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Safeway Inc. (NYSE:SWY)

Q2 2009 Earnings Call

July 23, 2009 11:00 am ET

Executives

Melissa C. Plaisance - Senior Vice President, Finance and Investor Relations

Steven A. Burd - President and Chief Executive Officer

Robert L. Edwards - Chief Financial Officer

Analysts

John Heinbockel - Goldman Sachs

Edward Kelly - Credit Suisse

Scott Mushkin - Jefferies & Co.

Simeon Gutman – Canaccord Adams

Regina Russell for Charles Grom - JP Morgan

Deborah Weinswig - Citigroup

Mark Wiltamuth - Morgan Stanley

Meredith Adler - Barclays Capital

Bob Summers - Pali Capital

Operator

Welcome to the Safeway second quarter 2009 conference call. (Operator Instructions) I will now turn the call over to Ms. Melissa Plaisance, Safeway's Senior Vice President of Finance.

Melissa C. Plaisance

Good morning everyone and thank you for joining us for our second quarter 2009 earnings conference call. With me this morning is Steve Burd, our Chairman, President and CEO, and Robert Edwards, our Executive Vice President and Chief Financial Officer.

Before we begin, let me remind you that this conference call may contain forward-looking statements. Such statements may relate to topics such as sales, margins, earnings, earnings growth, operating improvements, cost reductions, capital spending, debt financing, dividends, free cash flow, growth of Blackhawk, depreciation, product development, Lifestyle stores, additional growth vehicles, guidance and other related subjects. These statements are based on Safeway's current plans and expectations and are subject to risks and uncertainties that could cause actual events and results to vary significantly from those implied by such statements. We ask you to refer to Safeway's reports and filings with the SEC for a further discussion of these risks and uncertainties, including those set out under forward-looking statements and risk factors in Safeway's annual report to stockholders included in Safeway's most recent Form 10-K and subsequent quarterly reports on Form 10-Q.

And with that, let me turn the call over to Steve Burd.

Steven A. Burd

Let me start with net income. Net income for the quarter was $238.6 million, which compares to a net income last year same quarter of $234.3 million. Expressed in terms of earnings per share, we earned $0.57 per share this quarter as contrasted with $0.53 per share for the same quarter in 2008.

Let me just start by trying to give you a couple of highlights on the quarter before we get into some of the details. For starters, tax benefits, as expected, contributed significantly to the second quarter earnings. I think last time, as we faced our first quarter call, we anticipated about $0.11 a share in tax benefits. Those tax benefits actually came in at about a $0.14 level.

In terms of ID sales, ID sales were soft, largely due to a significant change in the average ring per item. I will talk more about that in some detail. O&A expenses, we believe were well-controlled but we were unable to overcome the ID sales decline.

In terms of free cash flow it was a very strong quarter helped out by the fact that we received a $160.0 million in cash as a result of a refund from the federal government.

In terms of sales, total sales declined 6.5% versus last year. This decline was largely the result of three factors, again, I'm looking at total sales: we've got lower fuel prices, which wouldn't be news to anybody on this call; a decline in the Canadian exchange rate, although that exchange rate is improving, it's still a decline from last year; and then finally, a decline in the average ring per item.

Looking at ID store sales, excluding fuel, they were negative for the first time in 18 quarters. We had a negative 1.5% ID before adjusting for Easter and we had a negative 2.2% ID sales number after adjusting for Easter. While the ID sales results were clearly disappointing, we were encouraged by our transactional and volume trends in the quarter.

Our perishable volume was the best result that we've had in 9 quarters. Our non-perishable volume was the best result we've had in 4 quarters.

The negative IDs resulting from these volume trends are driven by factors that we believe to be temporary, but let me try to give you a breakdown of the most important one.

We've been talking about deflation in two key commodity areas, dairy and produce, now for several quarters. And of course, we've been trying to predict exactly where that has been headed. We have not been correct on that. The deflation is deeper and more sustained than we had earlier predicted.

If I just look at produce and dairy, that deflation reduced ID sales for the entire company about 1% in the second quarter, and that will actually be a deeper effect in the third quarter.

We have been talking about trading down. I have often talked about the trade down to corporate brand. That's a good thing from a profit standpoint. That continues. We have a trade down from branded to generic drugs. That's a good thing from a profit standpoint. That has continued.

And I suspect those two elements will continue, particularly the corporate brand, as long as the economy is still in decline. I think once the economy stabilizes the trade down in the corporate brands will probably stabilize, but for the fact that we have concerted strategy to try to drive that as a profit driver.

And what we've tried to do is to take all other categories, which early on in the recession it was difficult see and measure trade down, but now we see that really across the board in virtually all categories.

When I add up those three components, it is close to 90 basis points of effect on total ID sales for the quarter.

And then, as all of you know, we have a strategy to invest in price to get to those magic price points in virtually all of our markets that we believe will sustain long-term sales and income growth for us. And that was about 50 basis points in the quarter.

Now if I just give you a window into the first four weeks of the third quarter, our perishable volume trends have further strengthened. We are on pace to have our best perishable volume, or if you want to think of it as tonnage, quarter in 11 quarters.

At the same time, we are experiencing our greatest deflation in 17 years, which means that the spike of those strong numbers of perishables, there's a good chance that the perishable ID numbers in the third quarter could be negative.

Our non-perishable volume is also on an improving trend and we are on pace to have our best volume tonnage quarter in 5 quarters. The deflation in produce and dairy we now believe will increase in quarter three and then we expect it to let up in quarter four, although I'm reluctant to try to give you a number on that, but common sense would tell us that it just isn't possible for it to not let up.

We expect 2010 to look very normal by comparison, creating the opportunity, we think, for volume increases and ID sales increases at the same time.

Maybe to just give you a little color on some of the perishable stuff, because unless you live this day-to-day you can't really appreciate this. Quarter two cost of milk was down 27% versus a year ago, eggs down 15%, cheese down 17%, butter down 14%. Turning to produce, apples down 23%, tomatoes down 13%, citrus down 68%, and during the cherry season, cherries down 42%.

So when you experience that kind of cost of goods decline and you've put normal, traditional margins on these products, you've got to appreciate that your average rate is going to come down.

Now trading down, we believe, should lessen as the economy hits bottom and starts to recover. Our price investments are also expected to moderate considerably in 2010 and frankly, I think normalize. And normalize to me means that cost reductions should be able to absorb any additional price investment that we have to make.

Turning to gross margin, our total gross margin rate increased 56 basis points but that includes fuel. When you exclude fuel sales, the gross margin on a non-fuel business, declined 43 basis points. This decline is largely a result of investments in price, with again, some improvements in mix, you know, on corporate brand, partially offset by some lower energy costs and lower LIFO charges as we see inflation just completely disappear.

On the O&A expenses, O&A expense increased 124 basis points from last year's second quarter. Again, when you exclude fuel, which is, I think, the best way to look at this, the O&A expense ratio increased 35 basis points.

Now this increase in O&A expense is largely due to a decline in the referred sales number. We actually believe that expense were well controlled. You essentially got no leverage on the sales side and so all of the fixed costs associated with occupancy, things like pension, those things just you don’t get any leverage on a negative sales number.

In terms of interest expense, interest expense, while it's a small number, I think it's important in terms of its direction. Interest expense declined for us $4.5 million due to lower average borrowing, offset partly by a very modest rise in the interest rates.

Our average debt outstanding declined by $375.0 million while the average borrowing rate increased from 5.95% to 6%.

Now earlier in the quarter S&P had placed Safeway on the negative watch, pending a review of our exposure to some underfunded multi-employer pension plan and after a thorough review—you may have seen a press release on this—they reaffirmed our rating.

And that's very important because it allows us to continue to have access to more than a billion dollars worth of commercial paper when the vast majority of our conventional competition does not have that access. And our overnight borrowing rate on that commercial paper today is 0.5% so when we have to borrow, that's a nice source to have.

Over the past seven months we've borrowed as much as $800.0 million through that commercial paper line and we had $555.0 million outstanding at the end of the quarter.

In terms of capital expenditures, we completed one new store and 36 Lifestyle remodels during the quarter, which is exactly the pace that we wanted to be on this year. Year-to-date we've completed two new stores and 46 Lifestyle remodels. As a result, we now have 76% of our stores that are currently in the Lifestyle format.

On a year-to-date basis we have invested $445.0 million and expect to spend about a billion dollars this year, which should include opening 10 new stores and completing 90 Lifestyle remodels.

Turning briefly to income taxes, our tax rate in the quarter was 15.9%. This compares to last year's second quarter rate of 37%. We expect the full year tax rate to be approximately 30%, maybe 30.5%.

In terms of cash flow, free cash flow for the quarter was $595.8 million compared to $442.0 million for last year's second quarter and free cash flow for the first half was $409.1 million compared to $238.0 million last year.

To give you a brief update on Blackhawk, the value of total card sales—this is what we offer in terms of face value of the card—increased 24% for quarter two and that leaves us at 25% for the first half of this year.

The sales of closed loop partner cards are an interesting one to follow because essentially those cards represent the gift cards of a lot of retailers who are going through the same kind of economic events that we are. The sales of the closed loop partner cards increased 22.4% in the quarter and are growing at a rate that is much faster than our partners' own card sales.

Year-to-date we are on plan for Blackhawk, both in terms of face value card sales and earnings.

In terms of other notable events in the quarter, we purchased 9.5 million shares of common stock at a total cost of $185.8 million. That still leaves us with a remaining board authorization of about $900.0 million.

While not a second quarter event, certainly a newsworthy event between this call and the last call, you recall in the second quarter of 2006 we received a $318.0 million federal tax refund. I think at the time we told you that we had made filings with the state, looking for a state recovery, and we did receive, a couple of weeks ago, a nice $43.0 million check from the state of California, which again, adds to our cash flow. Not free cash flow in the sense of how it's measured. This does not flow through the income statement, it simply is an addition to paid in capital.

And you recall from our last call that essentially, over the last ten years now, while people often don't like to give income credit, we had generated a billion dollars through the efforts of our tax department in getting refunds in something north of $500.0 million I think Robert has actually closed for the income statement.

Turning finally to guidance, which we put in our press release, we are adjusting our guidance for 2009 and there are really four basic reasons for doing so. First of all, the economy is not performing as well as we had expected it would at this time. I would go further and tell you that early on in the second quarter we saw a measurable downshift in that economy and the attitude of consumers and how they feel about their own purchasing decisions.

And of course, you can also see that that was reflected in a declining consumer confidence after it had recovered to something in the 50s it then dropped down. And that was reflected in our numbers. So we were never predicting that the economy would necessarily recover in 2009 but we didn't expect another drop.

Secondly, the competitive environment has required much greater prices than we had planned. And I think part of the explanation for that is that if all you do is look at ID sales, you know, for most people in our sector, you would see some negative numbers. And if you look beyond that at transactions, you look at households, you look at tonnage and volume, that's where we see some good news in our numbers. Obviously not everybody would have that.

What I sense is a bit of an overreaction to a declining report in sales. And so I would say it's just a tougher competitive environment.

The reason is that deflation, as I indicated, is much greater than we had anticipated in these two commodity areas, which represent almost 20% of our business.

And then finally, trading down has accelerated.

Now, if I tried to put a number to each of these events, I would tell you that the economy and competition represents about one-third of our change in EPS guidance, deflation represents about one-third, and trading down represents about another one-third. It's not fine science but those are generally good numbers.

So on the ID sales front, we had guidance out there of a positive .5% on the low end to a positive 1.5%. We are now saying that on the low end it could be as low as a negative 1.7% and on the high end a negative 1.0%.

In terms of EPS, we were $2.10 to $2.30. That range now goes to $1.70 to $1.90 and you may think of that as a broad range at this particular point, but again, there's enough uncertainty out there that it's a range that is comfortable.

And then in terms of free cash flow, our guidance has been $1.1 billion to $1.3 billion and there's no change in that guidance. We should be in that range.

So with that, Melissa, I'm prepared to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from John Heinbockel - Goldman Sachs.

John Heinbockel - Goldman Sachs

Your transaction count is up. Is that more existing core customers shopping more frequently where you actually think you're picking up some additional share? And if you think you're getting more share, where?

Steven A. Burd

It's not just transactions, it's household. So it's the households. When household counts are up, those are new households.

John Heinbockel - Goldman Sachs

So you think it's share or can you measure that?

Steven A. Burd

I still think we're not at the point where we're gaining share. But as I look at, particularly our trends in the third quarter, we are getting very close to gaining share.

John Heinbockel - Goldman Sachs

And if you look at the ROI on the price investments, we've talked about this in the past, how is that tracking today? Is there just something you've got to do in the ROIs, that will never be great in the short term or do you think it's actually getting better because of how you're spending the money?

Steven A. Burd

There are two varieties of price investments. As you know, we're very focused on providing good price points that represent everyday value so the difference between regular prices and promotional prices are basically narrow.

And in terms of those price investments stand alones, we feel very good about those price investments.

Other investments have been made for competitive reasons and if someone moves then we have to move.

And I'll give you a category. Let's take milk. I've been at this for 17 years. In 16 years when the cost of milk went down, essentially we maintained our pace profit. That's not happening in 2009. And the reason it's not happening is a number of competitors have chosen to use milk as a traffic builder and therefore what you have is a real profit squeeze in that category. And there are other examples to that.

So the good news here is when you consider our financial strength—balance sheet, borrowing power, etc., and you consider that we compete with as many non-public companies as we do public companies, there is just no way that most of those companies that we compete with in the conventional sector can possibly keep up with us. And so we see a lot of weakness across our geography and I'm going to stay below the radar screen on competitors. You've all seen one bankruptcy; you will probably see others. They may not be on that scale, but you will see others.

John Heinbockel - Goldman Sachs

And I know you don't like to talk geography, but is California a disproportionate problem or will it get worse or it's not really a disproportionate issue?

Steven A. Burd

It's not a disproportionate issue and if you look at unemployment here, it's higher than other parts of the country. That's also true in places like Oregon. But I don't really think that the unemployment—there are some counties that might be 25% and you would be affected there. But I kind of looked at this thing geographically and I don't think that geographically we are disadvantaged on the unemployment side as I've looked at ourselves and some of the other publicly traded companies. I think we're all basically in about the same situation.

John Heinbockel - Goldman Sachs

Given the reduction in profit guidance, is there still sort of a commitment to the buy back, for that to be a big part of use of free cash for the remainder of the year?

Steven A. Burd

Absolutely.

Operator

Your next question comes from Edward Kelly - Credit Suisse.

Edward Kelly - Credit Suisse

Could you explain a little bit further as to why trading down accelerating is a reason for lowering the guidance? Is that because it's trading down out of higher margin items into lower margin items?

Steven A. Burd

In the corporate brands and generic, that's not an issue, but when you trade down from a medium or even expensive bottle of wine to a lower price point, there's going to be a lot less there. And we are basically seeing people trade down in virtually every category, from 10% fat-content ground beef to 80%, from floral bouquets to maybe just a dozen roses.

So basically, in every category we have been able to identify a trade down, and if the price trades down even if you had a very similar margin, that's going to affect your income.

Edward Kelly - Credit Suisse

You started to get much sharper on prices maybe about a year ago and I think some would argue that it takes at least this long to begin to improve your value image. But if we could get your thoughts on when you think the market share gains from this strategy actually start.

Steven A. Burd

It's a little hard to predict. It's always been my view that the foot traffic responds to price change quicker than you run the survey. In the consumer survey. But there are things you can do through your marketing that if you can improve price perception while simultaneously improving price, you get a larger and quicker lift. So you will see us do both of those as we move through the balance of this year.

And so the bottom line is I think that we should be in a great position in 2010. I think we're in a great position if the economy merely stabilizes and frankly, if it actually starts a recovery, we'll be in a terrific shape.

Edward Kelly - Credit Suisse

And just to elaborate on the question that John asked about buy backs. You know, you have $500.0 million in debt coming due in September. Is it your goal to refinance that and then buy backs become a much larger percentage of your free cash flow use? How should we think about that?

Robert L. Edwards

You're right. We've got $500.0 million maturing on the 15th of September and right now we plan to refinance the entire amount.

Steven A. Burd

And if you look at the coupon rate of that debt, I think it's like 7.5%.

Robert L. Edwards

7.5%.

So in today's interest rates for us, are considerably lower than that. So the refinancing allows us to buy back more stock than we could if we didn’t do that.

Operator

Your next question comes from Scott Mushkin - Jefferies & Co.

Scott Mushkin - Jefferies & Co.

I just wanted to try to reconcile. I think Steve said that volumes were up, transactions were up, and households were up, but you're not gaining share. It seems if all those three things are going right you should be gaining share. So I was just trying to reconcile that a little bit.

Steven A. Burd

What I said, and I broke it between perishable and non-perishable. I'll give you a general description, then I'll break between perishable and non-perishable. If we look at transactions, they've been positive now for three or four quarters. In terms of households, that is also a positive and growing trend.

Then when you look at the tonnage, or what I call volume, and you look at the perishable side, in the second quarter you are basically flat on the perishable side and then if you look at the first four weeks of this quarter, I would say dramatically up.

And then if you look at the non-perishables, what I said was that we had our best result in four quarters and now we're seeing in the third quarter our best result in five quarters, that volume number is still a negative number. Right? And that's why we're still losing a little bit of share. Does that make sense to you?

Scott Mushkin - Jefferies & Co.

Yes, that's a great clarification. The second thing I wanted to poke at was your comments about employment. As we look at your markets and what you faced out there on the West Coast, it's the delta, the change that you've seen in a lot of your markets, you know, San Jose, Portland, all the way up the coast, that it's pretty stunning to see 500 basis points to 800 basis points in deterioration.

So I'm a little surprised, especially with your comments about the trading down, that you don't think unemployment rates are feeding into that and having an outsized effect on Safeway, especially given your positioning.

Steven A. Burd

Here's just to clarify. There's no question that unemployment has affected consumers' behavior, which is the economy effect that I talk about. What I was trying to answer with John's question is that I don't think we're disproportionately harmed by that. I actually took a look at the unemployment by state and the reason we may not be disproportionately harmed, is that you're looking at markets where we are very, very strong. And the stronger your brand, the better you weather these kinds of conditions.

And so in Northern California we're very strong and compete with only private supermarket companies. And then we have very strong market positions and brand presence in the Northwest. And so I think those sort of moderate the effect that you would get from big changes in unemployment.

So it does hurt the business. I can't sit here and tell you that we're hurt more than some of the other publicly traded companies.

Scott Mushkin - Jefferies & Co.

What is your confidence level that you're not going to come back to us next quarter and lower guidance again.

And just a quick update on any rebranding activities you're doing with the lowering of pricing. I heard you were going to do some of that and let people know and I wanted a little update there.

Steven A. Burd

In the old days, in the 80s, investment bankers used to, what was it Robert? They would write highly confident letters?

Okay, I would write one of those letters. In terms of the earnings guidance. Highly confident.

Scott Mushkin - Jefferies & Co.

So you feel like you [inaudible] basically with the $1.70 you $1.90?

Steven A. Burd

Yes.

Scott Mushkin - Jefferies & Co.

And any update on rebranding efforts in certain markets to let consumers know about your new value proposition?

Steven A. Burd

We've started that process and it actually will be done geographically.

Scott Mushkin - Jefferies & Co.

Have you started one? Have you done an area already?

Steven A. Burd

Yes.

Scott Mushkin - Jefferies & Co.

Do you want to say where?

Steven A. Burd

No.

Operator

Your next question comes from Simeon Gutman – Canaccord Adams.

Simeon Gutman – Canaccord Adams

Can we drill a little bit deeper on the competitive environment. Is the consumer cherry picking a little more? Is the primary customer changing actual supermarket? Is it channel loss or just the macro and a bunch of all things combined?

Steven A. Burd

If you look at what we would term our most loyal customer, where we have very large share of wallet, we continue to see great loyalty with that customer. I think as you move down that spectrum, in terms of share of wallet, you see less loyalty. The budget shopper is not very loyal at all. And I think as we look, not just at our numbers, but we can look at rest of market in the aggregate.

We don't know our competitors numbers but we look at rest of market, and we have traditionally been more promotional than virtually anybody we compete with. And so because of our movement to everyday price, we actually see a lower percentage of our business purchase on promotion. Although not much. And then rest of market, we see more of their business purchased on promotion.

And I think I understand our situation and I understand theirs and so I think that you do see shoppers today, particularly the budget shopper, shopping a lot more channels. Not just more conventional supermarkets, but more channels.

And so that's happened in every recession. And so it shouldn't be that unexpected. And we actually use the very term you used. We talk about the cherry picker. And so you try and design your marketing program in such a way that you can be cherry picked. You will find people come in and just buy those items, but if you really design it correctly, you don't have an abundance of that going on. Because that would really hurt you from a P&L standpoint.

Simeon Gutman – Canaccord Adams

And is it too early to start looking at budget shopper purchases and maybe you are bringing them back for certain things but it's hard to say if they are going to increase their spend with you when the economy at least stabilizes?

Steven A. Burd

When I talked about households being up, part of that is probably some of that cross-shopping. But we see, as we concentrate on certain categories in the store, we not only see loyalty to those categories, but we see new shoppers coming into those categories and buying them. And that's the strategy.

Simeon Gutman – Canaccord Adams

And then on the gross margin. First quarter definitely looked like an anomaly. I think this quarter proved it out. But now you're sitting on that tax gain, which I think the idea was to incrementally invest it, does that mean you accelerate the rate of investment or some of the lessons learned from the first quarter means that it's not going to go up much from where it is today?

Steven A. Burd

I think that what you see in terms of the gross margin effect this quarter, that's kind of a normalized but higher level of investment than we had planned at the beginning of the year, largely driven by competitive circumstances. Plus the fact that in an elongated recession, where you want to get some price adjustments in place, you should be in a bit of a hurry to make that happen.

Simeon Gutman – Canaccord Adams

On deflation, it almost is implicit that even know some of these categories are deflating, the tonnage is not completely offsetting it, and the question is, if we get back to less deflation or just slight inflation, and this is more just a guess, how does that affect demand? Do you think the customer could even cut back more or there's just not much more to go?

Steven A. Burd

I think we'll continue to see some trading down. I think the consumer needs to have some confidence that we're hitting their bottom. If I were to look at the categories of deflation here in the third quarter and I were to look at the volume trends, the volume trends right now in the third quarter are—you can't overcome 27% price declines—but the volume trends would be indicative of gaining market share.

Operator

Your next question comes from Regina Russell for Charles Grom - JP Morgan.

Regina Russell for Charles Grom - JP Morgan

I wanted to touch base on the price investment once more. The 50 basis points of investment that you made in Q2, is that just a true price investment or did that include any promotional activity? In other words, is it comparable to the 32 basis points in the first quarter?

Steven A. Burd

It is comparable. Keep in mind that that gross margin result is a combination of your promotional investments and your changes in everyday price and so both of those concepts are embedded in there. And as we lower our regular prices on those items that people purchase most often, what happens is that the gross margin investment becomes a slightly richer mix of every day price change relative to promotion.

But you will see us be every bit as promotional as any supermarket we compete with.

Regina Russell for Charles Grom - JP Morgan

You mentioned that the price investment would moderate in 2010, as I think about the back half should we expect maybe this level of investment through the second half or should we expect it to moderate into 2010?

Steven A. Burd

It's driven by two factors. It's driven by what we plan to do to position ourselves where we think we need to be. And then it's driven by whatever competitive response we may have to make. But I think order of magnitude, what we see for the balance of the year, is similar to what you saw here in the second quarter.

Regina Russell for Charles Grom - JP Morgan

We've been hearing about price breaks on national brands. Is there any color that you can give us around that?

Steven A. Burd

In general, what we're not seeing are cost of goods increases and you are seeing more promotional money being available to finance some of these things, and in some cases you are seeing better costs.

So I think it's a very different environment from 2008 because the CPG world, many of them also struggle with their volumes and therefore, their sales.

Regina Russell for Charles Grom - JP Morgan

On O&A, looks like down 1.6% on a dollar basis in the second quarter. Again, as I look at the back half, trying to think about what other buckets or drivers that could propel that in 2H.

Steven A. Burd

I think if you think about last year, last year we were hurt a fair amount by a drop in the Canadian exchange rate, which has improved. And that has effects on both gross margin and O&A. My recollection, Robert, is almost evenly split. And then we also took a big hit last year on workers' comp because interest rates were so low. And right now interest rates on those calculations are running a tad higher than they were last year and I don't think any of us know exactly where those are going.

And then of course the LIFO charge last year was the highest in 17 years. So all of those factors get better. As the economy gets better and interest rates rise, our pension expense should moderate. But that's a not a 2009 back half number, that's a possibility for 2010. Did that help you at all?

Regina Russell for Charles Grom - JP Morgan

That does. And then one final question. We've been hearing a lot about the SKU rationalization activities that are going on with you and your competitors. I was wondering if you can give us any color on what's taking place and what's really driving that?

Steven A. Burd

I think that for us it's a major learning that we had from our first small store format. I think I've said on previous calls that we discovered that we could be more aggressive on the front without sacrificing sales and improving profit.

I think another factor that supports that, in this kind of economic environment, although I would argue that this is a good thing to do regardless of economy, but it's a lot more clear which SKU is sitting on those shelves are not moving very well and there's more motivation, both on our part as well as the CPG world, to take those off the shelf and concentrate on the brands that really work.

Operator

Your next question comes from Deborah Weinswig – Citigroup.

Deborah Weinswig - Citigroup

In terms of the new households that are coming into your store, how would you characterize this group and is there a way to also get a greater portion of their existing wallet?

Steven A. Burd

That's the strategy. If you think about our advertising, whether it be an insert or radio or TV, it's really all about attracting new customers. That's what we consider an invitation to people who don't normally shop with us.

And then once they get in the store, a combination of the environment, how they're treated by our employees, and how the store is merchandised, the feature items that we're really priced well at, that's how you intend to increase that share of wallet.

For example, we have a whole host of items that have high household penetration where we have a better price point than a typical club store or certainly, when on promotion, even mass. And that's generally not known to people. They don't necessarily think about that. And effective merchandising can really help them do that.

So our objective is when we bring people in, which we're now doing, at a greater rate than we probably have in a couple of years, is regardless of whether they think they're there for a quick shop or whether they're thinking about putting their loyalty in our hands, we're making progress really across the spectrum in terms of share of wallet. So we try to get the loyal to be more loyal and the next level down to be more loyal. And I think that we're making a good conversion and that's why the volume numbers are improving.

Deborah Weinswig - Citigroup

So is there also an opportunity, or are you already participating in more direct mail to your existing customer base?

And also the newer households that are shopping with you, is there an opportunity to increase your communication to continue to drive not only trips but volume?

Steven A. Burd

Absolutely. I think you know we have years worth of data on our customers and what they shop and what they're interested in. Now, we capture and retain that for real-time access. We only go back about 18 months, but that's more than enough information to provide a very targeted promotion and we do that on a regular basis.

Those promotions, as I think you know, if properly targeted have anywhere between 15 and 20 times the response rate of some coupon drop that used to be the practice, and still is, by the CPG community.

Deborah Weinswig - Citigroup

Returning to the store base, I think previously you had provided the goal of 88% of your store base seeing the Lifestyle remodel format by 2010. Is that still what we should be looking for?

And then also in terms of new store growth, we're hearing from a lot of retailers a lot of the dealership locations becoming available, that there's new opportunities for growth. How should we think about Lifestyle remodels and also [inaudible] growth going forward?

Steven A. Burd

I think that we have slowed our pace on the Lifestyle remodel. I think our number at the end of this year will be around 79% and the current thinking is that next year's plan will be similar in terms of magnitude, in terms of capital spend. So we have pushed that out a little bit but we feel comfortable in that.

On the dealership issue, I think that what might slow that down as an opportunity is just the current economic environment. But you're correct to think it's typically the parcel of land that some of those sit on. In fact, we have a high-volume store that I can see here from the office that sits on a lot that used to be a car dealership. And that was before all the big changes.

Now yesterday we heard that maybe the administration wants to give TARP money to a couple of thousand dealers. So who knows how much land is going to be available. So that's another sort of dynamic in this equation.

Deborah Weinswig - Citigroup

There are so many moving pieces, it's certainly difficult to assess, but should we think about your greatest opportunity going forward on the gross margin side or the O&A side if you're going to take top line out of the picture?

Steven A. Burd

I'm going to give you an answer and I'm going to try to give you relative value of sales, gross margin, and O&A.

I actually think if you look at 2010 it will probably be an equal dose of sales and gross margin. And the sales number, because I think we'll have deflation behind us, I think most people would forecast that sometime in 2010 things would clearly stabilize, which helps on trading down and consumer confidence and some other things. And most people would probably see some kind of recovery.

So I think sales will be a good opportunity. I think gross margin would be a good opportunity because we're going to be in a more normalized mode. I think we will forever be investing but I think there's a real opportunity in gross margin because if you're not fighting deflation, you have a much better opportunity to improve shrink results, which feed into gross margin.

And on SKU rationalization, you've got a much better chance to improve gross margins, although you have to be extremely careful about SKU rationalization because it's not as simple as taking the weakest brand out. If that brand has a fair amount of loyalty you have to be thoughtful about that.

But I think there will be opportunities in gross margin.

And then on the O&A side, we have really had an extraordinary year and expect to have an extraordinary year on the O&A side but it won't be as clear on the O&A as a percentage of sales because of how the sales will report.

But I would put O&A kind of in third place next year. I think sales and gross margin will be the greatest opportunities for improving income, followed by O&A.

Operator

Your next question comes from Mark Wiltamuth - Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

I wanted to get some sense of where all the price investments have been made. If you look at two different axes, one would be everyday cuts versus promotional discounting, and then the second axis would be how much are you doing on a regional basis versus chain-wide reductions.

Steven A. Burd

The major emphasis is on everyday. So that if you looked at regular prices—we monitor this, as you know, we do full book monthly price surveys. And those capture both the regular price as well as the promotional price. And you would see a real concentration in the everyday price. And again, that's focused on items that people purchase most often. So if the purchase cycle were every six months, it wouldn't be on that screen.

And promotionally those investments relate in part to what you think you need to do to attract traffic to the stores, and then if somebody sets a new promotional price point for a key item to attract, we have to respond to that. So I think that a lot of our promotional stuff is either driven by a perception that it will attract or in response to competition.

Mark Wiltamuth - Morgan Stanley

And the regional reductions where you might be out of bounds versus just the chain-wide reduction where you're going after those items that matter the most for consumers.

Steven A. Burd

What we did early on was we made essentially chain-wide investments in our corporate brands. And then we've gone at the national brands pretty much on a regional basis, with a roll out schedule. So that's a much more regional.

Mark Wiltamuth - Morgan Stanley

If you at those full book comparisons, how many markets do you feel like you're a little out of bounds?

Steven A. Burd

I would tell you that right now if I look at it in half of our geographies we would be exactly where we want to be. Say half the business exactly where we want to be. Now, where that puts usually, it actually puts us on a full book basis, shelf to shelf, it actually puts us equal to or lower than sort of the pace setter. And it always puts us lower than everybody else in the market.

So when you look at 13,000 items, which is what we typically match on with a conventional supermarket, and you weight that by volume of purchase, we're in a much better position than you guys pick up on another item sample.

And then if I look at the balance of our business, without trying to collect the sales, I can think of one, two, three markets where we're very close and then the balance we've got a little bit more work to do. But we know exactly what that is and we have a plan for it.

Mark Wiltamuth - Morgan Stanley

Given your big investment in differentiation and the ingredients for Life campaign, do you need to be below the peers to draw customers back or do you just need to be close?

Steven A. Burd

It depends on the strength of the brand. We have an overpowering brand, which usually translates into a very high market share, you don't need to be the low-price supermarket. And it depends a lot on the nature of the vehicle.

And probably the best example I can give you, which I've talked about frequently, if you were to look at—let's go outside the conventional competitive space and you were to look at a super center, we still, to this day in 2009, we Lifestyle a store that competes only with a super center, for which there is much greater price threat than there would be with a conventional player. And we have well into the double-digit sales increases.

And of course there's a real powerful differential between us and a super center, between us and a club format. And I would say for most conventional out there, there is a very strong pointed difference in terms of the look and feel of the store, the shopping experience, which includes the service effort that we've been giving now for some 14 years.

And so our belief is that when we have our prices where they need to be, and you're correct, it's not always the low guy, that that's when our points of difference, we can really exploit those. Because you don't want to drive a campaign that says we're almost where we need to be on price but we've got a great shopping experience.

When you can deliver the best quality perishables in the best shopping environment and you've got no competitive disadvantage on price, we think that's how you win.

Mark Wiltamuth - Morgan Stanley

I just want to switch over to the multi-employer pension issue. Clearly the rating agencies were looking at this as an off balance sheet liability issue but could you walk us through the income statement implications, because as those employer plans come up for renewal, I would think that would put some pressure on your labor costs.

Steven A. Burd

I'm going to do two things. As you would expect, we had quite a dialogue with S&P, including a group of us taking a trip to New York. And I carried most of that dialogue at S&P, but I've forgotten some of the details.

But in essence, their concept was to maybe treat this as some form of debt. And what we did with them was we don't think it should be treated with debt, and we made all of those arguments because it doesn't have to be repaid. But one of the major arguments, and we have a lot of history with this, is that when we go to bargaining tables, there are three variables.

One is pension, one is healthcare and one is wages. And we and the rest of the players in our industry, many of whom we are often negotiating with, we basically set an objective, financially, and all three of those variables have to fit beneath that.

And so in recent times what you saw was healthcare costs escalating at a very high rate, which left no room for wage increases. And now as you see us getting healthcare cost under control, you've got this little issue, thanks to the financial market deterioration, and it's created an unfunded liability on the multi-employer pension plan.

That gets corrected as the economy gets better. It also gets partially corrected in negotiations. And there was a pension reform act a couple of years ago that lays out exactly what that correction process is, so it's not something you have to correct immediately, it's correct, or cured if you will, over a 10 to 13 year period.

And part of that reform legislation talked about how you must address the benefit reduction inside the pension plan itself. And so if you go back really in time, this is probably more than you ever wanted to hear, but in the old days, before that pension reform act was passed, we actually were running up huge surpluses and we were threatened with losing our tax deductibility. So that's [inaudible] our industry an increase in benefits and now in these times we're able to roll some of those back.

So the bottom line is we shared with S&P that we thought it was a very manageable event and that we would manage it through the negotiation process over this 10 to 13 year period, we would conform to the law and even if you wanted to treat this as some sort of a quasi-off-balance sheet debt, we were able to demonstrate that our financial rations still would retain our credit rating.

We were also able to demonstrate that if we ever had to just write a check we had more than the financial wherewithal to do that.

So the bottom line is, for us, S&P got comfortable and no change in rating. And that allowed us to keep our access to commercial paper. You can certainly appreciate the difference between 0.5% in interest and 7.5%, which is the debt we will retire.

And so we think it's a quite manageable event and we were able to prove that to S&P.

Mark Wiltamuth - Morgan Stanley

I understand the debt side of the argument, but how about the income statement implication? Are your labor costs going to go up?

Steven A. Burd

No, we don't believe so because we constrain it by an overall objective and so let me give you an extreme case. If we had to cure something, I can't think of a single market where this would occur, but if the pension improvement absorbed the entire budget that we had allocated for an adjustment, then everything else would have to give. We have no experience in the last 12 to 15 years where that's occurred. And so basically, it's included in all of our projections and when you talk to S&P, you also provide them with much longer-term projections, going out some five years, and everything will be contained within those standard objectives when you go to the bargaining table.

And if you look, we have made real progress in terms of that entire labor/benefit cost as a percentage of sales over time.

Operator

Your next question comes from Meredith Adler - Barclays Capital.

Meredith Adler - Barclays Capital

You made a comment about in a deflationary environment it's hard to deal with shrink. Could you elaborate on that a little bit and talk about your outlook?

Steven A. Burd

In an inflationary environment, and let's just take the center of the store for a second, if you had even a moderate inflationary environment, you're taking those inventories in six-month intervals is the way we do it, and in all likelihood you put this on the shelf, it would have a higher value than the goods were six months earlier. And so that even if you had some shrinkage, it's basically a financial calculation about the value of the inventory. And the value of the inventory is either stable or frankly, it could be up a little bit. So that has a reflection in shrink.

If you had a decline in the cost of goods, and let's say you had no real shrink, but the value of the merchandise that goes on the shelf is less valuable than it was six months ago, and it's the identical SKU count, then that would show up as shrink.

Meredith Adler - Barclays Capital

Could you talk about in this quarter, LIFO was clearly down. That's what lots of retailers are saying. Could you talk about what the benefit was to Safeway from LIFO this quarter?

Steven A. Burd

Last year we were probably running at a pace of $8.0 million to $10.0 million a quarter, last year's LIFO charge?

Robert L. Edwards

Last year was $7.8 million.

Steven A. Burd

And basically we took the LIFO charge this quarter.

Robert L. Edwards

It was about $0.01 a share.

Meredith Adler - Barclays Capital

And basis points? I'm just thinking about the gross margin.

Robert L. Edwards

One second.

Steven A. Burd

Take that $8.0 million divided by the sales.

Robert L. Edwards

Looks like it's about 9 or 10 basis points.

Steven A. Burd

Yes. And the expectation here, and we look at this every quarter, the expectation here, based on what we're seeing is that clearly last year was the highest inflation—the year before was the highest in 15 years, last year was the highest in 17 years, and we're anticipating on our LIFO layers, for that to be pretty flat on the year.

Meredith Adler - Barclays Capital

Another question I have is about the remodels. I forget if you told us how frequently you think you need to do a remodel. You have to really have volume stores. Is there a point at which the first set of Lifestyle remodels that were done, you need to put some money in again?

Steven A. Burd

I think that the normal cycle, I call normal 8 to 10 years, you would be closer to 8 if you had a really high-volume store. But as we look at the Lifestyle stores, because of how they were remodeled and some of the materials used, those Lifestyle stores are holding up better than any previous remodel. And so my belief is that we will actually get an extended life out of those remodels.

Now, that being said, as we learn something about a feature that we might put into a new Lifestyle store, we have already gone back and hit a few of those stores. So if you take our store in Redwood City, which is a very, very high-volume store, we touched that one, we touched it predominantly because we've learned something about the remodel process and thought that that store would benefit, and it was a major benefit just from raising the ceiling in the produce department. And so we came back and did that. But that wasn't because the store had gotten tired. And that one was done in probably 2004. I think we'll get an extended life out of these remodels.

If you look at the floor of the produce department there is virtually no wear, if you look at the produce bins, there is virtually no wear. Rather than using a lot of wood and millwork and stuff in the décor package, we basically painted the walls. And so I think we'll get better life out of these stores.

Meredith Adler - Barclays Capital

You said early on in the call that you thought that foot traffic would probably increase, or was increasing, faster than customer perception about price. You also said you thought that in 2010 you probably wouldn't need to make as many price investments. What metric, what will you be looking at when you decide you're okay and where you need to be? Is it price comparison or perception or traffic or what?

Steven A. Burd

Essentially you will see volume first but then you'll see market share gain. And just because we have market share gain it doesn't mean we'll stop but the furthering of market share gain may have nothing to do with pricing.

So I think on price it's about determining by market and by the nature of the competition, where you need to be because of your market shares and your brand and your perception in that market. And so that's something that first of all, you can estimate, and then if you see growing volume in market share, you know you're very close to the sweet spot, so to speak.

And I think from there it's just kind of a maintenance game.

Meredith Adler - Barclays Capital

I just want to confirm that the State of California actually gave you the tax refund in cash, they didn't pay it in paper.

Robert L. Edwards

One hundred cents on the dollar.

Operator

Your final question comes from Bob Summers - Pali Capital.

Bob Summers - Pali Capital

We have seen some pretty dramatic growth in the food stamp program so I'm curious about how that's impacted your business and maybe some of the things you're doing to capture the incremental dollars.

Steven A. Burd

We have seen the same thing. It's been pretty dramatic. And again, I don't think it's all that unusual for a recession and so you will see more of that in some geographies than others and you try to merchandise to take advantage of that.

Bob Summers - Pali Capital

And that involves what? Just lower price point items?

Steven A. Burd

First of all, it's the items that are eligible and secondly, it can also relate to the pack size. So offering somebody 24 rolls of 2-ply bathroom tissue, that's not going to work for somebody that is using that form of payment.

Bob Summers - Pali Capital

The guidance for 2009, the $1.70 to $1.90, does that include the tax benefit? And I guess we're up to $0.18 now, is there any more contemplated in the back half of the year?

Robert L. Edwards

We gave you the annual tax rate, which would imply about 36% for the second half. But at this point we're not contemplating any major tax benefits on the income line.

Bob Summers - Pali Capital

But that $1.70 to $1.90 does include the $0.18?

Robert L. Edwards

Yes.

Steven A. Burd

And just to clarify, I think that Robert's right, we're not contemplating any but I want you to be sure to know that we're working on things.

Robert L. Edwards

But it's not in the guidance.

Steven A. Burd

Just by way of a quick summary, I don't need to tell anybody on this call that it's a challenging environment. It's challenging because it's a pretty elongated recession. I think this might set a modern-day record, at least a 50-year record for [inaudible] and then for us it's an unprecedented commodity situation. But we believe we're making great progress on the fundamentals.

Transactions are positive and getting stronger, household counts are positive and growing steadily. Volume trends are improving across the board, non-perishable and perishable. Deflation will subside and when it does it will increase profits and it will increase the point of sales. Trading down will also decline, the economy improved or even stabilizing. Price investment, as I said, will normalize. Free cash flow, even at the low end of our guidance, is expected to be up 62% from last year. I can't imagine that's happening with the private companies that we compete with.

Our balance sheet and our access to capital is stronger and superior to virtually all of our conventional competitors. Our assets are in what I would term the best-of-class position and we think we're well positioned not only to weather what I might call an economic storm, but we're even better positioned for the economic recovery, which will take place at some point.

So we think results will get better as the economy stabilizes and they'll get a lot better once the recovery begins. So we like our positioning, we like the strength of our balance sheet. We're disappoint in the reported ID sales, but we are focused on the fundamentals of building the business and creating shareholder value.

With that, thanks for listening.

Melissa C. Plaisance

Thanks everyone. And I will be available if there are any follow ups.

Operator

This concludes today’s conference call.

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Source: Safeway Inc. Q2 2009 Earnings Call Transcript
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