SAFEWAY'S PLAN TO REVITALIZE

ELLIOT ZWIEBACH

SAN RAMON, Calif. -- Safeway said it's trying to lay the foundation to beat back the supercenter threat and restore its sales and earnings growth to industry-leading levels.

Steve Burd, chairman, president and chief executive officer, told an investors conference here he is confident the company will succeed.

"We will rely on our ability to out-execute everybody," he said. "There will be no one more determined, more tenacious, more focused and more willing to work hard than we are because we don't give up on things."

He said Safeway plans to reduce regular retail prices and lower costs -- including a major effort to restructure its labor contracts -- to narrow the gap with non-union operators.

Regarding labor, Burd said the company's goal is "to narrow the gap in every single negotiation without exception" by freezing wages or offering lump-sum payments; establishing a market-based rate for new hires; offering voluntary buyouts to senior employees; redesigning health-care packages; containing pension increases; and striving for more liberal work rules.

The pricing and labor efforts are likely to result in short-term sales and earnings shortfalls, Vasant Prabhu, senior vice president and chief financial officer, said, prompting Safeway to cut back on capital spending for 2003 and lower its earnings guidance for this year and next.

Prabhu said Safeway expects to spend $1.3 billion to $1.5 billion, or 3.5% of sales, on capital projects next year, compared with approximately $1.9 billion this year. "It's a scale-back, not an elimination of spending," Prabhu explained. "All markets will get the capital they need."

Prabhu also said Safeway is lowering its earnings guidelines to 78 cents to 80 cents per share in the fourth quarter (compared with consensus estimates of 82 cents); $2.77 to $2.79 for the full year (compared with estimates of $2.81); and $2.50 to $2.65 for 2003 (compared with estimates of $2.89).

He said the economic environment for 2003 is uncertain, "and if any recovery happens, it will be a second-half phenomenon."

Securities analysts told SN they believe Safeway's decision to reduce prices is in line with what other conventional operators are doing and therefore may not be as effective as the chain hopes. However, they said the changes Safeway is proposing in its labor contracts could have a significant, positive, long-term impact.

Mark Wiltamuth, an analyst with Morgan Stanley, New York, said Safeway's risk levels have gone up "now that it's scaling back on price and taking on the unions. With everyone in the industry taking prices down at the same time, it's possible Safeway's actions won't translate into a sales pickup for anyone.

"In terms of its labor stance, it's clear the increase on Safeway's expense line is very marked, which indicates it is under pressure because of the previous contracts it signed. However, Burd's tone was clear that the company needs to make changes, and Dominick's [its Chicago-based operation] will be the first real test. But the transition will not be an easy one.

Gary Giblen, senior vice president and director of research for C L King Associates, New York, said Safeway's pricing strategies "bespeak how tough it's been for the industry and how all [conventional supermarket] companies are moving in the same direction -- toward lower prices, added value and the best execution on perishables."

What appears more significant, he added, is the way Safeway is trying to lead the industry in redefining labor rates -- "something that must be done," Giblen pointed out -- "by taking a more implacable position vs. the union as it tries to wrestle labor rates down and redefine rates for new employees at all supermarket chains."

According to Chuck Cerankosky, managing director for McDonald Investments, Cleveland, "It's clear the difference between union and non-union stores goes beyond price competition to encompass in-store labor productivity as well. So Safeway's push for more flexible contracts is good because it addresses the issue of store-operating costs and labor productivity.

"The marketplace is forcing the chains to deal with this situation, and over the long term they will be successful because the industry doesn't have a choice. But it's a matter of taking it step-by-step, and that might mean having to take work stoppages in the short term, which makes for a bumpy road ahead. But it will require those kinds of short-term costs to get it done."

In his presentation to investors, Burd said Safeway's strategies have worked for nearly a decade, the company's upward motion was cut short over the past 18 months -- by the recession more than by supercenters or other alternative formats.

Its strategies over the last decade have been fairly simple, although the details were proprietary, Burd said. "But what we must do over the next three to five years will be highly visible."

Safeway's "highly visible" plan involves a four-pronged strategy, Burd said, encompassing the following components:

Lowering regular retail prices to narrow the price spread with newer formats.

"We won't back off on being price-competitive in any market," Burd declared. "We're aware what the price gap is and we know what objectives we want to reach, and everything we're doing should allow us to get there. But we're pacing ourselves, and we don't have to get there instantly. With only 15% of our stores competing with supercenters, we think geography is on our side."

Financing price reductions by lowering costs, including restructuring labor contracts and leveraging sales through centralization of procurement.

According to Rick Dreiling, executive vice president of marketing and manufacturing operations, the benefits of centralization encompass cost savings; the ability to develop a new level of category management expertise; and "vast opportunities" to boost sales by leveraging best practices.

"It's been a very complex undertaking -- like performing brain surgery on a runner without breaking stride," Dreiling said.

Enhancing existing points of difference by putting more emphasis on operating best-in-class perishables departments. "Other conventional supermarkets will talk about being best-in-class, but we will deliver while they simply talk about it," Burd declared.

Safeway has already begun testing a new produce merchandising program at six Northern California stores, and sales at those stores "are far outpacing the rest of the company," Dreiling said.

Regarding other perishables sections, Dreiling said Safeway plans to install service meat cases where appropriate; put a stronger emphasis on scratch goods in the bakery, including opening its first doughnut operation, The Ultimate Donut, at a store in Livermore, Calif., later this month; and strengthen its prepared-foods sections with the introduction next year of a line of restaurant-quality gourmet soups and a center-of-the-plate program.

Maintaining the focus on its existing competitive advantages, including basic customer service; venture activities, including a series of four-week "treasure-hunt" promotions; more personalized services, including Safeway.com and an expanded catering program; a broadening of its Safeway Select private-label line to encompass upscale wine and bagged salads; and a strong natural foods offering.

Burd said Safeway needs to begin making these changes immediately. "With the number of supercenters increasing, we believe now is the time to make adjustments so we can do well against them and build share on an ongoing basis."

In response to a question, Burd said identical-store sales of negative 1.4% in the third quarter do not reflect the company's performance in all divisions. "Some markets are performing famously, relatively speaking," he said.

In response to other questions, Burd commented on the company's position at chains it has acquired:

The advertising campaign Safeway is launching at Genuardi's, Norristown, Pa., "is designed to win back customers who left during the transition," he said.

"One difficulty there was that we were supplied by one wholesaler, and as we transitioned to another wholesaler for significant cost savings, the first one became disinterested in service levels, so our in-stock conditions deteriorated and the stores had less shelf discipline, which resulted in out-of-stocks.

"Now we're retooling and going after business."

The challenges Safeway is dealing with at Houston-based Randalls are the result of "a combination of a highly overstored market that's begun to rationalize, plus the things we've done there. When Randalls was acquired, it was operating with more theater, and that's an important part of what we're bringing back. "We believe we have a good chance of still being successful there, though it will require us to do things differently while the market rationalizes itself. But we don't contemplate closing stores there."

Burd said Safeway's appetite for additional acquisitions is not strong. "We've had successful integrations of Vons [in Southern California] and Carrs [in Alaska], but we've struggled in other areas because of market conditions and distance from our main office.

"In the last couple of years, we've seen a lot of assets for sale but we looked and said no. We have a lot to do with our own agenda, and while we're interested in acquisitions, we think a better way to go is to improve shareholder value with what we have over the next two to three years."

TOUGH TALKING IN CHICAGO

CHICAGO -- Union leaders here returned to the bargaining table with Safeway officials last week after workers rejected the company's contract offer for employees at Dominick's Finer Foods, the Safeway division based in Oak Brook, Ill. According to the union, 80% of the workers voted to authorize a strike, although no strike had been called as of last Wednesday.

Safeway, Pleasanton, Calif., said it would shutter its 113 Dominick's stores if workers went on strike and would sell the division if they did not agree to a new contract that was closer to the one negotiated by rival Jewel, a division of Albertsons, Boise, Idaho. About 8,900 Dominick's workers are covered by the contract with United Food and Commercial Workers Unions Locals 881 and 1546.

Steve Burd, chairman and chief executive, Safeway, explained to analysts why his company has taken the position that it would rather exit the market than operate under a more costly contract.

"The wage increase proposed by the union in Chicago means Dominick's would lose money in 2003 and become cash-flow negative in 2005, with negative [same-store sales] of 3%," he told analysts in a meeting monitored by SN. "The business would no longer have value and would become a profit drain on the company." He said Dominick's is not currently profitable -- a statement refuted by the unions -- and he said any customers lost because of the strike would be too costly to try to recapture.

"We haven't done any outside hiring in preparation for a strike, and we will dispose of the stores," he said.

Although details of the company's contract offer were not disclosed, Burd said it included a tiered wage structure in which employees would keep their current wages, "undergo gradual changes in health care" and get a signing bonus in lieu of a wage increase. Half of the workers would qualify for buyouts of up to $30,000.

"The solution is to maintain existing wages or give a lump-sum increase; hire new employees at a lower rate; offer voluntary buyouts; and limit health benefits to manageable levels of increase," Burd said.

He said Safeway had incorporated similar "wage tiers" in other markets -- including parts of Washington, California, Arizona and Hawaii, plus Alberta, Vancouver, Winnipeg and British Columbia, Canada.

"In the eastern U.S., many states have these features as common parts of their contracts, and five years from now, this will be a feature of every state with union operators," he said.

If the company does decide to sell Dominick's, Burd also said that a sale to a single buyer would be unlikely because of the contract. One alternative would be to sell some of the stores for alternate uses, "then bundle the rest of the stores to get some value."

A third scenario, he said, involves total liquidation through dozens of buyers in a short period.

"All three result in significant bank write-offs, and we use the funds to pay down debt or buy back stock, but all three scenarios are accretive to earnings," he said. "What's unique here is that, unless they accept the contract, the assets are worth more liquidated than as operating assets, so we get good results either way."