0.06	%	54		0.09	%	30		0.06	%

FIFO operating profit	670		2.65	%	608		2.68	%	1,628		2.79	%	1,504		2.85	%
Fuel operating profit	111		2.25	%	89		1.95	%	161		1.45	%	113		1.07	%

FIFO operating profit excluding fuel	559		2.74	%	519		2.86	%	1,468		3.11	%	1,391		3.30	%
Adjusted item	—				—				87		0.18	%	—

FIFO operating profit excluding fuel and adjusted item	$	559	2.74	%	$	519	2.86	%	$	1,555	3.30	%	$	1,391	3.30	%

Percentages may not sum due to rounding.

Interest Expense

Net interest expense was $112 million, or 0.44% of sales, in the second quarter of 2014 and $99 million, or 0.43% of total sales, in the second quarter of 2013. For the first two quarters of 2014, net interest expense was $259 million, or 0.44% of total sales, in 2014 and $228 million, or 0.43% of total sales, in the first two quarters of 2013. The increase in net interest expense for both the second quarter and the first two quarters of 2014, when compared to 2013, resulted primarily from an increase in net total debt, primarily due to financing the merger with Harris Teeter and repurchases of our outstanding common shares.

Income Taxes

Our effective income tax rate was 34.2% in the second quarter of 2014, compared to 35.5% for the second quarter of 2013. Our effective income tax rate was 34.7% for the first two quarters of 2014, compared to 35.5% for the first two quarters of 2013. The effective income tax rate for the second quarter of 2014 and the first two quarters of 2014 differed from the federal statutory rate primarily due to the utilization of tax credits and deductions, partially offset by the effect of state income taxes. The effective income tax rate for the second quarter of 2013 and the first two quarters of 2013 differed from the federal statutory rate primarily due to the effect of state income taxes, partially offset by the utilization of tax credits and deductions.

LIQUIDITY AND CAPITAL RESOURCES

Cash Flow Information

Net cash provided by operating activities

We generated $2.8 billion of cash from operating activities during the first two quarters of 2014, compared to $2.6 billion in the first two quarters of 2013. The cash provided by operating activities came from net earnings including noncontrolling interests, adjusted for non-cash expenses, and changes in working capital. The increase in cash from operating activities in 2014, compared to 2013, resulted primarily due to an increase in net earnings including noncontrolling interests and an increase in long-term liabilities, partially offset by changes in working capital. Changes in working capital provided cash from operating activities of $698 million in the first two quarters of 2014 and $883 million in the first two quarters of 2013. The decrease in cash provided by changes in working capital for the first two quarters of 2014, compared to the first two quarters of 2013, was primarily due to a decrease in the cash provided by store deposits in-transit, receivables and income taxes receivable and payable, partially offset by an increase in the cash provided by trade accounts payable. Prepaid expenses decreased significantly from year-end 2014 and 2013 reflecting prepayments of certain employee benefits at year-end in each year.

Net cash used by investing activities

We used $1.3 billion of cash for investing activities during the first two quarters of 2014 compared to $1.1 billion during the first two quarters of 2013. The amount of cash used for investing activities increased in the first two quarters of 2014 versus 2013, primarily due to increased payments for capital invest