Description

Disclosure: The author, his family, and funds the author manages and/or is associated with may or may not have a position in any of the securities mentioned in this write-up. Any of the aforementioned may trade in and out and around any of the securities mentioned without notifying you. The author undertakes no responsibility to update this analysis as the circumstances change. The analysis presented is the author’s own and is believed to be accurate. Do your own diligence. This write-up constitutes analysis and/or market commentary and is not an investment recommendation, and as such, should not be used in isolation to make an investment decision.

 Safeway is a food retailer that is currently trading at a 2012(e) free cash flow yield of 22%, using the low end of management’s guidance of $850-950mm ($3,900b market cap). In addition to the compelling valuation of the underlying business, there are a number of significant developments for which the market is not giving Safeway significant credit. Namely, the upcoming IPO of a stake in its high growth Blackhawk gift card business (1h 2013), the prospective early success of its “Just For U” digital marketing platform, it’s owned real estate/property development business and their wellness strategy.  I’ll address each individually. 

 Safeway has also executed a dramatic share buyback in recent years, buying back 20% of their shares outstanding in q1 2012 alone, followed up with another 12% in the second quarter of 2012. At the end of 2007, Safeway had 446mm shares outstanding compared to 240mm shares at the end of 2q 2012 (July 2012) for a decrease of 46% over five year the period. Debt levels have risen, but at just below 4x interest coverage the debt load is very manageable.

 Retail Food & Drug

 Safeway’s primary business is food and drug stores in the western U.S. (1,453 stores) and Canada (225 stores). Safeway’s average store is 47,000 sq feet.   Food retailing is an intensively competitive business and the unprecedented deflationary pressures in two of the last four years have squeezed margins for Safeway.

 In 200 Safeway began a major program to upgrade its stores to what they called “Lifestyle” stores. In their words..

  “Safeway’s “Lifestyle” store showcases the Company’s commitment to quality with an expanded perishables offering. It features an earth-toned décor package that is warm and inviting with special lighting to highlight products and departments, custom flooring and unique display features. The Company believes this warm ambience significantly enhances the shopping experience.” – 2011 annual report

 At the end of 2011, 87% of Safeway’s store base was Lifestyle stores and it expects to eventually convert most of the remaining stores to the Lifestyle format. Therefore, the major capex associated with the Lifestyle renovations is essentially behind it. 

 Safeway also has an extensive portfolio of private brands with associated manufacturing and wholesale businesses that manufacture the 14% of Safeway’s private label merchandise that is not purchased from third parties.

 Blackhawk gift cards

 Blackhawk is the largest third party distributer of gift cards in the world. It distributes gift cards and other payment products through 72,000 retail outlets, the backbone of which is grocery networks where it has 90% of the store locations of the top 50 grocers in North America. It also operates giftcardmall.com. Blackhawk has 500 different providers, many of which are exclusive to Blackhawk.

 Blackhawk is seasonally strong in the fourth quarter. It’s exhibited strong growth and Safeway will use the results through the fourth quarter of this year to file for the minority IPO, which is expected to happen sometime in the first half of 2013.

 The gift card business is an attractive one which requires little capital due to its negative cash conversion cycle (i.e. generates “float”).

 Just for U

 This quarter Safeway has ramped up its “just for U” digital marketing program, which creates personalized promotions. With last quarter’s continued roll-out, Just for U registered customers amount to about 36% of Safeway’s sales with management expecting that to be up to 45% by the end of the year.

 This tool is essentially a markdown efficiency mechanism. Safeway users shoppers history to mark down the products that it has determined are driving a particular unique shopper to the store, while not having to offer the same markdown to their other shoppers. This is driving loyalty and traffic and has been successful above management’s expectations. 

Property Development Centers (PDC)

 The PDC business is a non core business where Safeway will build their store, and also build all the shops around it. Steve Burd guides towards this business generating $60 to $70mm in pre-tax profit in five years with no net investment in the business.

 Owned real estate

 Safeway owns 42% of their stores. This is tangential to the story as there doesn’t appear to be any real estate related event in the near future but perhaps this resource affords them some financial flexibility in the future, should the need arise.

 Wellness

 Safeway has about 175,000 employees and spends less on healthcare today than it did in 2005 ($850mm vs. $1b). Safeway claims to have developed expertise that, working in conjunction with a partner who has developed an innovative technology, will drive incremental traffic to Safeway stores that could ultimately add 2%+ to ID sales when they reach their state of maturity (company guidance). Rollout will begin in the fourth quarter and will be complete through the U.S. by the end of 2013. 

 Valuation

Safeway currently has a $3.9b market cap and $6.6b of net debt for an EV of $10.5b. Estimated ebitda for 2012 is $2.1b for an EV/EBITDA of 5. The company guides towards fcf this year (2012) of $850-950.

 Blackhawk generated $78mm of ebitda in 2011. Details are currently sparse, but the face value of cards sold grew 25% between 2010-2011. One can have low confidence about the valuation for Blackhawk once it’s public, but at a wide multiple of EBTIDA range of 7 – 13x, Blackhawk would be worth between $550mm – $1,000.

 So here we have a classic dynamic where a small portion of Safeway’s EBITDA is generated by a high growth, attractive, and (potentially) high multiple business. Backing out the value of Blackhawk from the Safeway market cap and reducing the “stub” Safeway earnings accordingly will yield an even higher FCF yield of the supermarket business to the mid 20% level (low end guidance).

 Due to difficult business conditions, EBIT margins have been declining since 2007, from over 4% to around 2.5%. One could argue that Safeway current trades at a low multiple of low earnings.

 The combination of dynamics between a fairly defensive supermarket business and the upcoming Blackhawk corporate action, along with the other favorable developments at Safeway make it very attractive at the current price.

 Risks:

• Safeway has a deficit in its Multi-Employer Pension Plan (MEPP) that Credit Suisse estimated in a proprietary analysis to be as high as $7b pre tax  ($4.5b after tax) based on fair value of plan assets and liabilities. Using smoothed actuarial values reduces the underfunding to $2b pre tax. Cs notes that rising interest rates and asset values as well as cost sharing with employees would help reduce the size of this underfunding. All MEPP numbers were taken from referenced Credit Suisse March 2012 downgrade report. From the 2011 10k, ” Cash contributions to the Company’s pension and post-retirement benefit plans are expected to total approximately $160 million in 2012 and totaled $176.2 million in 2011, $17.7 million in 2010 and $24.4 million in 2009.”
• Chairman & CEO Steve Burd has been running Safeway since 1992 and is not well liked by the investor community due to general opacity with which he runs the company.
• Approximately 75% of Safeway’s 178,000 full and part time employees are part of a union.
• Early indication is that Just For U is progressing well, but should Safeway’s competition become aggressive with their own digital marketing program then Safeway’s advantage could be diminished or neutralized.

Disclosure: The author, his family, and funds the author manages and/or is associated with may or may not have a position in any of the securities mentioned in this write-up. Any of the aforementioned may trade in and out and around any of the securities mentioned without notifying you. The author undertakes no responsibility to update this analysis as the circumstances change. The analysis presented is the author’s own and is believed to be accurate. Do your own diligence. This write-up constitutes analysis and/or market commentary and is not an investment recommendation, and as such, should not be used in isolation to make an investment decision.

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