Fundamental Analysis - Safeway Inc.

IIT - STUART SCHOOL OF BUSINESS
Equity Valuation

ANALYSIS AND STOCK VALUATION

Thomas Binois

Equity Valuation - SWY Thomas Binois

This page has been intentionally left blank

2


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. Appendix

Note: The terms “Safeway”, “Corporation” or “Company” refer to Safeway Corporation and its subsidiaries
unless I indicate otherwise.

3


I US Grocery industry

Industry Overview

The US food market is approximately $932B in size which includes food grocery items and non-food grocery
items.

Where are those products sold?

Others,
7.8%

Independent /
Regional
Operators, 23.6%
Traditional
Grocers /
Discounters,
Specialty food 66.5%
Stores, 2.1%

Source: Bloomberg
Below 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 Joe's Wegmans Gas Stations
Safeway Sears Meijer Dollar-stores
A&P Costco Publix
Source: Bloomberg

The 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 remaining
36%. Food-at-home includes food for preparing and consuming at home and anywhere else except on the
premises where items are sold.

Some grocers have their own non-grocery food infrastructures on site which are important drivers of store
traffic.
Non-food
grocery,
36%
Food-at-
home , 64%

Source: US Department of Agriculture

4


The 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%

Industry Growth

The 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 inflation
2.9%.

Given the slowing food inflation and the moderate population growth, the US grocery industry is estimated to
grow 2-3% CAGR over the next several years. A 2.4% CAGR growth is expected for the Food-at-home sales
and 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


To get a sense of a long-term driver, I examined the largest component of the US grocery market: Food-at-home
sales currently representing about 64% of the $932B market.

US Food-at-home sales by type of outlet

According 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 food
retailers, which are defined as stores where 50% of the sales are food related products intended for consuming
off 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% in
1999) but on the other hand, warehouse clubs and discounters have gained significant share over the last 10
years, 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


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 gains

Food Inflation a key driver for food sales:

US Food-at-home sales 1970 – 2018E (Nominal Growth)


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


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)


Real Food-at-home sales growth has been more moderate over time as inflation appears to be a major driver of
aggregate 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 contraction
and decreased another -1.8% on a -1% nominal sales decrease along with a +0.8% inflation. The US
Department of Agriculture expects real Food-at-home sales to grow slightly +0.3% y/y through 2010/2011, then
starts 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 has
grown at 4.5% CAGR between 1970-2008, slightly below the +4.6% increase of the CPI for all items over the
same 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


CPI Food-at-home Price index vs. Nominal Food-at-home


Between 1990 and 2008, Food-at-home inflation increased at a +2.7% CAGR, driving a 3.8% CAGR in
Nominal Food-at-home sales (Real Food-at-home sales grew at a 1.1% CAGR over the same period of time
helped 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 the
2.7% CAGR reported in 1990-2009. The outlook reflects the fact that after the recession ends, it is expected the
commodity 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 a
2.7% 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


9


Population growth a key driver of food sales

US Population Growth (in thousands) from 1970 to 2050E

Source: Bureau of Labor Statistic

The US population has grown at a CAGR of 1.06% since 1970, based on the US Census data, while as I
mention above Food-at-home sales have grown at a +0.92% CAGR during the same period. Food-at-home sales
and Population growth have been very closely correlated over time (kho = 0.967) and it is expected the
relationship to be kept this way during the years to come.

US Population Growth vs. Food-at-home expenditures


10


National and regional population estimated and projections

Regional estimation growth is also a key estimator for the grocers to target the appropriate location. Breaking
down by regions, in the 2000-2009 period, the US population grew +0.9% CAGR with the West and the South
outpacing this growth at +1.4% and +1.3% respectively, while the Midwest and the Northeast lagged, with a
growth 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 Bureau

These figures imply that most of the US’s population growth between 2000 and 2030 will likely occur in the
South 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 in
these 3 states (30% in California, 6% in Texas but no store in Florida).

11


Food sales growth not sensitive to income growth

Contrary to a common belief, there is little relationship between individual personal income and Food-at-home
expenditures. In other words, well-off people do not necessarily eat more than badly-off people. Per capita
Food-at-home spending has changed very little since 1970, ranging about $1,880 and $2,150, while real per
capita 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


Gain Market share

Opportunities exist for the best-positioned grocers. Despite the difficult competitive environment and the share
shift to discount formats, analysts believe that stronger traditional grocers (those which have strong balance
sheet and leading competitive positions) can find compelling opportunities to grow market share and to
participate in the consolidation of the industry.

Notably, as the US market is really more of a collection of local markets, each market has a different
competitive dynamic. To have a greater market share at the local level helps drive better overall returns.

12


Major challenges of food retailer sales growth

Slow economic recovery
The 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 at
discounters.

A permanent shift in consumer behavior
Consumers 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 of
the 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 in
discount 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 share
Faster-than-expected expansion of discounters, clubs, and other competitors like dollar stores into food retail
could here again adversely affect traditional grocers. Indeed, for the past several years, traditional grocers as a
whole have steadily ceded share to discounters. Wal-Mart and Target’s combined share of the grocery market
has expended from 6.2% in 1998 to 18.7% in 2008. And the primary share donors have been the conventional
grocery chains or small independents.

Consumers today are much more willing to seek out value and split their shopping list between formats, though
this trend may be reversed of slow as the economy improves. However, the steady shift for traditional grocers to
discounters is viewed as secular by analysts.

Labor unrest
Many 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 one
competitive advantage for them in the future.

13


Discounters Taking shares

Companies like Wal-Mart or others discounters like Costco and Sam’s club have tremendously expanded over
the last 10 years. While the square footage growth has reduced for those grocers recently, it is expected that
those discounters will gain more shares in the market which will reduce traditional grocers’ or more precisely
local independents’ presence who do not have the same purchasing power than those giant discounters, as well
as their labor cost (Most of those giant like Wal-Mart are not unionized like I mentioned above).

Grocery Market Share shifting to discounters

Source: Market Metro Studies

The most influent grocery players in the US gathers Wal-Mart, Kroger, Costco, Supervalu and Safeway who
have grown from 25% to 36% market shares in 10 years. Note that contrary to other countries where the major
grocers 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


US Grocery Market Share - 2009

Walmart
18%
Kroger
8%

Safeway
Other 5%
62%
Supervalu
Costco 4%
3%

Even though it is important to analyze the market nationally it is also crucial to do research locally which offer a
good 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


15


Local Market Shares are key
As we viewed above the US grocery market is extremely dispersed at a national scale. But locally, the US
grocery market should be viewed as a collection of diverse markets (Chicago, NYC, Boston markets for
instance). 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 - (Von's)
14%
Wal-Mart
2%
Superflu -
Costco (Albertsons)
10% 13%
Stater Bros
(independent)
6%


In this market, the big Three (Kroger, Supervalu and Safeway) have the greatest market share. Wal-Mart is not
a big player with around 2%.

Chicago Market

Other, 42% Superflu (Jewel),
36%

Walmart , 2% Safeway
Kroger (Food 4 (Dominic's), 12%
Costco, 5%
Less), 3%


16


In Chicago, Supervalu leads with 36% of share. Wal-Mart is not a good player here too but the firm has recently
found an agreement with Chicago’s officials to open another supermarket in the suburb. That may have a
positive impact and help to grow its market share.

New York Market

A&P
30%
Other
50%

Ahold's Stop &
Stop
13%

Wal-Mart Costco
1% 6%


It is interesting to say here, that none of the big Tree players have a presence in the NYC’s area in the largest
market 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 limited
presence in the 3 largest markets in the country. One explanation to this is that those markets cited above are
more friendly-unionized states which are more reluctant to comply with Wal-Mart non-union policy. Wal-Mart
has stronger presences throughout Central and Southern US.

17


How could grocers build sustainable competitive advantages?

The fact that competition is intense could not be denied. However there are things traditional or local grocers
could do to increase their excess return and reinforce their ROIC. They must focus on building sustainable
competitive advantages.

Build national size and scale
Wal-Mart is the best example here. The company tremendous expansion over the last decade has rewarded the
company with vast network, distribution capability and purchasing power. All contribute the offer clients with
low prices and various products.

Strengthen local market shares position
Building 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 niche
It is crucial to think about what others do not target. Deep discount retailing is a good example. Supervalu’s
Save-A-Lot banner deals exclusively with targeted communities such as low-income customers. The company
does not spend money on advertising or on distributing national brands. They prefer private labels which are
generally priced 20 to 40% lower than national brand products. They do not put effort on stocking or handling
as the products are stacked on pallets in the store but they concentrated on delivering low cost high targeted
products such as milk, sodas or bread.

Target emerging trends
Whole Foods who is the leading retailer of natural and organic foods based its reputation on offering
exclusively healthy and rare products. Indeed, if you go to Whole Foods, 90% of their products could not be
found elsewhere. Most of the customers tie to Whole Foods mainly due to the quality and the exclusivity of the
items.

Offer convenience

Some stores are not preferred because of what they offer but simply because they are easy to access. Drugstores
like CVS or dollar items-valued stores are mostly pinpointed in high influence neighborhoods and are easy to
find. For the majority of them, they do not intend to offer a great products choice but in contrast they offer a
variety of products. That is the perfect location for someone who forgets to buy something at the supermarket
located 20 miles away or for someone who just needs chips and beers for the Sunday night football game.

Integrate vertically
Grocers 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 be
dependent 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 they
know they could only find those in Safeway’s distributors (Dominic’s, Safeway, Randall or Carr). In addition, it
is a way to secure the loyalty of their clientele.

18


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
Substitutes

Low Barrier-to-entry and high barrier-to-exit – Score 1 - Weight

The competition is extremely intense in the US grocery industry. Barriers-to-entry are relatively low (in most
market) and barrier-to-exit is high which gives the opportunity for weaker players to restructure though
bankruptcy and many of those operators earn ROC that is not relatively higher than their cost of capital. Thus
the stronger player could expand their presence through weaker grocers’ acquisitions.

Power of Suppliers – Score 4 - Weight

Historically, retailers have tried to exploit relationships with suppliers. A great example was in the 1970s, when
Sears sought to dominate the household appliance market. Sears set very high standards for quality; suppliers
that didn't meet these standards were dropped from the Sears line. You could also liken this to the strict control
that Wal-Mart places on its suppliers. A contract with a large retailer such as Wal-Mart can make or break a
small supplier. In the retail industry, suppliers tend to have very little power.

Power of Buyers – Score 2 - Weight

Individually, customers have very little bargaining power with retail stores. It is very difficult to bargain with
the clerk at Safeway for a better price on grapes. But as a whole, if customers demand high-quality products at
bargain prices, it helps keep retailers honest.

Availability of Substitutes – Score 3 - Weight

The tendency in retail is not to specialize in one good or service, but to deal in a wide range of products and
services. This means that what one store offers you will likely find at another store. Retailers offering products
that are unique (private label) have a distinct or absolute advantage over their competitors.

Competitive Rivalry within the industry – Score 1 - Weight

Retailers 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 while
reducing 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 a
heavy private-label focus (Supervalu’s Saver-A-Lot banner for example).
19


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 Finance

Over the last 5 years, Safeway has performed well in terms of valuation exceeding Supervalu and Whole Foods.

20


II Safeway Analysis
Background

Safeway is one of the largest food and drug retailers in North America. The company owns around 2000 stores
located 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 GroceryWorks.com which is an online grocer. In addition, Safeway has a 49% interest in
Casa Lay S.A. which operates mainly in Western Mexico.
The company currently employs around 200,000 employees who are covered under collective bargaining
agreements.

Pharmacy, 9%

Fuel, 9%

Non-Perishables,
09 Sales breaking down by category 45%
Perishables, 37%

Source: Safeway

The company has around 1500 stores out of the 2000 located in the US. Its main markets are located in the
Western half of the US - California (30%) and Washington (10%) and it also includes stores in Alaska (39
stores) and Hawaii (19 stores). However Safeway is also present at a lower scale around Philadelphia, in the
Mid-West and in Texas.
In addition, 13% of Safeway’s stores are located in Canada.

21


Safeway - US Store Base by States as 12/2009

Source: Safeway

Safeway – Canada by provinces as 12/2009

Source: Safeway

22


Canada, 15%

Safeway – 2009 Sales’ Location - $ 40B

USA, 85%

Source: Safeway

Safeway operates under various banners:

Others
Randall's
5%
6%
Genuardi's
5%

Vons
Banners 13%

Safeway
Dominick's 60%
11%

Source: Safeway

The company also developed his own private label product “Safeway”. The company own 35 manufacturing
and food processing across the country. Facilities include bakeries, cheese factories, milk plants, food and
vegetables processing plants. Approximately 22% of the private label products are manufactured by Safeway
and the rest are processed by third parties.

23


Strong Competitive position

As I said in the industry analysis, the US grocery market is very well fragmented. According to Metro Market’s
studies, Safeway positions itself third as the biggest grocers in terms of market shares behind Kroger and
Supervalu.

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

24


Safeway Growth Drivers

Safeway’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


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.

Safeway's Brands
Core Expertise Destination Wellness
Safeway Lucerne Safeway Select O Organics
Basic Red Primo Taglio Rancher's 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


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


 Format Innovations

As I mentioned above, the company launched a program entitled “Lifestyle” 7 years ago aiming a remodeling
its 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: Safeway

Completing 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: Safeway

Safeway own approximately 41% of its stores, while leasing the remainder. The company prefers to own stores
as 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


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 history

In 2009, the recent strengthening of the CA dollar against the US currency has curbed the overall sales of the
company as the Canadian business accounted for 15% of the total Safeway’s 2009 sales. Before 2009, the
Canadian 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: Bloomberg

As part of the revitalization procedure announced by the direction of Safeway, the firm closed various
underperforming stores across the US including 12 Dominick’s in 2004 and 14 in 2007 as well as 26
underperformed Randall’s stores in Texas. Therefore the number of Safeway square footage has reduced over
the last past years but as the store has implemented its proactive Lifestyle format program renewing stores, sales
per square foot has also gained.

29


$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: Safeway

Recent performance shows that both Operating margins and EBITDA margins have improved steadily in recent
years 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


Total sales in 2009 were $40.9 billion compared with $44.1 billion in 2008, largely as a result of lower fuel
sales, lower identical-store sales. Unprecedented levels of deflation in key categories such as dairy, produce
and meat, as well as our investments in price, reduced sales dollars. In addition, consumers continued to closely
monitor 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 (538MM
benefit). From 2004, capital expenditures increased for 4 straight years (2004-2007) because of the Lifestyle
roll-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: Safeway

The management has used the large amount of FCF to pay back debts and pay out dividends. The dividend
payout in 2009 was 20%. Safeway generated free cash flow of $1.5 billion, the highest in the company’s
history, and returned cash to its stockholders through $885 million in stock repurchases and $153 million in
dividends. 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: Safeway

From 2003, the company has put efforts to repay its debts to improve its balance sheet and its credit ratings.

31


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: Bloomberg

The company’s return as measured by ROC and ROE have come down from the 20% level reached for ROC
and close to 28% for ROE achieved in 2002. The strike that happened in Southern California negatively
impacted results in 2003 and 2004 and ROC began to show steady improvement beginning 2005.
Nevertheless in 2009, the ROE disappointedly dropped to 13% below SWY's 5-year average of 14% which is a
negative 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: Bloomberg

I believe that the biggest risk to returns is likely to be increasing competition from the more non-traditional
grocers, particularly Wal-Mart supercenters. However, I think that Safeway can compete effectively in this
challenging competitive environment. Successful initiatives like the Lifestyle remodeling program, the
development and launch of successful, multi-million dollar brand like O Organic and Eating Right all
demonstrate that Safeway has the ability to distinguish itself in a competitive environment.

32


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


Valuation
I considered Safeway’s valuation keeping in mind the strengths and weaknesses of the Company’s
fundamentals as well as opportunities and threats presented by the current economic scenario and competition
in the sector.

I have considered a two-phase growth rate of 3.8% growth in the next 4 years and the terminal growth rate of
2.4% 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 risk
premium 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 with
the 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 economic
conditions improve in the near future, the company decides to diversify into a related products category or enter
new 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 Hold
or 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


III Source

To perform this analysis, I used information contained in the third-party sources listed below:

Bloomberg – data Bloomberg Terminal
Reuters – www.reuters.com/finance/stocks/overview?symbol=SWY.N
Metro Market Studies – www.metromarketstudies.com/#samples
Safeway – www.safeway.com/IFL/Grocery/Investors#iframetop
Yahoo Finance – finance.yahoo.com/q?s=SWY
US Census – www.census.gov/ipc/www/idb/informationGateway.php
US Bureau of Labor – www.bls.gov/data/
Seeking Alpha – seekingalpha.com/symbol/swy?source=search_general&s=swy
US Department of Agriculture – www.nass.usda.gov/Statistics_by_Subject/index.php?sector
Morningstar – quote.morningstar.com/stock/s.aspx?t=swy
Daily Finance – www.dailyfinance.com/financials/safeway
Edgar Database – www.sec.gov/cgi-bin/browse-
edgar?company=&match=&CIK=swy&filenum=&State=&Country=&SIC=&owner=exclude&Fin
d=Find+Companies&action=getcompany

35


IV Appendix
WACC - SAFEWAY

SWY - WACC
Stock price Dec 2009 20.96
Effective tax rate 36.70%
Cost of Common Equity
20-Year Treasury Bond Yield 4.20%
Company Specific Beta 0.88
Equity 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 Yield
Long 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


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-10

EBIT * (1 - taxes) 743 905 1,053 1,132 1,270 1,397 1,328 1,548 1,425 1,640 1,392

Capital Expenditure -700 -700 -700 -700 -700 -700 -700 -700 -900 -1,050 -1,120

Depreciation & Amortization 1,110 1,108 1,103 1,107 1,112 1,116 1,110 1,110 1,093 1,071 1,136

Acquisitions -80 0 -80 0 0 -80 0 0 -80 0 0

Net change in non-cash working capital 12 31 12 22 8 -14 1 20 127 -86 11

Free Cash Flow 1,060 1,281 1,364 1,517 1,675 1,747 1,738 1,939 1,411 1,746 1,396

Present 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 WC
Terminal Value 11729 Present value of free cash flows = Firm Free Cash Flow/(1+WACC)^11
Present 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)^11
Present 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 9,237

Total shares outstanding 413
Fair value=Total_value_to_common_equity/Total_shares_outstanding
Fair Value $ 22.4

WACC 7.03%
g 2.40%

37

Fundamental Analysis - Safeway Inc.

More Related Content

Similar to Fundamental Analysis - Safeway Inc.

Fundamental Analysis - Safeway Inc.