Thursday, February 25, 2010

Safeway impresses with huge cash flow. readers unsurprised. (SWY)

Grocery-store operator Safeway (SWY) opened for trading this morning down 4.3%, at 22.50.  The shares then proceeded to climb 10% from that level to close at 24.73, a +5.2% gain on the day.

Along with the broad market being down early, some investors may have sold the stock on the headline news that Safeway lost $4.59 per share or $1.609billion in the fourth quarter 2009.  

That massive loss was due to a non-cash, goodwill writedown of $1.818billion, to erase from the balance sheet assets that are not assets. (Goodwill is the premium paid for previous acquisitions, and is an intangible asset).    The reason for the stock to so broadly outperform the market today was the big 2009 Free Cash Flow performance, as highlighted by  CEO Steve Burd:

“Excluding the non-cash goodwill impairment charge, our results were in line with our expectations,” said Steve Burd, Chairman, President and CEO. “Despite very challenging economic conditions, Safeway generated free cash flow of $1.5 billion in 2009. This exceeded our expectations and is the highest annual free cash flow ever achieved by Safeway.”

I bought the shares last August and encouraged TheAlpaNinja readers to do the same:

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.

So here we are in the mid-20's.  I still like the stock and I think it's headed higher, as I'll explain further below...

Gross margin was down 1% from the previous year, as a deflationary food environment continues to pummel grocers like Safeway.  Operating and administrative expenses, as a percent of sales, increased almost a percent.  Safeway's cost structure is hugely fixed in nature, and they're at the whim of deflationary trends that squeeze margins.  What should be clearly impressive to everyone, however, is their incredible 2009 cash flow performance in the face of such pressures.

As the company reduced their borrowing levels, 2009 interest expense dropped from $112.5million to $98million.  That's no small number, accounting for 4cents per share...

On the conference call, CEO Burd sounded very upbeat and could hardly wait until the March 3rd investor day, when the company will officially give some 2010 guidance.  He plans to share data with the investment community that should get people excited about a possible reversal in price trends in their stores.

As I've said before, Safeway is in a brutal business.  No only that, but a brutal business in direct competition with not just Wal-mart, but other suicidal competitors who can cause damaging price wars.  Safeway has high pension expenses and ongoing labor disputes.  They also are at the whim of (I keep repeating it) wild swings in food costs that are beyond their control, as well as the consumer "trade-down" effect to cheaper, lower margin products.  Safeway fights back on the trade-downs by offering a terrific assortment of their own store branded products, but in categories like liquor and wine they're out of luck.

Despite the above headwinds, I still think the stock is a great value.  The number one reason to own these shares is that Free Cash Flow is expanding as capital expenditures are slowing.  The big investments in Lifestyle remodels are largely behind them, and the contribution of remodeled stores will become more apparent in the coming years.  Safeway's strategy has been to grow "wallet share," or the percent of a person's shopping that is done at Safeway.  The thinking is that once prices rebound, that same shopper will do the same amount of unit volume, but at higher prices.

I have pretty conservative Operating Cash Flow Estimates for 2010/2011, but I'm quite curious about Safeway's capital expenditure outlook, which is critical for Free Cash Flow.  We'll find that out March 3rd.  But based on where I am now, Safeway has a current Free Cash Flow Yield of between 12 and 15%.  That's more than three times what it costs Safeway to borrow, as their 2019 debt yields 4.6%.

A Price-to-Earnings ratio in the mid-teens sends this stock to the upper 30's, and a Free Cash Flow Yield of 10% gets the stock there as well.  The market doesn't tend to reward this company with multiples on profits, but their increasing Free Cash Flow Yield will not be ignored forever.

Copyright 2010 AlphaNinja

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