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Investors seem to be perennially underestimating Safeway Inc. (NYSE:SWY). Although rumors have persisted that it is losing market share, the company has stated in conference calls that it has gained market share from all formats since second quarter of 2012. The company cited Nielsen for this data and declared that first quarter of 2013 was the fourth consecutive quarter of market share gains. In the first quarter of 2013, Safeway also demonstrated the strongest same-store sales comps since the third quarter of 2008 with a 1.5% increase in same-store sales.

The "Just for You" loyalty campaign and gas rewards program were credited for helping with the good results. The roll out of the "Just For You" loyalty campaign in 2012 at Safeway was aimed specifically at big-box retailers and it appears to be having an effect. Top grocer Wal-Mart (NYSE:WMT) experienced a contraction in same-store sales for the first quarter of -1.4%. "Just for You" uses consumer purchase information to detect which products are not being purchased at Safeway, then sends the consumer a coupon for those items. This reduces the attractiveness of heading to a Wal-Mart or Target (NYSE:TGT). In general, shoppers prefer better quality, convenience and choice of items at a local supermarket, but they will trade down for better price. If this incentive is removed, the consumer stays with the local market.

Safeway has a leading position in many major metropolitan areas. This helps with the distribution and economics revolving around the all-important circulars. The weekly ad specials, or circulars, are the most important driver in the grocery industry. Shoppers use them to plan meals and purchases for a given period. Target and Wal-Mart have difficulty attracting shoppers for meal-specific and full-spectrum pantry stocking missions. Both stores compete poorly in meat and produce, and usually lack hot foods or floral departments. Shoppers may prefer Safeway for other reasons as well. The company was ranked No.1 in the U.S. for seafood sustainability, among other green awards.

As an investment, Safeway has also returned over $2.5 billion to investors over the last two years through share buybacks and dividends. Additionally, the company has the potential for a credit upgrade from Moody's and S&P later in the year or in 2014. We expect the company to move from an average rating of BBB/BBB- to BBB+/A- as debt is reduced to less than 2x EBITDA and the economy recovers. Planned debt reductions in 2013 and 2014 will increase pre-tax net income by $55 million per year. The company has stated in conference calls that total debt will be reduced to $4.8 billion by year-end 2013.

Economy is the most important factor for Safeway. In general, supermarkets are sensitive to the economy and they experience strong rebounds in economic recoveries. Stronger economic conditions allow them to charge slightly more for the average product. Considering the low profit margins of supermarkets, this can be extremely beneficial. Safeway increased its operating profit by 68% from 2002 through 2006 as the U.S. recovered from the year 2000 recession. If the current economy begins to rebound, this will most likely benefit Safeway.

We think there are further indications of strong value. Safeway has an extensive network of distribution, manufacturing and food processing facilities and is a dominant player in the West Coast supermarket game. As stated in the company's financial documents, Safeway owns most of its store base and distribution facilities. In the company's financial filings, the original purchase price of this real estate is carried at $8.7 billion for the land and buildings. Since Safeway is over 75 years old, we believe, on average, that the real estate values have increased and could be worth closer to $15 billion or $60 per share today. To create a Safeway today, the cost would range between $25 billion and $30 billion, or more than $100 per share.

There has been speculation regarding the spinoff of some of the real estate by paying a dividend in REIT shares directly to shareholders. The company addressed this at the annual analyst meeting. Such a spinoff could put a tax free share dividend of $20 to $30 per Safeway share in investors' hands. Safeway plays an active role in real estate investment. The company has its own PDC or property development corporation. Safeway uses the PDC to develop commercial properties in which it is the anchor tenant and then it may sell all or portions of the property for a profit.

One of the strongest facets of Safeway was the creation of Gift Card subsidiary Blackhawk (NASDAQ:HAWK). Blackhawk was created internally by Safeway and has grown over 200% since 2008. Blackhawk sold over $8.5 billion in gift cards in 2012 and is growing. Safeway conducted a small IPO in early 2013, raising over $250 million for Blackhawk. The company continues to hold on to close to 40 million shares of HAWK, valued at roughly $1 billion. This equates to a value of about $4 per Safeway share. Since Blackhawk is expanding margins and revenues in the growing electronic payments or interchange market, the shares could rise in price.

Since Safeway has the 19th lowest PE in the S&P 500 and ranks in the top 10% or so as far as dividend size, we believe that the shares are undervalued in the twenties. We project the earnings to top $2.50 in 2013 and rise to $3.10 in 2014, resulting in 25% earnings growth and possibly a lot of upside for investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Clients of Broxton Capital are long SWY.

Source: A Bull Case For Safeway