Fundamental Analysis - Safeway Inc.


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Comprehensive equity report - Safeway Inc.

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  • Agreed. They should try entering into emerging markets like China so that they cater to the masses and the population is also in a huge amount. The GDP growth of China is more than double as compared to US because of their population size of the economy
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Fundamental Analysis - Safeway Inc.

  2. 2. Equity Valuation - SWY Thomas Binois This page has been intentionally left blank 2
  3. 3. Equity Valuation - SWY Thomas Binois Table of contents: I. US Grocery Industry Industry overview Industry growth Key drivers of food retailer sales growth Major challenges of food retailer sales growth Discounters taking shares of the market Local market shares are key How could grocers build sustainable competitive advantages? Porter Analysis Performance relative to the S&P 500 and other peers II. Safeway Analysis Background Strong Competitive position Growth Driver Financial Position Investment positives and negatives Valuation III. Source IV. AppendixNote: The terms “Safeway”, “Corporation” or “Company” refer to Safeway Corporation and its subsidiariesunless I indicate otherwise. 3
  4. 4. Equity Valuation - SWY Thomas Binois I US Grocery industry Industry OverviewThe US food market is approximately $932B in size which includes food grocery items and non-food groceryitems.Where are those products sold? Others, 7.8% Independent / Regional Operators, 23.6% Traditional Grocers / Discounters, Specialty food 66.5% Stores, 2.1% Source: BloombergBelow are the main grocery players across the United States Traditional Grocers Discounters Specialty food Stores Independent/Regional Operators Others Kroger Wal-Mart Whole Foods Markets H-E-B Drugstores Supervalu Target Trader Joes Wegmans Gas Stations Safeway Sears Meijer Dollar-stores A&P Costco Publix Source: BloombergThe US Grocery industry distinguishes two main categories of products: the Food-at-home sales and the Non-food grocery sales. The former accounts for 64% of the US Grocery industry while the latter the remaining36%. Food-at-home includes food for preparing and consuming at home and anywhere else except on thepremises where items are sold.Some grocers have their own non-grocery food infrastructures on site which are important drivers of storetraffic. Non-food grocery, 36% Food-at- home , 64% Source: US Department of Agriculture 4
  5. 5. Equity Valuation - SWY Thomas BinoisThe food-at-home basket and Non-food grocery includes the following: Food-at-home Non-food grocery Meat, Fish, Eggs 23.2% Prescription drugs 32.5% Fruit and vegetables 14.7% Health & beauty 23.9% Cereals and bakery 14.2% Household products Nonalcoholic Beverage 12.0% Alcoholic beverage Dairy and related products 11.1% Paper products Sugar and sweets 3.8% Tobacco and gas Fats and oils 2.9% Other foods 18.1% Source: US Department of Agriculture Industry GrowthThe US grocery market has been growing at a mid-single digit rate over the last 10 years, driving by Food-at-home sales growth at 4.4% CAGR and Non-food grocery sales growth at 8.2% CAGR.Over the last 10 years, the Food-at-home has been mainly driving by the population growth 1% and the inflation2.9%.Given the slowing food inflation and the moderate population growth, the US grocery industry is estimated togrow 2-3% CAGR over the next several years. A 2.4% CAGR growth is expected for the Food-at-home salesand 3% CAGR growth for the Non-food grocery. US Grocery and Food-at-home sales previsions $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 US Food-at-home (In Billions) US Grocery Market (In Billions) Source: Bureau of Labor Statistics 5
  6. 6. Equity Valuation - SWY Thomas BinoisTo get a sense of a long-term driver, I examined the largest component of the US grocery market: Food-at-homesales currently representing about 64% of the $932B market. US Food-at-home sales by type of outletAccording the US department of Agriculture data, Non-traditional food retailers (such as supercenters,Warehouse Club Stores, Dollar stores) have been gaining significant market share from the Traditional foodretailers, which are defined as stores where 50% of the sales are food related products intended for consumingoff premises (such as supermarkets, specialized food stores).For example, supermarkets accounted for 56.8% of the Total Food-at-home sales in 2009 (down from 59.8% in1999) but on the other hand, warehouse clubs and discounters have gained significant share over the last 10years, representing around 28% of the Total Food-at-home sales in 2009, up from around 13% in 1999. Grocery Market share shifting towards discount Formats Source: Market Metro Studies 6
  7. 7. Equity Valuation - SWY Thomas Binois Key drivers of food retailer sales growth As Food-at-home represents the bigger portion of the traditional grocers’ sales, I assumed Food-at-Home as a good proxy for grocery industry’s long-term growth. Thus I examined Food-at-home sales over time to examine longer-term trends and drivers. What are the key drivers to food retailer growth? Food inflation Population growth Market share gainsFood Inflation a key driver for food sales: US Food-at-home sales 1970 – 2018E (Nominal Growth) Source: US Department of Agriculture Growth in Food-at-home, as illustrated in the figure above, has been relatively steady over time, with moderate year to year volatility. Note that the nominal Food-at-home sales have contracted only three times since 1970. In 1987: -1.3% In 1992: -0.1% In 2009: -1.4% 7
  8. 8. Equity Valuation - SWY Thomas Binois But historical nominal Food-at-Home sales growth trends are much lower when factoring out the inflation Food-at-home inflation 1970s 8.0% 1980s 4.3% 1990s 2.8% 2000s 3.0% Estimation: 2009-2019E 2.0% Source: Bureau of Labor Statistics The Bureau of Labor Statistics anticipates that Food-at-home sales growth over the 2009-2019E period will be moderate to a 2.4% CAGR on Food Inflation about 2.0%. US Food-at-home sales 1970 – 2018E (Real Growth) Source: US Department of AgricultureReal Food-at-home sales growth has been more moderate over time as inflation appears to be a major driver ofaggregate food sales. Real Food-at-home sales decreased -2.9% y/y in 2008 as nominal sales increased +3.3%,which was below the +6.4% inflation rate. During 2009, real Food-at-home sales continued with its contractionand decreased another -1.8% on a -1% nominal sales decrease along with a +0.8% inflation. The USDepartment of Agriculture expects real Food-at-home sales to grow slightly +0.3% y/y through 2010/2011, thenstarts steadily increasing its growing pace towards +0.9% through 2018.According to the consumer price index CPI from the US Bureau of Labor Statistics, Food-at-home inflation hasgrown at 4.5% CAGR between 1970-2008, slightly below the +4.6% increase of the CPI for all items over thesame period. The correlation between Food-at-home inflation and Nominal Food-at-home sales over the 1970-2008 period is very high 0.991. 8
  9. 9. Equity Valuation - SWY Thomas Binois CPI Food-at-home Price index vs. Nominal Food-at-home Source: US Department of AgricultureBetween 1990 and 2008, Food-at-home inflation increased at a +2.7% CAGR, driving a 3.8% CAGR inNominal Food-at-home sales (Real Food-at-home sales grew at a 1.1% CAGR over the same period of timehelped by a 1.1% CAGR for population).Food-at-home inflation over the next 10 years (2010-2019) is expected to be moderate to a 2% down from the2.7% CAGR reported in 1990-2009. The outlook reflects the fact that after the recession ends, it is expected thecommodity inflation to be reduced and thus bringing a moderate overall inflation.Indeed the US Department of Agriculture’s most recent inflations projections from February 2010 starts with a2.7% y/y increase in 2010 and then steadily decrease to a 1.6% to +1.8% annual range through 2019. Food-at-home Sales & Price Y/Y Change Source: US Department of Agriculture 9
  10. 10. Equity Valuation - SWY Thomas Binois Population growth a key driver of food sales US Population Growth (in thousands) from 1970 to 2050E Source: Bureau of Labor StatisticThe US population has grown at a CAGR of 1.06% since 1970, based on the US Census data, while as Imention above Food-at-home sales have grown at a +0.92% CAGR during the same period. Food-at-home salesand Population growth have been very closely correlated over time (kho = 0.967) and it is expected therelationship to be kept this way during the years to come. US Population Growth vs. Food-at-home expenditures Source: Bureau of Labor Statistic 10
  11. 11. Equity Valuation - SWY Thomas BinoisNational and regional population estimated and projectionsRegional estimation growth is also a key estimator for the grocers to target the appropriate location. Breakingdown by regions, in the 2000-2009 period, the US population grew +0.9% CAGR with the West and the Southoutpacing this growth at +1.4% and +1.3% respectively, while the Midwest and the Northeast lagged, with agrowth at +0.4% and +0.3% respectively.The same pattern is expected for the following years for a national growth of +0.8% CAGR over the 2010-2030E with the West and the South leading with a +1.2% growth. US Regional Population Growth CAGR 2000-2009 CAGR 2010E-2030E US 0.9% 0.8% Northeast 0.3% 0.2% Midwest 0.4% 0.2% South 1.3% 1.2% West 1.4% 1.2% Source: US Census BureauThese figures imply that most of the US’s population growth between 2000 and 2030 will likely occur in theSouth and in the West particularly in states like California, Texas or Florida.This positions Safeway very well for longer-term growth since about 36% of the company’s store base is inthese 3 states (30% in California, 6% in Texas but no store in Florida). 11
  12. 12. Equity Valuation - SWY Thomas Binois Food sales growth not sensitive to income growthContrary to a common belief, there is little relationship between individual personal income and Food-at-homeexpenditures. In other words, well-off people do not necessarily eat more than badly-off people. Per capitaFood-at-home spending has changed very little since 1970, ranging about $1,880 and $2,150, while real percapita incomes have more than doubled since 1970. The weak correlation factor between the 2 variables (Kho=-0.45) confirms that there is a little relationship between the two data sets. Food-at-home per capital vs. Disposable personal Income Source: Bureau of Labor Statistic Gain Market shareOpportunities exist for the best-positioned grocers. Despite the difficult competitive environment and the shareshift to discount formats, analysts believe that stronger traditional grocers (those which have strong balancesheet and leading competitive positions) can find compelling opportunities to grow market share and toparticipate in the consolidation of the industry.Notably, as the US market is really more of a collection of local markets, each market has a differentcompetitive dynamic. To have a greater market share at the local level helps drive better overall returns. 12
  13. 13. Equity Valuation - SWY Thomas Binois Major challenges of food retailer sales growth Slow economic recoveryThe economy continues to stagnate in 2010, with the release of the still weak unemployment rate of 9.6%(September 2010). Persistent weakness could encourage consumers to increase their grocery spending atdiscounters. A permanent shift in consumer behaviorConsumers have focused more on price than ever during the recession and have outrageously switched to low-prices retailers such as discounters, warehouse clubs or other discount formats to save money. And for most ofthe consumers that stayed faithful to their traditional grocers, they often switch products to cheaper alternatives(buy generic brands instead of the genuine brand).There is a risk that consumers continue to shop more indiscount channels or fail to trade back up to higher price products even after the economic recovery takes hold.That could impact traditional grocers’ pricing and further impact their margins and earnings. Intense Competition for market shareFaster-than-expected expansion of discounters, clubs, and other competitors like dollar stores into food retailcould here again adversely affect traditional grocers. Indeed, for the past several years, traditional grocers as awhole have steadily ceded share to discounters. Wal-Mart and Target’s combined share of the grocery markethas expended from 6.2% in 1998 to 18.7% in 2008. And the primary share donors have been the conventionalgrocery chains or small independents.Consumers today are much more willing to seek out value and split their shopping list between formats, thoughthis trend may be reversed of slow as the economy improves. However, the steady shift for traditional grocers todiscounters is viewed as secular by analysts. Labor unrestMany of the traditional grocers are heavily unionized and valuations could suffer if labor relations deteriorate.Furthermore, giant discounters like Wal-Mart do not employ unionized workers and that could be onecompetitive advantage for them in the future. 13
  14. 14. Equity Valuation - SWY Thomas Binois Discounters Taking sharesCompanies like Wal-Mart or others discounters like Costco and Sam’s club have tremendously expanded overthe last 10 years. While the square footage growth has reduced for those grocers recently, it is expected thatthose discounters will gain more shares in the market which will reduce traditional grocers’ or more preciselylocal independents’ presence who do not have the same purchasing power than those giant discounters, as wellas their labor cost (Most of those giant like Wal-Mart are not unionized like I mentioned above).Grocery Market Share shifting to discountersSource: Market Metro StudiesThe most influent grocery players in the US gathers Wal-Mart, Kroger, Costco, Supervalu and Safeway whohave grown from 25% to 36% market shares in 10 years. Note that contrary to other countries where the majorgrocers represent more than 70% of the market, the US grocery market is very fragmented. US Grocery Market Share - 2000 Kroger 8% Safeway Walmart 5% 8% Supervalu 1% Costco 3% Other 75% Source: Metro Market Studies 14
  15. 15. Equity Valuation - SWY Thomas Binois US Grocery Market Share - 2009 Walmart 18% Kroger 8% Safeway Other 5% 62% Supervalu Costco 4% 3% Source: Metro Market StudiesEven though it is important to analyze the market nationally it is also crucial to do research locally which offer agood insight into the companies’ true competitive positioning.The main grocers have also had the highest ROIC in recent years. 2008 - ROIC 16.90% 13.40% 12.60% 11.20% 10.40% 10.40% 7.90% Whole Target Supervalu Safeway Kroger Costco Wal-Mart Food Market Source: Metro Market Studies 15
  16. 16. Equity Valuation - SWY Thomas Binois Local Market Shares are keyAs we viewed above the US grocery market is extremely dispersed at a national scale. But locally, the USgrocery market should be viewed as a collection of diverse markets (Chicago, NYC, Boston markets forinstance). Each sector has different leaders with different set of competitive dynamics.Let have a closer look to those sectors independently: LA/Orange County Market Kroger - (Ralphs Other and Food 4 Less) 32% 23% Safeway - (Vons) 14% Wal-Mart 2% Superflu - Costco (Albertsons) 10% 13% Stater Bros (independent) 6% Source: Metro Market StudiesIn this market, the big Three (Kroger, Supervalu and Safeway) have the greatest market share. Wal-Mart is nota big player with around 2%. Chicago Market Other, 42% Superflu (Jewel), 36% Walmart , 2% Safeway Kroger (Food 4 (Dominics), 12% Costco, 5% Less), 3% Source: Metro Market Studies 16
  17. 17. Equity Valuation - SWY Thomas BinoisIn Chicago, Supervalu leads with 36% of share. Wal-Mart is not a good player here too but the firm has recentlyfound an agreement with Chicago’s officials to open another supermarket in the suburb. That may have apositive impact and help to grow its market share. New York Market A&P 30% Other 50% Aholds Stop & Stop 13% Wal-Mart Costco 1% 6% Source: Metro Market StudiesIt is interesting to say here, that none of the big Tree players have a presence in the NYC’s area in the largestmarket in the US and the largest grocer of the US Wal-Mart has a minuscule one.To conclude, what it is interesting to point out here is that the national leader Wal-Mart has a very limitedpresence in the 3 largest markets in the country. One explanation to this is that those markets cited above aremore friendly-unionized states which are more reluctant to comply with Wal-Mart non-union policy. Wal-Marthas stronger presences throughout Central and Southern US. 17
  18. 18. Equity Valuation - SWY Thomas Binois How could grocers build sustainable competitive advantages?The fact that competition is intense could not be denied. However there are things traditional or local grocerscould do to increase their excess return and reinforce their ROIC. They must focus on building sustainablecompetitive advantages. Build national size and scaleWal-Mart is the best example here. The company tremendous expansion over the last decade has rewarded thecompany with vast network, distribution capability and purchasing power. All contribute the offer clients withlow prices and various products. Strengthen local market shares positionBuilding strong local market share positions is important since it enables a retailer to better leverage fixed costs,including warehousing and distribution. Occupy an under-served market nicheIt is crucial to think about what others do not target. Deep discount retailing is a good example. Supervalu’sSave-A-Lot banner deals exclusively with targeted communities such as low-income customers. The companydoes not spend money on advertising or on distributing national brands. They prefer private labels which aregenerally priced 20 to 40% lower than national brand products. They do not put effort on stocking or handlingas the products are stacked on pallets in the store but they concentrated on delivering low cost high targetedproducts such as milk, sodas or bread. Target emerging trendsWhole Foods who is the leading retailer of natural and organic foods based its reputation on offeringexclusively healthy and rare products. Indeed, if you go to Whole Foods, 90% of their products could not befound elsewhere. Most of the customers tie to Whole Foods mainly due to the quality and the exclusivity of theitems. Offer convenienceSome stores are not preferred because of what they offer but simply because they are easy to access. Drugstoreslike CVS or dollar items-valued stores are mostly pinpointed in high influence neighborhoods and are easy tofind. For the majority of them, they do not intend to offer a great products choice but in contrast they offer avariety of products. That is the perfect location for someone who forgets to buy something at the supermarketlocated 20 miles away or for someone who just needs chips and beers for the Sunday night football game. Integrate verticallyGrocers have succeeded recently with growth in private label which in some case is manufactured internally.Those products are essentially 20-40% lower priced than national products and grocers do not have to bedependent on other national vendors. They can control their own production and set their own price.Furthermore, it is also a way to distinguish from other grocers. If customers tend to like Safeway products theyknow they could only find those in Safeway’s distributors (Dominic’s, Safeway, Randall or Carr). In addition, itis a way to secure the loyalty of their clientele. 18
  19. 19. Equity Valuation - SWY Thomas Binois Porter Analysis – US Grocery Competitive Rivalry within the industry 5 4 3 Barrier-to-entry 2 Power of Suppliers 1 0 Availability of Power of Buyers SubstitutesLow Barrier-to-entry and high barrier-to-exit – Score 1 - WeightThe competition is extremely intense in the US grocery industry. Barriers-to-entry are relatively low (in mostmarket) and barrier-to-exit is high which gives the opportunity for weaker players to restructure thoughbankruptcy and many of those operators earn ROC that is not relatively higher than their cost of capital. Thusthe stronger player could expand their presence through weaker grocers’ acquisitions.Power of Suppliers – Score 4 - WeightHistorically, retailers have tried to exploit relationships with suppliers. A great example was in the 1970s, whenSears sought to dominate the household appliance market. Sears set very high standards for quality; suppliersthat didnt meet these standards were dropped from the Sears line. You could also liken this to the strict controlthat Wal-Mart places on its suppliers. A contract with a large retailer such as Wal-Mart can make or break asmall supplier. In the retail industry, suppliers tend to have very little power.Power of Buyers – Score 2 - WeightIndividually, customers have very little bargaining power with retail stores. It is very difficult to bargain withthe clerk at Safeway for a better price on grapes. But as a whole, if customers demand high-quality products atbargain prices, it helps keep retailers honest.Availability of Substitutes – Score 3 - WeightThe tendency in retail is not to specialize in one good or service, but to deal in a wide range of products andservices. This means that what one store offers you will likely find at another store. Retailers offering productsthat are unique (private label) have a distinct or absolute advantage over their competitors.Competitive Rivalry within the industry – Score 1 - WeightRetailers always face stiff competition. Traditional grocers face an intense pressure from discounters like Wart-Mart who consistently expand their grocery division and allow additional footage to food departments whilereducing others. Dollar stores are also growing fast and warehouse clubs enable clients to buy in bulk (Costco).And deep-discount formats that offer tremendous value on a limited assortment of essentials, usually with aheavy private-label focus (Supervalu’s Saver-A-Lot banner for example). 19
  20. 20. Equity Valuation - SWY Thomas Binois Performance relative to S&P500 over the last 5 years $250 $200 $150 $100 $50 $0 1/4/05 1/4/06 1/4/07 1/4/08 1/4/09 1/4/10 Supervalu Kroger Safeway Whole Foods Source: Yahoo FinanceOver the last 5 years, Safeway has performed well in terms of valuation exceeding Supervalu and Whole Foods. 20
  21. 21. Equity Valuation - SWY Thomas Binois II Safeway Analysis BackgroundSafeway is one of the largest food and drug retailers in North America. The company owns around 2000 storeslocated in 21 different states and in 5 Canadian provinces.The company has an extensive network which allows it to efficiently store and distribute its goods.Safeway also own which is an online grocer. In addition, Safeway has a 49% interest inCasa Lay S.A. which operates mainly in Western Mexico.The company currently employs around 200,000 employees who are covered under collective bargainingagreements. Pharmacy, 9% Fuel, 9% Non-Perishables, 09 Sales breaking down by category 45% Perishables, 37% Source: SafewayThe company has around 1500 stores out of the 2000 located in the US. Its main markets are located in theWestern half of the US - California (30%) and Washington (10%) and it also includes stores in Alaska (39stores) and Hawaii (19 stores). However Safeway is also present at a lower scale around Philadelphia, in theMid-West and in Texas.In addition, 13% of Safeway’s stores are located in Canada. 21
  22. 22. Equity Valuation - SWY Thomas Binois Safeway - US Store Base by States as 12/2009 Source: Safeway Safeway – Canada by provinces as 12/2009 Source: Safeway 22
  23. 23. Equity Valuation - SWY Thomas Binois Canada, 15% Safeway – 2009 Sales’ Location - $ 40B USA, 85% Source: Safeway Safeway operates under various banners: Others Randalls 5% 6% Genuardis 5% Vons Banners 13% Safeway Dominicks 60% 11% Source: SafewayThe company also developed his own private label product “Safeway”. The company own 35 manufacturingand food processing across the country. Facilities include bakeries, cheese factories, milk plants, food andvegetables processing plants. Approximately 22% of the private label products are manufactured by Safewayand the rest are processed by third parties. 23
  24. 24. Equity Valuation - SWY Thomas Binois Strong Competitive positionAs I said in the industry analysis, the US grocery market is very well fragmented. According to Metro Market’sstudies, Safeway positions itself third as the biggest grocers in terms of market shares behind Kroger andSupervalu. Local Market Shares positions for the Big 3 - 2009 30% 24.9% 25% 18.8% 19.4% 20% 15% 10% 5% 0% Safeway Supervalu Kroger Source: Metro Market Studies 24
  25. 25. Equity Valuation - SWY Thomas Binois Safeway Growth DriversSafeway’s EPS has been driven by different factors: Sales growth Cost Reduction Product innovation Additional growth vehicles Sales growth Over the past few years, Safeway has tried to enhance customer loyalty and drive perceptions in terms of value to improve customers traffic in the stores. Safeway has recently suffered from the financial distress as the customers traded down their budgets and headed into low cost club stores rather in traditional grocers which deliver upscale products at higher prices. To change the customers’ conception of Safeway being a too much expensive store, the company has developed campaigns aiming at offering low prices products on various items. Safeway is now offering 5000 low prices per week and established a $5 products choice policy every Friday on a large range of products. Besides, customers are rewarded with frequent discount flyers given at the cashier desk along with their receipts. To try to improve the loyalty of their clients, Safeway also emphasizes on its corporate brand and work on the quality of its private label products as those products are only offer in Safeway’s banners. At Safeway, customers participate also to make to company do better. Safeway surveys them on the quality of its private label products asking what could be improved. And here the results: over the last 2 years, the majority of Safeway’s products have been growing faster than national brands products. Safeway also owns about 380 fuel sites (in 21% of its stores) which help drive traffic. Especially now, customers are value-conscious so having fuel pumps facilities next to the grocery stores help customers save additional dollars they would spend to go from the grocery store to another fuel site. The remodeling of Safeway’s stores has been a critical component to the sales growth strategy. 4 years earlier, Safeway have commenced a project aiming a restyling it stores and therefore making various enhancements. This project includes a much improve produce department, greatly enhanced floors, more attractive fixtures and better lighting. Safeway believes its customers need to shop in a neat and upscale environment to make them feel comfortable. Providing very high quality products continues to be a keep point of differentiation versus competitors. Safeway has a very rigorous screening process to carefully monitor the quality and the freshness of its products. Because produce is a leading factor used by shoppers in deciding where they spend their grocery dollars. Cost reduction Safeway realized significant cost reduction over the past years. Last year, the company announced they saved $166M with notable improvements in both shrink and overheads. 25
  26. 26. Equity Valuation - SWY Thomas Binois Safeway undertook creative projects to lower its energy costs. The company produces its own natural gas to deliver directly to the utility that processes the gas for the company. It is the first grocer that has taken this initiative and that gives the company a distinct cost advantage over the competition. Innovations  Product Innovation Innovation in terms of products is a key factor to distinguish Safeway from its competitors and be rewarded by customers’ loyalty. The company has recently consolidated its private label portfolio from 70 brands to 10 brands. Each of the 10 brands has a specific role and they are categorized into 4 classes: Core, Expertise, Destination and Wellness. Safeways Brands Core Expertise Destination Wellness Safeway Lucerne Safeway Select O Organics Basic Red Primo Taglio Ranchers Reserve Eating Right Total Pet Care Signature Café Source: Safeway Core Category Safeway: largest banner brand Basic Red: Safeway’s value brand Expertise Category Lucerne: Safeway’s proprietary dairy brand. Manufactured high quality products Primo Taglio: a premium line of meat and cheese Total Pet Care: solutions for pets. Food, litter, accessories 26
  27. 27. Equity Valuation - SWY Thomas Binois Destination Category Safeway Select: products destined to compete with national products or even offer greater values. Safeway Select also aims at occupying new niches that does not have any national brand competitors. Rancher’s Reserve: offers tender beef Signature Café: deli/food product department such as sandwiches or pre-cooked meals. Wellness Category O Organics: once of the most popular Safeway’s products. Organics products have to pass stringent standards to be considered as organic foods. The first year where the line was launched in 2006, it made $160M in sales. The second year, it did $300M up to the 2009 where it recorded 500M in sales. Eating Right: the most recent category of products essentially for health-conscious consumers. Safeway has high expectations for those products in the future in terms of sales growth. The line has now over 250 products in 20 food categories. In 2009, the line recorded $300M in sales. Sales of private label products were helped recently by the run-up in food inflation last year, which was the highest experienced by the industry in decades (commodity prices increased). And this increase in prices impacts directly the consumers as vendors passed those increases in price along to them. After Mid-2008, the commodity prices started declining but most of the retailers did not reflect this turndown. However Safeway lowered its private label products price which helped those to drive penetration and boost Safeway’s performance. 27
  28. 28. Equity Valuation - SWY Thomas Binois  Format InnovationsAs I mentioned above, the company launched a program entitled “Lifestyle” 7 years ago aiming a remodelingits stores. The Lifestyles stores are designed to be more aesthetically pleasing to consumers, as they have earth-toned décor, subdued lighting, customized flooring and other special features. Source: SafewayCompleting the Lifestyle roll-out is a key part of the company’s strategy to drive sales and profitability.Safeway has been investing significant amounts of capital into aggressively rolling out these updated stores(both new and remodeled) in recent years. This program is due to be done by 2011. 120% 100% 100% 90% 80% 80% 73% 59% 60% 43% 40% 26% 20% 8% 1% 0% 2003 2004 2005 2006 2007 2008 2009 2010E 2011E Development Lifestyle Store Base Source: SafewaySafeway own approximately 41% of its stores, while leasing the remainder. The company prefers to own storesas it offers greater flexibility in renovating, remodeling, expanding or closing stores. Real estate - Stores ownership 43% 41% 40% Safeway Kroger Supervalu Source: Metro Market 28
  29. 29. Equity Valuation - SWY Thomas Binois Additional growth vehicles Safeway recently opened up a small format store located in Southern California. As we saw in the industry analysis, locally based stores could have a huge impact and benefit the entire store base. Safeway also announced that it would expand its private label and notably the Wellness Category to other chains. That will increase the presence of Safeway and the firm will receive royalty on these sales. Healthcare is Safeway’ third potential growth vehicle. The company believes that they have developed a very strong competency in managing healthcare costs which may translate into new business opportunity. The company has announced in its last conference call that they are in the last stage of rolling out this new business, which will be called Safeway Health Company. Safeway’s Financial Position Recent sales historyIn 2009, the recent strengthening of the CA dollar against the US currency has curbed the overall sales of thecompany as the Canadian business accounted for 15% of the total Safeway’s 2009 sales. Before 2009, theCanadian currency was strong relative the US$ which helped to boost the overall sales. Canadian Dollar is significantly weaker Y/Y Change in CA$ vs. US$ 15% 10% 5% 0% 2002 2003 2004 2005 2006 2007 2008 2009 -5% -10% -15% -20% Source: BloombergAs part of the revitalization procedure announced by the direction of Safeway, the firm closed variousunderperforming stores across the US including 12 Dominick’s in 2004 and 14 in 2007 as well as 26underperformed Randall’s stores in Texas. Therefore the number of Safeway square footage has reduced overthe last past years but as the store has implemented its proactive Lifestyle format program renewing stores, salesper square foot has also gained. 29
  30. 30. Equity Valuation - SWY Thomas Binois $501 $500 $482 $460 $441 $439 2004 2005 2006 2007 2008 2009 Safeway Sales per Sq foot Source: Safeway Safeway retail square footage (in MM) 83 82.5 82 81.5 81 80.5 80 79.5 79 2002 2003 2004 2005 2006 2007 2008 2009 Source: SafewayRecent performance shows that both Operating margins and EBITDA margins have improved steadily in recentyears except in 2009 where the financial distress adversely affected those ratios. Safeway Operating and EBITDA Margins 10% 8% 6% 4% 2% 0% 2002 2003 2004 2005 2006 2007 2008 2009 -2% Operating Margins EBITDA Margins Source: Bloomberg 30
  31. 31. Equity Valuation - SWY Thomas BinoisTotal sales in 2009 were $40.9 billion compared with $44.1 billion in 2008, largely as a result of lower fuelsales, lower identical-store sales. Unprecedented levels of deflation in key categories such as dairy, produceand meat, as well as our investments in price, reduced sales dollars. In addition, consumers continued to closelymonitor their spending, trading down to private label goods and other lower-priced items.Safeway has generated solid and consistent FCF in the recent years. The FCF has been consistently positive,though it did jump to above $1B in 2004 due primarily to a large positive swing in working capital (538MMbenefit). From 2004, capital expenditures increased for 4 straight years (2004-2007) because of the Lifestyleroll-out remodeled program started in 2003.Starting 2008, the CAPEX has slowed as the lifestyle program has reached 80% of its completion in 2009. Safeway FCF - In $MM $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 2002 2003 2004 2005 2006 2007 2008 2009 Source: SafewayThe management has used the large amount of FCF to pay back debts and pay out dividends. The dividendpayout in 2009 was 20%. Safeway generated free cash flow of $1.5 billion, the highest in the company’shistory, and returned cash to its stockholders through $885 million in stock repurchases and $153 million individends. Safeway also reduced our debt by $598 million.Note that in 2002, the company repaid $1.5B of shares funded through borrowings and FCF. Cash Used for Share Buybacks (In $MM) $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 2002 2003 2004 2005 2006 2007 2008 2009 Source: SafewayFrom 2003, the company has put efforts to repay its debts to improve its balance sheet and its credit ratings. 31
  32. 32. Equity Valuation - SWY Thomas Binois Safeway - Net Change in Debt in $MM $1,000 $500 $0 2002 2003 2004 2005 2006 2007 2008 2009 -$500 -$1,000 -$1,500 Source: BloombergThe company’s return as measured by ROC and ROE have come down from the 20% level reached for ROCand close to 28% for ROE achieved in 2002. The strike that happened in Southern California negativelyimpacted results in 2003 and 2004 and ROC began to show steady improvement beginning 2005.Nevertheless in 2009, the ROE disappointedly dropped to 13% below SWYs 5-year average of 14% which is anegative sign. Safeway ROE and ROC Trends 30% 25% 20% 15% 10% 5% 0% -5% 2002 2003 2004 2005 2006 2007 2008 2009 -10% -15% -20% ROE ROIC Source: BloombergI believe that the biggest risk to returns is likely to be increasing competition from the more non-traditionalgrocers, particularly Wal-Mart supercenters. However, I think that Safeway can compete effectively in thischallenging competitive environment. Successful initiatives like the Lifestyle remodeling program, thedevelopment and launch of successful, multi-million dollar brand like O Organic and Eating Right alldemonstrate that Safeway has the ability to distinguish itself in a competitive environment. 32
  33. 33. Equity Valuation - SWY Thomas Binois Investment positives and Investment negatives Investment Positives Safeway is located primarily on the coasts in the US. It has good growth opportunities by expanding business to other US regions, and further strengthening in Canada. SWY has a time-tested, robust business model. The company has strong brand value and loyal customer-base. The company also has a well-established distribution network and benefits through backward integration. I do not see any strong factor that can strongly change this equilibrium in future, and SWY will continue to generate sustained revenues. Under the leadership of current chairman and CEO Steve Burd, Safeway is rated to be among the best corporate governance companies in the US. Management has a corporate governance quotient higher than 91% of S&P 500 companies and 97.7% of all food retailing companies. A good and stable management team, with a long-term vision, should be able to lead SWY through this recession. Remodeling: with a long-term growth vision, Safeway undertook remodeling of all its stores to “Lifestyle stores.” The new, energetic, and bigger stores will generate higher sales in the future. Safeway has also been increasing number of fuel-stations, which will offer low margin but sustained revenue growth. By 2010, 90% of all stores will be remodeled into the “Lifestyle store,” thus freeing lot of capital expenditure that in the past was committed to remodeling. Investment Negatives The food retailing sector is extremely price-competitive. If Safeway loses its price edge, it may lose its customers to other larger players in the industry. If the economic recession continues for some time, there may come a day when only companies with deep pocket will survive. Safeway does not have enough size and strength to withstand the economic meltdown for long. “Lifestyle stores” are expensive to maintain. The current economic slowdown may force customers to change buying behaviors and accept less expensive products. In such a price war, Safeway may lose out to cheaper alternatives. Operating in a unionized environment and union exposure as high as 80% of employees, Safeway is vulnerable to inflexibility and financial and operational inefficiencies. The participation of 80% of employees in the union makes Safeway susceptible to strikes and union demands. Safeway’s defined pension plan was $320MM underfunded at the end of 2009. Safeway may be required to make larger cash contributions to its pension plans, particularly if returns on plan assets are below expectations 33
  34. 34. Equity Valuation - SWY Thomas Binois ValuationI considered Safeway’s valuation keeping in mind the strengths and weaknesses of the Company’sfundamentals as well as opportunities and threats presented by the current economic scenario and competitionin the sector.I have considered a two-phase growth rate of 3.8% growth in the next 4 years and the terminal growth rate of2.4% which is the industry average of sales growth rate.The risk free rate is taken to be 4.2%, which is the prevailing 20-year Treasury rate, with a market riskpremium of 5%. The beta I have considered is at 0.88 as of December, 2009. On the basis of these assumptions,I calculated the WACC to be 7.03%. I have considered the marginal tax rate of 36.7%. This may change withthe new government and the changing political environment.Based on these assumptions, I found the intrinsic value to be $22.37 per share.I undertook a sensitivity analysis on the WACC and the 5-year growth rate and realized a realistic price range of$21.61 to $51.57 per share.Based on these analyses, I am recommending a HOLD for Safeway. This may further improve if economicconditions improve in the near future, the company decides to diversify into a related products category or enternew regions of the country, or if the real estate development business shows signs of profitability.Note that due to the bad 2009 year that Safeway had, many analysts downgraded Safeway from a Buy to a Holdor a Hold to a Sell rating. Analysts Recommendations Current Month Three Months Ago 8 7 5 4 4 3 3 2 2 2 Strong Buy Buy Hold Underperform Sell Source: Reuters 34
  35. 35. Equity Valuation - SWY Thomas Binois III Source To perform this analysis, I used information contained in the third-party sources listed below: Bloomberg – data Bloomberg Terminal Reuters – Metro Market Studies – Safeway – Yahoo Finance – US Census – US Bureau of Labor – Seeking Alpha – US Department of Agriculture – Morningstar – Daily Finance – Edgar Database – edgar?company=&match=&CIK=swy&filenum=&State=&Country=&SIC=&owner=exclude&Fin d=Find+Companies&action=getcompany 35
  36. 36. Equity Valuation - SWY Thomas Binois IV Appendix WACC - SAFEWAY SWY - WACCStock price Dec 2009 20.96Effective tax rate 36.70%Cost of Common Equity20-Year Treasury Bond Yield 4.20%Company Specific Beta 0.88Equity Risk Premium 5.00%Cost of Common Equity 8.60%Default Spread (Bond Rating S&P BBB) 2.00%Cost of Debt (Risk free rate + default spread) 6.20%Market Capitalization and After-Tax Weighted Average Market Value Weighted After- Current Yield After Tax Yield Percent Cost of Capital (in $B) Tax YieldLong Term Debt 6.20% 3.92% $ 4,383 34% 1.32%Preferred Stock 0.00% 0.00% $ - 0% 0.00%Common Stock 8.60% 8.60% $ 8,654 66% 5.71%Total - WACC $ 13,037 100% 7.03% 36
  37. 37. Equity Valuation - SWY Thomas Binois DCF – SAFEWAY (In Millions) SWY - DCF 31-Dec-20 31-Dec-19 31-Dec-18 31-Dec-17 31-Dec-16 31-Dec-15 31-Dec-14 31-Dec-13 31-Dec-12 31-Dec-11 31-Dec-10EBIT * (1 - taxes) 743 905 1,053 1,132 1,270 1,397 1,328 1,548 1,425 1,640 1,392Capital Expenditure -700 -700 -700 -700 -700 -700 -700 -700 -900 -1,050 -1,120Depreciation & Amortization 1,110 1,108 1,103 1,107 1,112 1,116 1,110 1,110 1,093 1,071 1,136Acquisitions -80 0 -80 0 0 -80 0 0 -80 0 0Net change in non-cash working capital 12 31 12 22 8 -14 1 20 127 -86 11Free Cash Flow 1,060 1,281 1,364 1,517 1,675 1,747 1,738 1,939 1,411 1,746 1,396Present Value of Free Cash Flows 502 649 740 881 1,041 1,162 1,238 1,478 1,151 1,525 1,305 Firm free Cash Flow =Ebit(1-tax) - CAPEX + D&A - Acquisitions - Net Change in non-cash WCTerminal Value 11729 Present value of free cash flows = Firm Free Cash Flow/(1+WACC)^11Present Value of Terminal Value 5556 TV =FirmFreeCashFlow*(1+g)*(1-StableRetentionRate)/(WACC-g)Sum of PV of all Free Cash Flows 11,672 PV of TV =Terminal_Value/(1+WACC)^11Present Value of Terminal Value 5,556 Sum of PV of firm free cash flow =SUM(PresentValueFirmFreeCashFlows)= Total value of the corporation 17,228+ Cash 890 Total value of the corporation =SUM(Sum_of_PV_of_all_Free_Cash_Flows,Present_Value_of_Terminal_Value1+ Marketable securities 0- Short term debt 4,498 Total Value Common Equity =SUM(Total_value_of_the_corporation,Cash,Marketable_securities)- Short_term_debt -- Long term debt 4,383 Long_term_debt= Total value to common equity 9,237Total shares outstanding 413 Fair value=Total_value_to_common_equity/Total_shares_outstandingFair Value $ 22.4WACC 7.03%g 2.40% 37