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Many of my colleagues and I are currently long Safeway (NYSE:SWY) for its industry leading valuation and strong growth potential. Last night's sale of Safeway's entire Canadian portfolio of branches to Sobeys and a resulting after-market share price surge, that reached a high of 34%, has raised the common question: Do I hold on through the breakout or do I take profits and look for a better entry?

The goal of this article is to lay out, for everyone curious about how this event might affect Safeway's share price, how the recent injection of $5.8 billion of cash will exchange for the loss of all 200-plus operating Canadian stores. Furthermore, it will attempt to offer a broad guidance for the short term share price.

Due to the time constraints of these types of decisions under uncertainty, one must make the least number of assumptions. Unfortunately, this type of analysis leads to a wider range of possible prices. We will therefore begin with the quantitative foundation and further incorporate qualitative knowledge, in the conclusion, to narrow our results and help make an informed decision.

Fundamentals

As of market close on June 12, 2013, Safeway's fundamentals were (taken from Charles Schwab database):

  • Market Cap: 5.57B USD

  • P/E: 9.46 (vs. industry 15.06)

  • P/forecast earnings: 9.97 (vs. industry 14.81)

  • P/S: 0.13 (vs. industry 0.96)

  • P/CF: 3.26 (vs. industry 12.84)

  • Dividend: 3.43% (vs. industry 2.86%)

Canadian Branch Operations

Safeway Canada represents a significant component of Safeway's operations. It boasts 6.6B USD in revenue, 419M USD in operating profits and 544M USD in EBITA in the trailing twelve months that ended March 23rd, 2013.

In relative terms, after the sale of Safeway's Canadian division, Safeway will sacrifice roughly 15% of its current revenue and 23% of its EBITA. It is a reasonable preliminary assumption that Safeway will lose roughly 15-23% of its share value as a result. This represents a loss of 3.47-5.32 USD per share.

I would further emphasize that the share value loss on operations will likely be closer to a 15% loss since the highly competitive consumer staples industry is mostly market share driven and will therefore be more highly affected by changes in revenue than EBITA.

Division of Cash Injection

In the same article, Safeway officials report that, after taxes and expenses and currency conversion, the company will be receiving 3.92B USD for the sale.

  • Half of this money, 1.96B USD will be used to pay down debt.

  • Slightly under 1.96B USD will be used to buy back shares

  • The remainder will be used to invest in growth opportunities

To determine a lower bound for the short term share price equilibrium we must assume that rational investors will immediately benefit from the cash used to buy back shares. This amounts to a gain of slightly under 8.13 USD per share or 35% from the disclosed information given.

It is quite a coincidence, after looking at these number, that the ask price immediately jumped up 8 USD or 34.6% after the news was released.

Incorporating Additional Allocations of Cash

The sum of 1.96B USD will be used to pay down debt, essentially reducing leverage risk. A small undisclosed amount will be used to invest in growth, which could motivate investors to reward this company with a stronger price to earnings ratio than it historically has experienced. These allocations combine to represent non-immediate benefits to shareholder value.

These figures are used to construct the upper limit gain of 16.26 USD per share.

Future Outlook

The full range of this analysis, after subtracting the future value lost in operations from the immediate share value gains, shows a gain of 2.81-12.79 USD per share. In relative terms, this represents a gain of 12.2%-55.3% on today's (Wednesday] closing price of 23.11 USD.

To narrow the range, we must assume that investors value Safeway on its market share and sales over EBITA. This will bring our lower bound gain to 4.83 USD per share or 21% while maintaining the upper bound of 55.3% given successful growth investments and the positive shareholder reception of the debt reducing strategy.

Moving Forward

It seems the after-market reacted very rationally to the news. Safeway shares settled at 29.97 USD after market from 23.11 USD at market close (a 29.68% gain).

Some Downside Risk from 29.97 USD

I find it very unlikely that the price will end up under 30 USD per share tomorrow barring the event of very poor overall market and sector performance as the fear of Fed tapering grows.

High Upside Potential

On the positive side, I believe that Safeway is in a great position to experience a short squeeze. Currently, Safeway has 49.3M shares short which represents 21% of the float and requires roughly 10 days to cover. We can be sure to see some margin calls tomorrow after such a drastic share price surge this afternoon.

Safeway's exit from Canada will allow operations to focus on a much narrower and more focused audience in a single Country. Margins will likely improve as a result.

Finally, even with a recent loss of working capital, Safeway still maintains industry leading price to earning, book, revenue and cash flow ratios. I suggest hanging onto the stock if you were already fortunate enough to be holding it. My current price target is 33 USD.

Source: Safeway's Exit Out Of Canada, The Math Done For You