Monday, August 17, 2009

Safeway shares are cheap, ready to rise (SWY)

AlphaNinja - Safeway (SWY) shares have underperformed as of late, but I think they represent a great buy at these levels. On the recent conference call, management took 2009 earnings guidance down to 1.70-1.90 per share, well below its previous target of 2.10-2.30. Management guessed wrong about the severity of the consumer-driven downturn. Swings like that do little to improve management credibility with Wall Street.

There are plenty of reasons not to like the stock, one being their largest competitor, Walmart. Safeway's employee unions have caused serious disruptions in operations in years past, and are a thorn in managements’ side when taking on Walmart Supercenters and their non-union labor. 80% of Safeway's 197,000 employees are unionized, governed by 430 separate union contracts that are re-negotiated every 5years. To call that a headache is an understatement. Additional competition from Costco and other club stores makes this industry intensely brutal on price. Safeway does consider itself to be in better balance-sheet shape than certain West Coast privately held competitors. While I appreciate that the company is in better shape to weather the storm, citing potential bankruptcies in the industry certainly means things can get a lot worse for Safeway also. What I mean is, “Hey we’ll survive and they won’t” sounds nice, but Safeway “surviving” with a $5 stock price certainly would not be a rosy scenario. From the call:

“So the good news here is when you consider our financial strength—balance sheet, borrowing power, etc., and you consider that we compete with as many non-public companies as we do public companies, there is just no way that most of those companies that we compete with in the conventional sector can possibly keep up with us. And so we see a lot of weakness across our geography and I'm going to stay below the radar screen on competitors. You've all seen one bankruptcy; you will probably see others. They may not be on that scale, but you will see others.”

While sales and earnings were down significantly, management pointed out on the conference call that “Our perishable volume was the best result that we've had in 9 quarters. Our non-perishable volume was the best result we've had in 4 quarters.” Prices are down considerably, but the volume data suggests that Safeway is gaining both new customers and a larger portion of customer “wallets,” or their total grocery spending., which will be felt once consumer budgets revive a bit more.

Then there’s the dreaded “trade-down effect,” that retailers of all stripes hate – but Safeway is well positioned in this regard. As shoppers skip the premium priced salad dressing they’ll trade down to the Safeway brand. This shows up as lower sales, but Safeway’s profit is higher on it’s own branded products, so the overall gross profit dollar impact is not as severe as one would think.

“We have been talking about trading down. I have often talked about the trade down to corporate brand. That's a good thing from a profit standpoint. That continues. We have a trade down from branded to generic drugs. That's a good thing from a profit standpoint. That has continued. And I suspect those two elements will continue, particularly the corporate brand, as long as the economy is still in decline. I think once the economy stabilizes the trade down in the corporate brands will probably stabilize, but for the fact that we have concerted strategy to try to drive that as a profit driver.”

If you listen to a few of Safeway’s calls, one thing that is at times confusing is their explanation of “investing in price.” A more honest explanation would be “oh our margins are falling,” or “we had to cut prices to drive traffic,” both of which are closer to the truth. Further confusing things is that management separates “promotional activity” from actual price cuts in everyday merchandise. Yeah we get the difference, but it’s cloudy. Either way, gross margins in this business have and will be falling, so the strategy is to increase customer traffic, and the amount of their budget that your customer spends at Safeway. In a business with low single digit profit margins, here’s CEO Burd’s thoughts:

“When you can deliver the best quality perishables in the best shopping environment and you've got no competitive disadvantage on price, we think that's how you win.”

Another (not major) concern of mine is the recent trip management had to make to the East Coast to convince Standard & Poors not to cut their credit rating. Why is that so important? Because that little rating allows Safeway to tap the Commercial Paper market, borrowing for half a percent, versus higher rates in conventional debt markets. (We can save the discussion over CP as a legitimate lending tool for another day).

“So the bottom line is, for us, S&P got comfortable and no change in rating. And that allowed us to keep our access to commercial paper. You can certainly appreciate the difference between 0.5% in interest and 7.5%, which is the debt we will retire.”
Safeway does have a decent amount of debt out there, but see below that they are nowhere near any danger zone in terms of the credit agreements, nor does it look likely that they will be.

Operating & Administrative Costs as a percent of sales increased 35basis points, a pretty good showing in this deflationary environment (the goods Safeway sells are plummeting in price, while their rent, employee salaries, etc are not). From the call:

"Quarter two cost of milk was down 27% versus a year ago, eggs down 15%, cheese down 17%, butter down 14%. Turning to produce, apples down 23%, tomatoes down 13%, citrus down 68%, and during the cherry season, cherries down 42%."

Over the last few years, Safeway embarked on a big push to transform its stores to a new “Lifestyle” format – essentially redecorating and remodeling stores, with the main difference being an expanded perishables section. Tough period to go “upmarket” of course, as the economy tanked at the same time. The point though, is that heavy capital expenditures on store remodels will slow, with about 76% of stores currently being Lifestyle models.

Though the company reduced earnings guidance, their expectation for Free Cash Flow remains in the $1.1-1.3billion range. The midpoint would lead to a FCFY(Free Cash Flow Yield) of over 15%, which is a great yield that compensates for the many dangers facing Safeway. I’m buying shares and think they’ll hit the mid-20’s before too long.

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