PLEASANTON, Calif. -- Can Safeway continue to lead the industry?
Safeway achieved some of the industry's most spectacular financial returns through most of the 1990s, but sales have fallen off their industry-leading pace in the last couple of years, earnings expectations have been modified, and observers are expressing a bit more skepticism about the company's ability to outpace the rest of the trade.
However, Steve Burd, Safeway chairman, president and chief executive officer, has no doubts Safeway can keep up the pace.
According to Burd, Safeway's financial goals over the next five years include growing sales 4% to 7% annually; boosting same-store sales 3% to 4% a year, which will require growing square footage 4.5% to 5% a year; improving margins on earnings before interest, taxes, depreciation and amortization by 20 to 30 basis points a year; and reducing operating and administrative expenses by $1.6 billion over the five-year period -- all geared to maintaining earnings-per-share growth of 13% to 15%.
Burd said he's confident Safeway can achieve those returns because of the company's track record over the past decade.
"Cost reductions have become an integral part of our corporate culture," he said, "and while other companies might have more potential [for cutting costs], I believe that five years from now we will probably win the race for best cost reduction because we're so practiced at it, because it's second nature to all of us and because we work it so hard."
Safeway's ability to cut costs will ultimately enhance sales, he pointed out.
Burd made his remarks during a recent presentation to investors. He declined SN requests for an interview.
"Outside of Its Control"
Industry analysts have learned not to doubt Burd's abilities, but they expressed some doubts that Safeway can keep the financial ball rolling at such a strong pace.
According to Meredith Adler, an analyst with Lehman Brothers, New York, "Safeway hasn't stumbled, but some factors are simply outside of its control.
"Whatever is within Safeway's ability to control it, Safeway is able to make it go well. So when it says it can control O&A expenses, it can. And when it puts its mind to gross margin, shrink and other supply chain issues, it's able to make improvements.
"But sales is something outside its control, and as the environment has gotten more difficult and the economy has become weaker, that has impacted Safeway's ability to grow sales."
Jonathan Ziegler, San Francisco-based managing director for Deutsche Banc Alex. Brown, New York, said Safeway's returns have not been as strong the last couple of years as they were through most of the 1990s. "Safeway is still a richer margin company," he said, "but right now it's generating the same kind of growth and returns as Kroger is generating."
In the last couple of years Safeway has lowered its earnings projections from the 16%-to-18% annual per-share growth it was talking about in late 2000 to the 13%-to-15% level it's now anticipating, he added.
Lisa Cartwright, a retail analyst with Salomon Smith Barney, New York, said Safeway is second to none in terms of its ability to execute. "Clearly, Safeway is very good at identifying opportunities and getting the most benefits possible.
"The management team there was able to execute one of the most successful turnarounds in food retailing history, and possibly in all retailing history, with Safeway leading the industry from 1993 to 1998 in terms of same-store sales growth, earnings growth, margin expansion and return on invested capital. And Safeway expanded EBITDA margins by 400 basis points, and no one else came closer than improving margins 200 basis points during that period.
"But to a certain extent a lot of those results were driven by the fact the company had a very good structural base from which to deal with the issues it was facing and there were a lot of things that needed to be improved.
"But now Safeway is a well-oiled machine, and it's harder to find ways to improve results. A supermarket can do a lot of easy things -- like enhancing perimeter departments or utilizing category management -- to drive sales. But for Safeway there's not a lot of that kind of thing left to do, and it's getting more difficult to find ways to improve what it has or to find cost-savings opportunities."
Burd said he's confident Safeway can improve on its results by cutting costs and improving margins through a series of initiatives, "but it's not as easy as flicking a switch because in the retail food business, it's so easy for the competition to see what we're doing. So we're looking for ways to grow our sales in much more of a stealth fashion, and that takes a little more effort, a lot more thought and a lot more technology."
As Safeway moves forward, its goals include the following:
Boosting sales through acquisitions and organic growth.
Reducing expenses by lowering the cost of goods, reducing shrink, spending promotional dollars more efficiently and improving corporate brands programs.
Seeking new sources of revenue through nontraditional merchandising programs.
Safeway, the nation's third-largest conventional supermarket retailer (after Kroger Co. and Albertson's), operates close to 1,800 stores with 2001 sales of $34.3 billion -- a 7% increase that included nearly $1 billion in sales from Genuardi's Family Markets, Norristown, Pa., which the company acquired a year ago. Earnings per share climbed 15% to $2.59 in 2001, and EBITDA margins rose 38 basis points to 10.45%.
On the Acquisitions Trail
Acquisitions have played a key role in Safeway's growth in the past five years, and they are likely to be just as significant moving forward.
Safeway's five acquisitions since 1997 have added $11 billion to its sales base. Those acquisitions encompassed Vons Cos. in southern California in 1997; Dominick's Finer Foods in Chicago in 1998; Carrs in Alaska and Randall's in Texas in 1999; and Genuardi's in Philadelphia in 2001.
Safeway is interested in making further acquisitions, Burd said, though he isn't giving out any clues where or when the next one will be. Because of where its existing stores are located, Safeway has a wider geography in which to make acquisitions than either Kroger or Albertson's, observers pointed out.
"Safeway could go into the Northeast, the Southeast or the Midwest because it doesn't cover as much of the U.S. as either of the other major chains," Adler told SN -- "and it has no preference on whether its expansion is contiguous or not.
"If it can buy something big that's next to one of its existing divisions, it would be happy to do so if the company met all its other criteria. But it could just as easily buy something in an entirely new market."
According to Cartwright, "The markets in which Safeway operates are fairly saturated, and there's not much room to add new stores. So to drive top-line growth of 6% to 7% will require Safeway to go outside its existing markets for acquisitions, or to enter new markets."
The most likely area for acquisition would be somewhere on the East Coast, Cartwright said. "Safeway has an East Coast presence with Genuardi's and its Washington, D.C., division, but it lacks scale, so adding stores anywhere on the East Coast would help lower its cost structure and provide top-line growth. And it could enable Safeway to switch from using an outside supplier -- C&S Wholesale Grocers -- and to invest in its own distribution center."
She said Safeway would like to make an acquisition this year, "but the properties that are available are not to Safeway's liking and the companies it's interested in don't seem to want to sell."
Burd said Safeway will continue to be very selective in making acquisitions.
"We buy companies with strong market shares and good physical assets," he said. "We want stores with sales in excess of $1 billion, stores where we can achieve labor-cost parity -- nonunionized stores anywhere and unionized stores only in markets that are heavily unionized -- and stores where we can improve EBITDA margins by 300 to 400 basis points."
Safeway also expects its acquisitions to be accretive within 12 months, Burd added.
According to Burd, finding companies that are for sale is not difficult -- what is difficult is finding companies that meet Safeway's standards and that are available at the right price. "We're not going to overpay," he declared.
"Over the last two years we've talked with more companies with potential assets than in the previous seven years, and that's probably still true today," he said.
"We've kicked a lot of tires, but we've said no to most of the companies we looked at because the difference between the bid and the ask was too broad. And in most cases, we believe there were no other bidders because most of those companies didn't change hands."
The peak time for regional operators to sell their assets was late 1998, Burd said. "EBITDA margins were at an all-time high and price-earnings multiples were at 8.5, near their all-time high. Since then, both EBITDA margins and multiples have declined, and dozens of assets are no longer sellable as a single unit so they must be fragmented if they are to be sold.
"That's what happened with Abco in Arizona. Of the 50 stores that were originally for sale, we bought 11 on the first round [early last year], 14 were sold to other operators and 25 stores simply disappeared. And now that the dust has settled, a couple of stores that were sold to independents are back on the market, and we expect that will continue to happen this year and beyond.
"The only thing that could change that situation is if regional independents become more realistic about the value of their companies and sell as a single unit."
Looking For Organic Growth
In terms of organic growth, Safeway expects to expand square footage by 4.5% this year at a cost of $2.1 billion -- about the same level as in 2001, when it grew square footage 4.6% at a cost of $2 billion.
Safeway's capital spending as a percent of sales has been escalating the past few years, hovering between 5% and 6%, Burd said. "The old rule of thumb in the retail business was that spending 3% of sales was enough to maintain your asset base and keep the stores in good shape. But we spent 5.9% last year and we'll spend 5.7% this year."
Safeway plans to open 85 new stores this year and remodel 250, compared with 84 openings and 255 remodelings in 2001. Burd said Safeway is likely to begin reducing capital spending next year "because our stores are in good shape so we'll need to do less remodeling."
Adler told SN she expects Safeway to maintain the same pace of new-store openings next year while cutting back the number of remodelings, possibly to about 200.
Most new stores fall into Safeway's 55,000-square-foot prototype, though the chain is willing to go up to 65,000 square feet where space permits and down to 42,000 square feet where space is more limited, Melissa Plaisance, Safeway's senior vice president, finance and investor relations, told SN.
Most 65,000-square-foot locations are what Safeway designates internally as "next generation" stores, she said -- stores with Starbucks counters, expanded selections of natural foods, expanded pharmacies (including some drive-throughs) and gas pumps in the parking lots.
Safeway will open approximately 15 next-gen stores this year, industry observers said.
New Revenue Sources
Besides featuring new in-store offerings, Safeway is trying to add new revenue sources at store level -- testing gift catalogs at some northern California stores (enabling club-card holders to buy general merchandise items from a catalog at lower prices); putting its own name, Safeway Select, on in-store banks at some stores; and selling advertising space on flat-panel displays at the checkstands.
Safeway also experimented with gift cards for other retailers and, during last year's fourth quarter, selling toys.
Ziegler said Safeway's in-and-out toy program last Christmas "was a great start. And although the presentation was not adequate, just the fact Safeway did it was significant. A 'treasure hunt' program like that is a good idea because it's been one of the major success stories for warehouse clubs, yet few supermarkets have gotten into it."
"It takes a lot of guts and experience to try something like that," Cartwright added. "That's why you see very few chains taking on 'treasure hunt' merchandise -- because if you guess wrong, it's a big negative."
One of Safeway's major accomplishments since Burd joined the chain in 1993 has been its ability to boost EBITDA margins. "When we started in 1993, EBITDA was 5% -- among the lowest in the food retail sector," Burd said. "We met our first goal of 7.5% and then progressively advanced the number to 9%, 9.5%, 10% and now [nearly] 11%.
"We never outlined a time frame for getting to each new level, and we don't know how high is high, but we know that some retail sectors are considerably higher than 11%."
Continuing to Cut Costs
According to Burd, EBITDA margin growth is a function of O&A cost reductions. Safeway's goal for the next five years, Burd said, is to cut expenses $1.6 billion through a series of initiatives, including the following:
Lowering the cost of goods, including moving toward centralization of procurement. Safeway is already buying some meat items in Denver and some grocery categories here, and plans to begin buying produce later in the spring through a facility outside Phoenix.
According to Cartwright, it's not unusual for large chains to look at centralizing procurement because of the success Wal-Mart has enjoyed. "There are certainly administrative savings, but central procurement also provides the ability to execute better and get better deals.
"But to really get as good as Wal-Mart, a supermarket must be able to gather and share information with vendors, and supermarkets don't have enough information yet to be able to share that kind of information for all categories."
Reducing shrink. Safeway was able to reduce shrink by $138 million last year and expects a further reduction of $180 million this year, Burd said.
While Burd did not indicate what Safeway is doing to reduce shrink, analysts said it is using data-mining technology -- letting a computer look for checkstand aberrations, inconsistencies between vendor deliveries and sales, or other unusual situations.
Shrink is something Safeway began looking at only recently, Adler pointed out. "When Burd came to Safeway, the company made a list of where it thought it had opportunities for savings, and since shrink was in line or better at that time, it was not an area Safeway looked at. But when it went back to the list, shrink control had slipped, and Safeway decided it had an opportunity for improvement that it didn't know it had."
Improving corporate-brand programs "by making sure Safeway has the right visibility of product, the right marketing at the right time, and the appropriate pricing vs. national brands," Adler said.
The company is also expanding its corporate labels, she noted. Since rolling out its premium Select label in each of its divisions, it introduced the new Primo Taglio line of sliced deli meats and cheeses last year "that has proved to be a great launch," Adler noted.
Ziegler said private label is one of Safeway's biggest growth opportunities. "I don't think Safeway has milked it yet for all it's worth," he said. "Everyone has private label, but everyone is still learning about it. And although companies like Safeway and Kroger have higher penetrations than some other U.S. companies, they're not yet up to the level of some Canadian or British retailers, so they're not yet getting the full bang for their buck.
"In addition, some customers at Randall's and Genuardi's still have a negative image of private label, and they haven't figured out yet how high-quality Safeway's private label really is, so there are opportunities for growth there -- and Safeway has an opportunity to get people to try its corporate brands by putting in some sampling programs, like the clubs do."
According to Cartwright, Safeway tried to accommodate customers who preferred the previous line of sliced meats Randalls had been carrying before it was replaced by the Primo Taglio line. "Safeway went back to the previous supplier and asked them to come back, but at a different price point, and the supplier said no. So it's going to take time for some customers to accept some of the changes."
Spending promotional dollars more efficiently by investing cost savings into price and promotions.
According to Adler, Safeway is using historical sales data to optimize its use of promotional dollars by finding out what kind of lift it can get promoting various items at varying pricing levels. "It's a matter of looking at which items benefit from promotions and which don't, so it can eliminate promotions of products that don't get the company anywhere," she said.
Safeway is also testing multiple pricing, Ziegler said.
The Tesco Factor
But the most significant source of store-level changes could result from Safeway's involvement with Tesco, Ziegler added.
Tesco is the United Kingdom-based retailer with whom Safeway has been talking about home-delivery opportunities, but Ziegler said he believes their relationship goes beyond that. "Every chain has something special going for it," he noted, "and one particularly attractive aspect of Safeway's power comes from its joint venture with Tesco.
"Although the companies have said they are talking only about home delivery, that is not the only important program likely to surface. Safeway would be foolish not to trade best practices with Tesco," he said.
"Safeway management is spending time with Tesco, which is years ahead of U.S. companies in terms of merchandising and creativity, and if Safeway integrates some of Tesco's programs into its U.S. operations, it could result in some significant sales increases.
"Tesco operates some very exciting stores -- it's further along [than U.S. companies] on private label; it provides some interesting household services, including health, pet and car insurance and other financial services, all under the Tesco name; and it has a bigger presence in general merchandise.
"Seeing the model at Tesco, it's encouraging that Safeway is linked with those guys because it offers opportunities to create programs that could drive sales and make Safeway's stores more exciting."
What Tesco could learn from Safeway, Ziegler added, is a focus on cost controls.
Cartwright said she believes Safeway and Tesco will "eventually do some benchmarking to see where one is better than the other. And that could lead to Safeway offering more private-label products, more prepared-food items, more self-scanning, more general merchandise categories and more 'treasure hunt' merchandise."