Description

Safeway, Inc. is the third largest grocery store company in the US and Canada (after Kroger and Albertson?s), operating 1,800 stores. Most of the company?s stores are located in the western US region, where it holds the #1 market share. About 33% of the Company?s store base is in California. Safeway has done a great job generating very high and consistent ROE and ROIC metrics since its LBO in 1986 (and IPO in 1990), and has industry-leading cash flow margins, despite the inherent low-margined nature of food retailing.

Despite increasingly competitive conditions, SWY?s valuation is compelling:
SWY generates significant free cash flow. In 2002 which proved to be one of the SWY?s most difficult years (along with all of its grocery peers), the Company generated about $600MM in run-rate free cash flow (after interest, taxes, and capital spending). 2003 capital spending will be cut to $1.2BN (from $1.4BN in 2002) due to fewer store openings and remodels, which should lead to free cash flow generation of around $800MM, assuming no operating improvements. This results in a free cash flow yield of 9% on SWY?s $9N market cap. The degree of the ?margin of safety? on the Company?s equity is significant, as $8BN to $10BN of free cash flow after debt service and taxes can be returned to shareholders over the next 10 years (the company does not currently pay a dividend, but has been aggressively buying back stock) . On an earnings basis, SWY trades at 7.7x normalized trailing earnings.

Earnings are likely to improve when the economy turns:
The entire US grocery sector has come under numerous top line and expense pressures over the past year, including a slowing economy, food price deflation, expansion of competitive formats (Wal-mart and Target supercenters and Costco), and wage/labor and pension costs. SWY was also a victim of these forces, with comparable store sales down almost 2% in 2002 (in line with all other grocers, except Wal-mart supercenters), and normalized EPS (excluding goodwill impairments) was about flat at $2.60 vs. 2001. The equity valuations across the sector were also decimated in 2002 (SWY down 57%, some of its peers fared much worse). Over the past decade, grocers have increased margins and retained pricing power by offering higher-margined products/services, such as deli counters, in-store bakeries, ready-to-eat, and pre-made foods. As a result, grocers have become more cyclical and are by no means recession-proof (to the great surprise of investors in 2002!). When the economy turns, same store sales will likely increase and food price deflation will reverse as consumers become less price sensitive, and pay up for higher priced items, convenience, or better service. Fresh foods and prepared/ready to eat foods comprise about 35%-40% of SWY?s sales mix (higher than other grocers and Wal-Mart supercenters), and the gross margins of these products range from 30%-40% which is significantly higher vs. the 15%-25% margins of most grocery items (e.g. canned, boxed goods); these ?premium? items are a key contributor to SWY?s exhibiting higher margins vs. its peers. Thus a better economy will likely benefit the consumption of these higher-margined products and translate into same-store sales and earnings growth.

The Wal-Mart threat seems overdone as there will always be a market for a higher-service, higher-quality, and more convenient grocer: SWY equity actually trades at a discount to Kroger, Albertson?s, and Winn-Dixie (trading at P/Es of 10x-13x forward earnings), partly because investors are worried about the opening of Wal-mart supercenters in California, where 40 centers will be opened over the next few years (and longer-term Wal-mart will likely introduce the smaller Neighborhood Market format). Wal-mart is aggressively expanding in the Western US, and there is the fear that SWY?s margins can go nowhere but down, given they?re the highest in the industry and that today?s grocery companies will go by the way K-mart did when it tried to compete with Wal-mart and Target. While margins will be pressured in the near- term (some of which is due to price sensitivity of consumers in a downturn), I believe the ?Wal-mart effect? will not be as significant as investors may believe for the following reasons:

Wal-mart supercenters have topped out about 20%-25% market share in other markets (where they have been for 5+ years), and Albertson?s, Kroger, Delhaize, and even Winn-Dixie have done a decent job competing with these supercenters, given that they really serve different market segments (to varying degrees). While a low-price, low service grocery store as found in the Wal-mart supercenters has been and will continue to be very successful, there will always be a need for more convenience-oriented, higher service, and higher food/item quality grocer that provides a good shopping experience to the consumer.

Safeway is a better operator than all of its pure grocer peers, has a lower cost structure, industry leading margins, generates higher returns on capital, and has the strongest balance sheet in the industry. The company has a very strong business and competitive position and has a great management team that has successfully earned that position.

Safeway will not go down the path of K-Mart; One of the major reasons of K-Mart?s demise was that it could not compete with the superior inventory control and replenishment systems of Wal-mart and Target. In contrast to K-mart, Safeway has excellent inventory control and point of sale systems, and examination of working capital and asset utilization metrics over time confirm this.

Safeway?s geography is a competitive advantage: Over 80% of SWY?s stores are concentrated in the Western US, which makes for lower distribution costs vs. its grocery peers. Also, many of its stores (especially in California) are in denser urban and suburban areas with prime real estate locations; in many of these regions, a Wal-mart supercenter would unlikely be even be built (although the Neighborhood market format of Wal-mart would be a longer-term threat).

Safeway?s customer demographic is different from Wal-mart?s. Industry surveys indicate that Safeway?s average customer household size is 2.6 members, with household income of about $46,000. Wal-mart?s household size is 3.1 persons with household income of $36,000. ABS, KR, and Ahold are all in between the two, which points to Safeway?s competitors being more threatened longer-term by Wal-mart given that their customer profiles overlap more vs. Safeway.

The industry is still fragmented. In contrast to other retail formats, the grocery industry is still fairly fragmented compared to department stores, discount stores, and toy stores. Industry trade associations estimate that the top 10 supermarket companies make up about 40%-45% of annual food sales. Of total supermarket sales, about 85% are contributed by chains and the rest by independents. This suggests that more efficient, national chains (including Wal-mart) will, as a group, continue to gain market share at the expense of smaller and weaker players, who are at a major disadvantage with regard to costs, purchasing, advertising, and overhead given the thin margins of this industry. Thus both grocery and superstore formats can thrive in an industry that is still fragmented.

The grocery industry will likely be economically rational: In a scenario where competition increases, it is likely that all grocers will cut capital spending for new store openings (many have already stated they will be doing so in 2003), and invest more in existing stores/remodels, which should ease competitive pressures over time and result in higher returns on invested capital.

Even a more draconian scenario justifies the price paid for SWY equity. A large portion of SWY?s capital spending is for new stores (company plans to open 50-55 in 2003). However, the maintenance capital spending for a grocer is significantly lower. SWY?s maintenance Capex (including some remodeling of the existing store base) is conservatively estimated at about $900MM a year or even lower (roughly the Company?s depreciation rate), which means that about $300MM a year in cash flow can be ?freed up? if SWY sales and earnings fail to increase. Assuming a continued difficult operating environment, and lower Capex, SWY can still generate $800BN-$1BN in annual free cash flow.

Management is shareholder friendly and has a good track record of generating returns on capital higher than its competitors. The Company has been aggressively buying back stock and plans on using all its free cash flow to do so. Over the past year, it has repurchased $1.5BN ($2.9BN since 1999). Moreover, the current share repurchases are not being done at over-valued levels. Based on current equity prices, the Company has the ability to reduce its share count by 10% annually, which will result in a corresponding percentage increase in EPS, even if in the unlikely scenario where there is no earnings growth.

SWY has the strongest balance sheet in the industry. While rated mid-BBB, SWY really has the balance sheet and debt service coverage statistics of a weak single-A or high-BBB rated entity. Both S&P and Moody?s have wanted to upgrade SWY?s credit ratings over the past few years, but SWY management has discouraged them from doing so in order to incorporate a degree of financial flexibility for acquisitions or share repurchases. Even though Albertson?s is rated as mid-BBB, the credit statistics of ABS are weaker than SWY?s. Moreover, several players now in the high-yield space, are rated BB or lower (Winn-Dixie, Delhaize, Ahold, Pathmark, Great A&P, Ingles, Stater Brothers) and have much less capacity to withstand protracted competitive price wars vs. SWY. SWY is able fund all of its share repurchases through free cash flow without levering-up the balance sheet. It can even be argued that the Company should actually borrow more to fund repurchases, given that its bonds trade only 120 bps over the 10-year treasury, for an all-in yield of ~4.0%, or an after-tax cost of debt capital of below 3%. SWY actually funded about $1BN of its share repurchases with debt over the past year, and the Company?s credit stats are still much stronger than its mid-BBB ratings would suggest (leverage of 2.5x, and interest coverage of 8.6x). While management has stated that future repurchases will only be made with free cash flow, there is still some flexibility to borrow modestly to conduct repurchases at levels that can be very accretive and would likely represent a very good use of the Company?s very cheap debt capital.


Safeway?s Biggest Negatives:

Capital allocation blunders on the acquisition front: During the 4Q of 2002, SWY took a $1.1BN non-cash charge to write-down goodwill associated with the acquisitions of its Randall's and Dominick's banners (this was on top of charges in 2001 totaling ~$700MM). These banners were purchased in Oct-98 and Jul-99 respectively when SWY spend over $3.5BN (now they are worth only about $1.5BN on a book value basis). The Dominick's banner is up for sale, but there has been no update on any potential buyers. These purchases and subsequent write-downs represent a weakness in management's capital allocation decisions, as it has underestimated the competitive threats and labor costs a few years ago and egregiously overpaid for these businesses (which have lower margins vs. the rest of SWY). I believe that management will make-up for these missteps by allocating capital disproportionately to shareholders.

Centralized marketing blunders in 2003: During 1Q of 2003, SWY reported lower EPS of $0.44 down 18% from last year?s level. The shortfall was primarily due execution problems (i.e. inventory shortages on marketed items in certain regions) of transitioning to a centralized-marketing and purchasing program. This is a rare misstep for a management known for a good operational record. Given that SWY should realize considerable cost savings from this effort, this seems more like a short-term issue that is able to be corrected by the 2nd or 3rd quarter of 2003.

What to do with the labor costs: Clearly SWY, like its grocery peers, is at a cost disadvantage relative to WMT, Costco and Target given its significantly unionized workforce (about 76% of its 193,000 employees). Management is addressing these issues by either disposing of entities with poor profitability (Dominick's or Randall's) or by making changes to labor contracts over the next 3-5 years, including: maintaining existing wage rates and instead paying bonuses, fine-tuning increases or implementing freezes at different job tiers, capping health care benefits, conduct employee buyouts (voluntary severance or early retirement), and provide lower pension benefits over time. SWY will also attempt to implement a ?joint bargaining? approach with Kroger, Albertson?s and Ahold in overlapping markets to negotiate collectively with labor unions. However, this strategy can backfire with work stoppages, or strikes (which can be very costly, especially for SWY?s weaker competitors who may want to opt out of the joint bargaining strategy). I believe that the biggest threat posed by Wal-Mart is on the cost side (due to labor advantages), not the revenue growth side, but SWY management seems to have good recognition on what needs to be done to remain competitive.

Catalyst

An economic rebound will likely result in better top and bottom line growth, given the Company?s larger exposure to higher-margined fresh, prepared meals, and ready-to eat items vs. its peers and Wal-Mart (resumes core business EPS growth of 5+%; historically the company?s EPS has grown at 13%-15%, including share repurchases).

Share repurchases at a rate of $600MM-$800MM per year so long as price remains depressed (share repurchases can increase EPS by 8%-10%).

A more normalized multiple on the shares. If SWY trades in line with the rest of the sector multiple (10x-12x currently which is significantly below historical 14x-18x range for the sector) on a mid-cycle earnings ($2.60-$3.00/share) the price per share could easily be in the low $30 range. A multiple of at least 12x is warranted given the expected returns in the sector should be about 10% (essentially SWY?s free cash flow yield), and the long-term growth rate should be around 2%-3% (slightly below GDP). A 10% minimum return assumption on a 3% growth rate yields a multiple of over 14x (using this multiplier would peg SWY equity at over $35/share).

The successful sale of Randall?s and Dominick's, which could improve profitability of SWY (due to high labor costs at these entities) and give SWY more cash to repurchase shares.

Continued industry consolidation (more companies driven out of business or store closures vs. acquisitions) of this still fragmented industry. The larger players will continue to steal market share at the expense of smaller players that don?t have the same cost advantages and economies of scale with regard to distribution and advertising.