Shop at Costco, Invest in Safeway

Investing is a lot of hard work. The time one has to spend staying current on existing positions, analyzing candidates for new positions and staying on top of macroeconomic events that could take a heavy toll on your portfolio despite the quality of your individual investments, can quickly add up. While we have been blessed with a number of powerful tools, we have also been cursed with access to so much information that the signal to noise ratio is rapidly diminishing.

When looking for new investment opportunities, I have found it useful to look back at positions I once held but are no longer in the portfolio. If an old position is now at an attractive price, it saves me the time required to familiarize myself with the company, the sector it operates in, seasonal effects if they exist and the price history of the stock.

I recently started thinking about Safeway (SWY), a company that we sold from the SINLetter model portfolio back in November 2006 at $30.81 for a gain of 22.65%. The stock has lost nearly a third of its value since last 2006 but at the same time its balance sheet has gotten stronger and its earnings have increased. The world we live in now is quite different from the one we were in 2006 and a deep recession combined with P/E contraction easily explains the drop in Safeway's stock price over the last two years.

I was originally attracted to Safeway back in early 2006 because of the potential for its "O Organics" line of products. Safeway executed very well with this private label brand by introducing products that not only had a great taste profile (their O Organics Blueberry jam is a personal favorite) but were also positioned right next to conventional products instead of being hidden away in a separate organic section. The brand has been so successful, that the company is now in the process of selling these products through other retailers both domestically and overseas. As mentioned in this Wall Street Journal article, Safeway has already signed up 240 Albertson's stores, 150 ShopRite stores in South Africa and 100 Exito supermarkets in Colombia. Essentially Safeway is at the verge of becoming a grocery store chain as well as an organic/natural food products company like Dean Foods (DF), all rolled into one.

Safeway is also positioned well for consumers who are downgrading from Whole Foods (WFMI) during this recession. I have been seeing an emphasis on local produce at my neighborhood Safeway and the company is stepping up efforts to source 30% of its produce locally. Based on the product I want to buy, I alternate between Safeway, Whole Foods and Costco (COST) but the majority of my shopping is done at Costco. Every time I enter a Safeway or Whole Foods, I am usually in a state of price shock as they sometimes tend to charge almost twice the price for the exact same products I buy at Costco (lovers of Oroweat Whole Wheat bread probably know what I am talking about).

As an investor however, I see this translating into better margins for Safeway. To verify that this is indeed the case, I decided to do a comparative analysis of these three grocery chains and also threw in Kroger (KR) for good measure as you can see below.

Comparative Analysis: When I pulled the numbers for Safeway and compared it with other grocery store chains, they confirmed what I noticed in the stores. Safeway not only has better margins than the rest of the group but also sells at a cheaper valuation when compared to other grocery store chains and sports a higher dividend yield. While Safeway's overall balance sheet is more leveraged that Whole Foods or Costco, the company has a better current ratio (current assets divided by current liabilities) than Kroger and is almost on par with Costco.

click to enlarge image

Comparison of Supermarkets (June 30, 2009)

Risks: The key problem that Safeway faces along with most other supermarkets is declining revenue in a very difficult economic environment. Safeway has been cutting costs but that will only help to a certain point. Hopefully the roll out of the "O Organics" brand to other supermarket chains at a premium price point will help the company grow both revenues and margins through this downturn.

The other risk weighing Safeway down is the potential of a worker's strike in Colorado. The 2004 strike in Southern California hurt Safeway's results and that episode is still on investor's minds as they keep an eye on the developments in Colorado.

Conclusion: Shop at Costco but invest in Safeway.

Comments

[psonava:]

I may have missed it but did you calculate in the fact that anyone that shops at Costco pays an annual membership fee that goes straight to their profit margin?

Jul 08 11:22 AM

[Big Bear La...:]

Most small business owners pay $100 membership fee annually but its recovered by 2% costco rebate and buying gasoline there with AMEX rebate card saves 3-5% on cheapest gas in town. So it doesn't go straight to their profits.


On Jul 08 11:22 AM psonava wrote:

> I may have missed it but did you calculate in the fact that anyone
> that shops at Costco pays an annual membership fee that goes straight
> to their profit margin?

Jul 08 01:24 PM

[Asif Suria:]

@psonava You are absolutely right about Costco making most of their money on the membership fees. I am quoting from memory here and so don't hold me to the number but I believe they get more than 60% of their profits from membership fees given how low their margins are on the products they sell.

Big Bear almost makes a good point about rebates. I have an executive membership and get back almost as much money in rebates as I spend on the membership fee.

At any rate, I don't have to specifically calculate the membership effect because it is included in operating margins and Safeway's operating margins are better than Costco's even without membership fees.

Jul 08 07:12 PM

[Mark kastel...:]

It should be noted that the jury is out in terms of the organic consumer's opinion of Safeway's organic product line.

Their organic milk comes from Aurora Dairy which owns five massive factory farms and was found by the US Department of agriculture to have been "willfully" violating federal organic standards.

After the Bush administration let the corporation off with, in essence, a one-year probation, after career civil servants recommended banning Aurora from organic commerce, consumers from around the country sued Aurora, Wal-Mart, Costco, Safeway and others alleging fraud.

To succeed in the organic marketplace it is imperative to have the respect and confidence of the sophisticated organic consumer.

Mark A. Kastel
Senior Farm Policy Analyst
The Cornucopia Institute
Cornucopia, Wisconsin

Jul 09 08:29 AM

[Asif Suria:]

Interesting thought Mark. Thank you for sharing with us.

I noticed your 2006 paper about Wal-Mart rolling out its organic initiative. Who would have imagined a few years ago that Wal-Mart would one day become the nations largest purchaser of organic milk and cotton.

What are your thoughts on Dean Foods, another company on my radar as a potential investment?

Jul 09 05:50 PM