SAFEWAY TACKLES CENTRALIZATION

Mark Hamstra

PLEASANTON, Calif. -- Safeway here said it expects to quickly resolve some of the problems that led to its first-quarter earnings shortfall.

In a conference call discussing its earnings for the first quarter, Safeway said it is getting a handle on its new centralized procurement strategy and that the worst of its same-store sales declines are behind it. Safeway previously had warned that its first-quarter earnings would be below analysts' forecasts because of problems related to the implementation of centralized procurement and other issues.

Steve Burd, chairman, president and chief executive officer, said the company has completed the centralization of its meat and produce categories but it is still struggling to centralize its nonperishable operations. Centralizing nonperishable marketing and procurement is much more difficult, he said, because of the large numbers of suppliers and the historical vendor-allowance contracts involved.

In the meat and produce categories, which account for less than 20% of sales, Burd said the benefits of centralized marketing and procurement are already being felt in the form of "substantially higher" margins, after a period of growing pains when margins were squeezed.

"We expect gross margins in nonperishables to follow a similar pattern," Burd said, noting that he anticipated a turnaround by the late third or early fourth quarters of this year.

He said the centralization process caused the company to reduce its prices too much in the first quarter, but the company corrected its pricing as the quarter progressed.

Analysts said Safeway might have tried to do too much too fast.

"Given that it's so complex, maybe they shouldn't have done it all at once but instead little bit by little bit," said Mark Husson, analyst, Merrill Lynch, New York. "But ultimately it's got to be the right way to go."

Chuck Cerankosky, analyst, McDonald Investments, Cleveland, said the timing of the move to centralization also played against the company.

"It has short-term costs and long-term benefits, and it's taking place at a time when the more cautious consumer spending sentiment out there is putting a great deal of pressure on their business and that of every other retailer," he said.

The weak economy continues to put pressure on the sales of all retailers, Burd noted, and analysts agreed that consumer spending patterns must improve in order to drive sales gains at supermarket companies.

"Consumers are spending a lot less on discretionary items," said Cerankosky, "and there's a lot of discretionary items, when you think about it, in a modern combination food and drug store -- the expensive wines, the expensive seafood, the books and magazines. There are a lot of things you can cut out of your shopping expenses, and very often those are high-margin items."

He said Safeway is being particularly hard-hit by the economy because it historically had done "such a great job of upselling the customer."

Safeway said higher health care and pension expenses, shrink costs, the severe winter weather in Denver and changes in accounting for vendor allowances also affected earnings in the first quarter. Also, higher fuel volumes drove sales in the quarter but squeezed margins because of increased costs.

The severe snowstorm that buried the Denver area under up to seven feet of snow in March cost the company about $18 million to $20 million, Burd said, and although most of that was covered by insurance it still brought down earnings by "about a penny a share" in the first quarter.

Adopting new accounting methods to adhere to Securities & Exchange Commission rules for reporting vendor allowances also cost Safeway about $10 million before taxes.

Burd said the company had eliminated vendor allowances with a few suppliers, and he noted that the company would much prefer a "dead net" cost structure for purchasing in which all deals from suppliers are worked into the initial pricing.

"In order to do that, it's a little like digging up the scrolls from the Dead Sea," he said, because of the complicated trail of vendor-allowance contracts dating back through previous years.

Interest expenses also were about $10 million higher in the first quarter than they were in the year-ago period.

Going forward, the company also said it planned to use its cash to reduce debt levels. Trade reports before the conference indicated that the company was debating whether to increase debt to buy back stock.

The company also said it expected its capital expenditures for the year to be in the "mid to low range" of the previously reported $1.1 billion to $1.3 billion, as it cuts down its planned remodels to about 120 to 125 stores. Previous projections called for 135 or more remodels this year.

Burd declined to comment on the potential timing of the sale of the company's Dominick's division, but he did say the bidding process is under way. The company also reduced the value of Dominick's on its books, a move that reflects lower bid prices than the company originally projected, analysts said. Dominick's had a $4.4 million loss from operations in the 12-week first quarter ended March 22.

For the period, Safeway reported net income of $162.6 million, a decline of 51% from year-ago levels before a one-time charge of $700 million for accounting changes in the 2002 first quarter. Earnings per share were 44 cents -- or 36 cents including the loss on Dominick's -- vs. 66 cents a year ago before the 2002 accounting changes.

Sales increased 2.4%, to $7.54 billion, primarily because of new store openings, the company said. Comparable-store sales were flat, while identical-store sales fell 0.5%.

The company projected second-quarter earnings of 47 cents to 49 cents per share and earnings for the full year of $2.20 to $2.25. That compares to a loss of $1.75 in 2002 after accounting charges, but net income per share of $2.49 in the preceding year.