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Why Safeway Is Overpriced


The trend is not Safeway's friend, and a rescue looks unlikely.

Safeway's (SWY) initial disclosure of its multi-employer pension obligations was enough for a Credit Suisse analyst to downgrade the stock from outperform to neutral earlier this week. I look at the new rating as a change from "I don't see any way out of its pricing problems vs. the competition," to "I don't see any way out of its pricing problems vs. the competition, and now it cannot use a significant portion of its balance sheet to help reposition itself, either." Yuck.

A couple months ago I wrote a note called Safeway and SuperValu: Why Clinging to Margins Can Hurt. Here it is again:

I have always thought that too many investment analysts, at least where the consumer sector is concerned, do not pay enough attention to marketing and marketing strategy, and spend too much time playing with financial ratios. They do not look at relative prices charged to consumers versus what their competitors charge. They then do not sound an alarm for future market share losses and the effect that will have on stock valuations. In the food retailing area, Safeway and SurperValu (SVU) are examples.

Safeway's prices are about 18% higher than Wal-Mart's (WMT), and 11% higher than Kroger (KR). The price differential range that consumers notice and act on has typically been 5-8%, though I believe that that level is probably lower, given the consumers' present state. Safeway has had flat to down EBIT for about three years as sales have just not come in this environment, while Kroger has had expanded sales. (I know they only overlap in certain markets, but the price differential is appropriate for positioning throughout the US in my opinion). Safeway's heretofore-strong urban/suburban California has been relatively protected from supercenters because it could not acquire space or had to fight zoning hostility for large stores. But Family Dollar (FDO) will be expanding strongly into California over the next few years. And Walmart has decided to rev up growth of its neighborhood markets as the return on assets on new supercenters has declined.

Just assuming a 5% across-the-board price cut to halve the price differential with Kroger, which would probably result in a relatively static market share, I cut a projection of 2011 revenue by 5% (analysis here can be extremely rough, and still impart the concept). The result is a reduction of $594 million of gross profit dollars against an operating income estimate of $1,137 million operating profit, or a 52% hit before any SG&A offsets. If you wanted to gain some market share, as Kroger has done over the past few years, you cut the prices 11% to Kroger's level. That would more than wipe out all operating income before SG&A offsets.

That does not give me the warm and fuzzies about Safeway or about SuperValu, which has followed the same sort of strategy, except that it opened its own grocery discounter. I have to wonder if it is too late to reverse course for these companies.

Looking back, this piece of corporate strategy was like the old story of the bear (Walmart, then the dollar stores, and finally the overextended consumer that would have to retrench, if anybody saw that far in to the future 10 years ago) going after the campers. Kroger reasoned, 'We do not have to beat Walmart. We just have to put on my running shoes (lower prices) and beat the other supermarket chains.' As for Safeway's and Supervalu's managements, well, I do not know what they were thinking, but I'm sure it had something to do with protecting margins.

Additionally, I can add to that recent note the fact that the traditional supermarket now sells less than 50% of the food in the nation. The trend is not Safeway's friend.

Now we have FASB coming out, far too late in my opinion, with the requirement that corporations tell shareholders what pension liabilities are for multi-employer pension funds. Safeway has $3.7 billion of shareholders equity. The underfunding of Safeway's liabilities to these funds is, according to management, $1.22 billion. That is 32% on the low end. Estimates by Credit-Suisse, made by their analysts in conjunction with their accounting experts with differing assumptions, are substantially higher.

My opinion is that, strategically for an investor, the present earnings quality is suspect. It should be looked upon as what it would be if prices equaled those of Kroger. So earnings should be seen as non-existent. Then, taking a long-term investment view, you have to ask what can be changed. Within the present operation that would be "not much," unless you depend on the balance sheet to fund losses, either for much lower prices or for an investment in a new discount priced operation. But the balance sheet is severely compromised for these pension obligations.

So, I see the stock as being overpriced at $21. I could not recommend shorting it, because the cash flow is no problem now and earnings are not going to be falling off of any imminent cliff. Nevertheless, unless there is a big recovery in consumer spending to validate the Safeway supermarket's relatively upscale product positioning, and higher interest rates to lessen the pension liability, the future looks like an inexorable journey to a train wreck.
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