Safeway by the Numbers

ELLIOT ZWIEBACH

After losing its way, Safeway believes it has found the right path. Analysts believe it might still have a difficult journey ahead, however.

According to Steve Burd, chairman, president and chief executive officer of the Pleasanton, Calif.-based chain, 2009 was “a very difficult year for Safeway and for all of food retail. But we think it was a year we accomplished some very significant things that put us in really good shape for what's going to happen in 2010.”

One of the most significant moves Safeway made was to adopt an everyday pricing policy for some items that put the chain at parity with other conventional operators, Burd told investors at the chain's annual analysts conference earlier this month at its offices in Pleasanton.

“Achieving parity by year's end wasn't originally planned at the start of 2009,” he explained, “but we got it done because we felt from a strategic standpoint that's exactly what we needed to do so we could start 2010 in a very strong price position — and then, as the economy recovers, the points of difference that Safeway goes to market with, including the overall shopping experience and product quality, would become quite meaningful.

“[Last year] wasn't the best time to invest in everyday price because people tend to buy more on promotions during recessions. But the average length of a recession is around 16 months, so we felt really compelled to be in a hurry and get to a price parity position [with] conventional retailers.”

Safeway's financial performance in 2009 reflected the challenges it faced, with a loss of $1 billion following a $1.8 billion goodwill impairment charge; a sales drop of 7.4% to $40.9 billion; and a decline in identical-store sales, excluding fuel, of 2.5%.

Operations in 2009 were impacted by “extraordinary, unprecedented deflation” in the fourth quarter, combined with the chain's decision “to step on the accelerator” to lower pricing to achieve parity with its conventional competitors, Burd noted.

Opinions from industry analysts on Safeway's immediate prospects were generally cautious, with several saying it might take longer than Safeway anticipates for revitalization to occur.

“It's a little too early to say Safeway has won the game, but prospects for victory are a lot more promising than they were a year ago,” John Heinbockel, managing director for Goldman Sachs, New York, said.

Mark Wiltamuth, executive director at Morgan Stanley, New York, said investors have been trying to get “more bullish” on grocery stocks, but “Safeway's meeting was a minor setback as company guidance for 2010 came in below expectations, and first-quarter expectations appear to be too high.

“It is clear that heavy price reductions for the third and fourth quarters will carry into the first half and weigh on margins, making for a frustrating start to 2010.”

Meredith Adler, managing director at Barclays Capital Markets, New York, noted that deflation was not the driver of Safeway's weak same-store sales last year, “so [given that] Safeway has invested heavily in its stores and that service is very good, the weakness seems to be due to losses in market share. It's not even clear that recent investments in price and advertising, if they were to continue for a while, would change that perception in the near term.”

PRICE PARITY

“Price position is going to be really critical,” Burd said, “and we think the ‘Ingredients for Life’ initiative makes so much more sense if you don't have to compromise on price, because now all the other dimensions that we've created in the lifestyle stores really get to play out. And if we are correct in predicting the economy will begin the slow movement back to health, I think those points of difference will really be important. The price advantage is an opportunity to build share.”

Although prices are constantly changing, he added, “it's a very different story when you are on your way to parity or below parity, so we think we have already absorbed the reactions of the marketplace.”

Heinbockel said Safeway improved the gap with its primary conventional competitors by 450 basis points, to a spread of approximately 2.3%, “while on a shelf-price-only basis that also incorporates promotions — and Safeway remains highly promotional — the spread improved by a lesser 190 basis points.

“The gaps with Kroger are greater, and [while] Wal-Mart and other non-conventionals cannot be removed from the equation, Safeway has made clear progress, and that progress should lay the foundation for a better sales and profit outlook in the second half of 2010 and beyond.”

Wiltamuth said that, even at shelf-price parity, “Safeway may have trouble luring back customers with pricing that merely matches leading competitors.

“Whether or not price discipline holds will be a function of how aggressive competitors are at continuing to pursue price reductions. The biggest wild-card is Wal-Mart, which has pledged to widen its price lead over grocers, [and] with traffic negative [at] Wal-Mart, there is risk the company could get more aggressive on price during 2010.”

Other analysts said Safeway's use of the term “parity” may be misleading.

“It appears the company has developed its own definition of price parity that it believes is more useful than the traditional definition,” Adler pointed out.

“The new definition takes into account not only everyday shelf prices but also promoted prices on those items — perhaps because Safeway thinks consumers will be focused on the actual net price they are paying at checkout. That may most accurately represent what consumers experience at a Safeway store, but it does not provide investors with information about how shelf prices have changed, since Safeway has always offered attractive promotions.”

Adler also said it's doubtful any retailer can ever say it is “done” lowering prices, as Safeway has. “Certainly Supervalu believes it has more work to do to improve its everyday shelf prices, and Kroger has said many times in the past nine years the work is never really finished. So it is likely that reaching real price parity will be a work in progress for all food retailers.”

Gary Giblen, managing director for Quint-Miller & Co., New York, said what Safeway has achieved is “not price parity as consumers would define it.”

“It's more of a theoretical number because Safeway is weighting prices based on the volume of each item sold, so if some high-turn items are very competitive and other low-turn items are not, the overall result is more favorable,” he explained.

“But my trade sources tell me Safeway doesn't have true price parity and that it often requires consumers to buy multiple items to get the everyday price.”

As to whether Safeway might have to lower prices further to meet competitive situations, Giblen told SN: “With Wal-Mart positioned to launch a major price rollback, it's going to make consumers even more aware of everyday pricing levels, and I think Safeway would be inclined to drop prices further rather than risk losing traffic.”

Andrew Wolf, managing director at BB&T Capital Markets, Richmond, Va., told SN he isn't sure if Safeway will opt to move further down on price, “even if some competitors in some markets decide for strategic reasons to move pricing down. But, in general, unless things heat up again, I don't see a downward pricing spiral.”

INFLATION RETURNS

“Though it's anybody's guess what the real rate of inflation will be,” Burd said, “we believe inflation will come in at negative-1% for the quarter.”

Safeway is expecting inflation of positive-0.5% in the second quarter, 0.7% in the third and 1% in the fourth, compared with an eight-year average of 3%. “We're trying to be pretty careful in our guidance, and I doubt you'll find anybody else bold enough to try to predict inflation,” Burd noted.

According to Wiltamuth, “Safeway sees deflation ending by the end of the first quarter, which is roughly one quarter earlier than current market expectations. [But] it may take until July before the industry laps out of deflation.”

Wolf said Safeway's expectations for 2010 are “prudent and conservative, which is as it should be, since no one knows exactly how inflation will develop. It seems clear industry conditions will improve as inflation returns this year, but whether those improvements come sometime in the second quarter or early or late in the second half is impossible to predict.”

Burd said he's also optimistic about more rational pricing in the marketplace.

“When you look at everything we've been through and how we weathered that storm, you can only speculate that a whole host of other [operators] didn't do nearly as well, and that's what leads to more of a return to normalcy in the competitive landscape,” Burd pointed out.

“Plus, we've opened up a gap with secondary competitors, which is an indication of their inability to respond. We see different [responses] across all the geographies in which we compete, with some companies raising prices, even primary competitors, while others are reducing promotions or featuring higher promotional price points.”

Safeway said it may not spend as heavily on advertising going forward — a decision several analysts said could be a mistake.

The heavy spending Safeway invested in advertising its new lower-pricing position was apparently successful at driving short-term customer perceptions, Adler pointed out, “but it is unclear how long those perceptions will last if advertising is reduced and if everyday shelf prices are not, in fact, equal to those of conventional competitors.”

Wolf said Safeway will have to do a lot more price advertising to hold onto the volume gains it's been getting from heavy promotions of its lower everyday pricing — “similar to what Kroger does, with a pricing statement to talk to people about, which means a shift of money at Safeway away from promotions to advertising.”

But it could take as long as one or two years to change consumer perceptions, Wolf added. “Safeway has done a good job promoting the lower-pricing program at store level, and that has succeeded in changing the shopping habits of some customers. But it takes longer for people to be impressed by what they see initially — it requires them to come back again and again till they're sure pricing is still low,” he explained.

Giblen said Safeway could learn from the experience of Austin, Texas-based Whole Foods Market in pursing a long-term advertising strategy. “It took Whole Foods more than a year to convince consumers it has good prices for high-quality products, and it could take up to 2½ years for Safeway's pricing strategy to actually change consumer perceptions.”

GENERATING CASH FLOW

Safeway expects cash flow in the range of $900 million to $1.1 billion in 2010.

“Going forward, we expect to use free cash flow primarily to return cash to shareholders — the first priority is continuing the dividend, and the second priority is returning cash through stock buybacks,” Burd explained.

Since initiating a dividend in 2005, with a payout of about $45 million, Safeway increased the quarterly divided by 15% in 2006; by 20% in 2007 and again in 2008; and by 21% last year, when the total cash payout was $153 million.

In 2009, 70% of free cash flow was returned to shareholders in the form of a dividend or stock buyback, the company said, and over a five-year timeframe, Safeway has returned about $2.4 billion to shareholders through one method or the other.

“We do expect to continue to reduce debt,” Burd said, “and with a very strong balance sheet, we have very good credit ratings that provide access to capital at very attractive rates. We made a debt reduction in 2009, but we haven't committed ourselves to a debt reduction in 2010. We've got some debt due in August, and we're just going to maintain our flexibility.”

Safeway said free cash flow will exceed the chain's scheduled debt repayments by about $3.3 billion by the end of 2014.

Adler said she's not sure Safeway will be able to accumulate as much free cash as it hopes to. “Generating free cash flow of $1.1 billion every year through 2014 may be tough to accomplish,” she said. “For example, if sales stay weak because tonnage continues to decline, the company will be pressured by competition to continue to lower its prices. And if expense control does not offset the impact of these pressures, then operating cash flow would decline.”

Safeway's remodeling efforts in 2010 will be geared predominantly to “lifestyle-light” remodels, which cost about 25% less than full-scale remodels, Burd said, “so it's easy to see why our capital program can be sustained at a much lower level than our competition.”

Capital expenditures this year will be $900 million to $1 billion, compared with just over $850 million in 2009 — with spending reduced to an average of about 2.3% of total sales over a five-year period.

“Obviously, we were engaged in some very heavy capital spending in 2005, 2006, 2007 and even 2008 because we felt the lifestyle store remodel program was just as good a defense as it was an offense,” Burd said. “But cutting back on capital spending last year gave us an extraordinary year on free cash flow.”

With construction activity down in many markets, “bids for construction projects are significantly less than we have seen historically,” Robert L. Edwards, executive vice president and chief financial officer, noted, “so there is a lot more competition to work on our stores — and the bids we are receiving are significantly less than what we have projected.”

If competition does not step up their capital programs, Burd added, “that just means the quality of their assets will begin to deteriorate, and that puts us in a good relative position. We think we can run at a reduced level of capital spending for an extended period of time. We don't think our competitors can, unless they let their asset base deteriorate, which would be an advantage for us.”

By the end of 2009, Safeway had remodeled 79% of its store base, or just over 1,350 stores, Burd said. The company plans to open 20 new stores and complete 80 remodels in 2010 — to bring the total store base remodeled since 2003 to 85% — compared with eight new stores and 82 remodels last year.

Burd also said Safeway believes it can let remodeled stores operate for 10 years before they need to be upgraded.

Giblen said it doesn't seem reasonable for Safeway to go 10 years between remodels. “The industry norm is five to seven years, and while the lifestyle stores may look good today, there's no telling how quickly they may become passé and require remodeling,” he told SN.

Giblen also said he doesn't believe Safeway can cut back cap-ex to just 2.3% of sales and maintain its store base in top condition. “That level of spending is ridiculous,” he said. “Any healthy competitor has to spend 3.5% to 4% of sales on remodeling.”

EARNINGS OUTLOOK

Safeway's guidance for 2010 earnings falls in the range of $1.65 to $1.85 per share, compared with $1.56 in 2009 that excluded a goodwill impairment charge of $4.40 per share and an 18-cent tax benefit.

That guidance represents “a good set of numbers in this challenging environment,” Burd noted, and though the numbers will probably change, he said, the pattern should hold, with more strength in the second half.

Karen Short, an analyst with the New York office of BMO Capital Markets, Toronto, said she had hoped for “more robust” earnings guidance from Safeway. However, she said she applauded management for being conservative, “because 2009 will be remembered for significant downward EPS revisions” by Safeway and other chains.

Although Short said she is hopeful “there is upside to guidance,” she said she opted to take a more conservative approach herself by maintaining her prior below-consensus estimate of $1.82 per share, which she noted is still within the chain's guidelines.

Wiltamuth said he believes gross margin sacrifices have become a permanent part of Safeway's ongoing strategy. “The price reductions are not going to be rolled back,” he explained. “A permanent shift in value to the consumer has occurred, [and] we don't see any earnings snapback.”

Safeway also anticipates sales trends to reverse this year.

“We expect volume to be positive in 2010,” Burd said, following the 7.4% decline in overall sales and the 2.5% drop in identical-store sales, excluding fuel, for 2009.

Safeway's expectations for sales growth are not based on any additional efforts to lower prices, Burd noted, “but simply watching what we did late last year play out in the first half of this year. The real unknown is the degree of price inflation.”

Burd also said Safeway anticipates ID sales in 2010 will move from negative to positive — to somewhere between flat and up 1% by the end of the year.

Helping to boost sales, he added, is the fact Safeway anticipates competitive openings will be at a 10-year low.

Wiltamuth said he doubts Safeway can turn negative ID sales to positive within a year. “With comps running at minus-3% to minus-4% in the last two quarters and deflation carrying over into the first quarter, it may be hard for Safeway to achieve that level of comp recovery in one year,” he noted.

“Even with price parity, it may take time to lure customers back. But Safeway management may be reluctant to lay out a negative goal [on ID sales because] it sends a bad message to store managers.

“Any margin positives will have to be reinvested in lower prices to keep customers coming back,” Wiltamuth added. “The best chance for operating margin expansion is through sales leverage.”

Giblen said he's not sure Safeway can gain the increased volume it's anticipating without maintaining a strong advertising program, “but the company tends to support profitability and free cash flow, so advertising may fall off.

“That would be unfortunate, because some of the lift it's gotten since lowering prices is the result of heavy advertising, and it may be the impact of the advertising rather than the pricing that's been improving sales.”

Short said she expects ID sales to decline 2.7% in the first quarter, she expects them to reach positive-1% by year's end, at the high end of the chain's guidance.

Wolf told SN he expects Safeway's volume to pick up as the year progresses. “It's already turned a little bit positive, though by year's end it probably won't be much greater than something in the range of plus-0.5%.”

According to Heinbockel, “Volume trends have clearly improved since prices were reduced and the ad campaign [that accompanied the price reductions] was launched, and momentum has only built further in the first quarter.

“This is encouraging, as these efforts tend to gain strength over time as consumer price perception gets better, which would argue for positive volume growth throughout much of 2010.”

After an aggressive year of cost-cutting in 2009, Safeway expects “a substantial amount” of further cost reductions in 2010, Burd said.

“If you look at how aggressive we think we will be on both gross margin and cost reduction, which enhances gross margin, we see a big opportunity in 2010. We think the hard work we did on our cost structure in 2008 and 2009 was not done by the competition, and therefore we think we have dramatically improved our relative cost position.

“We made a lot of progress in shrink in 2009, but it was kind of hidden from view because of the decline in price per item,” Burd pointed out. “But shrink is an area that we keep forever in mind because when we look at the turns we get on a particular item, our first instinct is to look across all stores, and something that might be turning 20 times a year at one [location] may turn only twice at another. So that may be an item we don't want to carry in that store, and it gives us an opportunity for inventory reduction.

“One of the things we do as we go through our category reviews to optimize the sets on a per-store basis is to look for opportunities in certain stores to give an advantage to a particular brand to build share,” Burd explained. “As you increasingly cluster your categories, there are actually nine different, distinct divisions we look at, and since the fourth quarter of 2009 we've had some categories under very aggressive review that are both enhancing sales and improving gross margin.”

GROWTH OPPORTUNITIES

“We are not a particularly acquisitive company,” Burd said. “We think some of the best returns you can get are buying assets in an existing market, where you basically eliminate the advertising spend that company was bearing and you often shut down a lot of overhead costs. So in-market and adjacent-to-market are the best kind of return acquisitions to make. However, given our relatively large market shares, we can't really pull off an in-market deal of any scale, and there are very few adjacent market deals of scale.”

That was good news to Heinbockel, who said, “Acquisitions are, fortunately, nowhere on the list of cash-flow deployment priorities.”

Safeway also sees opportunities in the ongoing growth of Blackhawk — the gift-card program Safeway sells to retailers all over the world — which Burd said has the potential this year to penetrate more of the drug, convenience and mass channels.

“What we've enjoyed doing over the last several years is really building Blackhawk as a private company,” he explained.

“The fact we keep a lot of information hidden is because we think we can develop a stronger long-term growth story, although that also means we don't get the full value of Blackhawk recognized in our share price. And for right now, that's OK — it doesn't bother us.”

In a recent filing with the Securities and Exchange Commission, Safeway said an independent valuation firm had estimated the value of Blackhawk's restricted stock at $7.50 per share.

“When we started talking about Blackhawk three or four years ago, we did it to demonstrate that we can build income streams that don't require a lot of capital assets,” Burd told investors.

“I get questions all the time about whether we would spin it off. A spin to me means you jettison the assets, and we never really think about that — we built it to be an earnings growth story within Safeway. That doesn't mean we won't someday share some of the ownership with others — which we could do strategically — or in a public offering.

“If we did it strategically, it would allow us to make the business more valuable as a result of the strategic partner either domestically or on foreign soil.

“We've got an entrepreneurial management team that owns stock in Blackhawk, and there are liquidity provisions, and perhaps there is a reason to have part of the stock some day in public hands.”