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Safeway Inc. (NYSE:SWY)

Q2 2013 Earnings Call

July 18, 2013 11:00 am ET

Executives

Melissa C. Plaisance - Senior Vice President of Finance & Investor Relations

Robert L. Edwards - Chief Executive Officer, President and Director

Peter J. Bocian - Chief Financial Officer and Executive Vice President

Analysts

Scott Andrew Mushkin - Wolfe Research, LLC

John Heinbockel - Guggenheim Securities, LLC, Research Division

Shane Higgins - Deutsche Bank AG, Research Division

Edward J. Kelly - Crédit Suisse AG, Research Division

Meredith Adler - Barclays Capital, Research Division

Charles Edward Cerankosky - Northcoast Research

Todd Duvick

Jason DeRise - UBS Investment Bank, Research Division

Andrew P. Wolf - BB&T Capital Markets, Research Division

Operator

Welcome to the Safeway Second Quarter Earnings Conference Call. [Operator Instructions] This call is being recorded. If you have any objections, please disconnect at this time.

I would now like to turn the call over to Ms. Melissa Plaisance, Safeway's Senior Vice President of Finance and Investor Relations. Please go ahead.

Melissa C. Plaisance

Thank you, Shirley. Good morning, everyone, and thank you for joining us for our second quarter 2013 earnings conference call.

With me today are Robert Edwards, President and CEO; and Pete Bocian, Executive Vice President and Chief Financial Officer. Today, Robert will provide opening comments about the quarterly results and our plans to grow the business. Pete will then provide more details on the quarter with a focus on continuing operations, as we have classified our Canadian operations as discontinued operations beginning with the second quarter. Pete will also spend some time discussing our guidance going forward. Robert will then close the prepared remarks with a few comments.

So before I hand the call over to Robert, I'd like to remind you that management will make statements during this call that include forward-looking statements within the meaning of the federal securities laws. Forward-looking statements contain information about our future operating or financial performance. Forward-looking statements are based on our current expectations and assumptions and involve risks and uncertainties that could cause actual results or events to be materially different from those anticipated. However, we undertake no obligation to update or revise any such statements as a result of new information, future events or otherwise. For a list and description of those risks and uncertainties, please see our filings with the SEC.

And with that, I'll turn the call over to Robert.

Robert L. Edwards

Thanks, Melissa. Thank you, and good morning to those who are on the call. We achieved some significant milestones this quarter with the announced sale of our Canadian operations and the Blackhawk IPO. These actions and the substantial cash proceeds we expect to receive will allow us to broadly enhance stakeholder value.

As most of you know, we entered into an agreement to sell substantially all the net assets of Canada Safeway Limited to Sobeys Inc. for CAD 5.8 billion in cash. Total cash proceeds after taxes and expenses are currently estimated to be approximately CAD 4 billion. The proceeds are expected to be used to pay down $2 billion of debt to maintain our current debt ratings, to buy back stock and to invest in growth opportunities. This transaction, which is valued at a multiple of approximately 10.7x, represents a -- an EBITDA multiple of approximately 10.7x -- represents an attractive price at over 2x the prevailing U.S. market multiple of 4.9x for Safeway at the time of the announcement. It allows us to realize the higher multiples attributed to Canadian supermarket companies and the premium attributed to our strong operations. We believe the transaction maximizes the value of our Canadian assets. The substantial cash proceeds in this transaction will allow us to create value for all stakeholders at Safeway. The transaction is anticipated to close in the fourth quarter of 2013 and is subject to customary closing conditions and regulatory clearance. Given the sale of our Canadian operations and a combination of items that are onetime in nature, this is an interesting quarter to present to the investment community in my first earnings call as CEO.

First Call estimates for the second quarter, our consolidated earnings per share of $0.50, when you add continuing and discontinued operations together and adjust for the 4 one-time items mentioned in our earnings release, we were just above the consensus estimate of $0.51 per share.

With this quarterly release, we have begun reporting our Canadian business as discontinued operations. To assist you, we have restated the last 4 quarters for this change and have filed slides on a form 8-K available on the SEC website to help with year-over-year comparisons. In addition, we have provided a few slides summarizing key messages from the call.

Earnings per share from our continuing U.S. operations showed significant growth in the quarter, up 20% as reported and up 40%, adjusted for items discussed in the press release.

Our non-fuel U.S. IDs were 1.2% in the quarter, which is close to the 1.3% we saw in the U.S. in the first quarter, adjusted for the 40 basis point New Year's Eve holiday shift in quarter 1. We saw an improvement in sales as the second quarter progressed. In the third quarter to date, our non-fuel IDs are 1.4%. We believe non-fuel IDs will continue to improve in the remaining weeks of the third quarter.

Our U.S. market share, as measured by Nielsen, grew for the fifth consecutive quarter. We gained 20 basis points in the supermarket channel and 2 basis points in the all outlet channel. We remain focused on our initiatives to increase loyalty and our sales in our core supermarket business.

Just for U continues to drive sales. We now have 5.8 million households registered, and incremental sales per Just for U user are still strong. We expect to complete the launch of our iPad app in all markets this month, and additional enhancements to our mobile app are underway.

Our partner fuel roll-out is on track and in most of our U.S. divisions. The launch of Texas should be complete in the early part of the fourth quarter. 19 center store remodels have been completed. The target for completions at year end is close to 250 stores. 87 premium stores were re-merchandised in perishables by the end of the second quarter. Enhancements to the nonperishable areas of these stores are expected to be completed in the third quarter. We are targeting a total of 150 premium stores by year end. We are pleased with the results of all these efforts to date.

Our Private brands portfolio continues to grow and contribute to loyalty and profitability. On a year-to-date basis, our penetration and dollar sales of Private brands is up 37 basis points and, in volume, up 53 basis points in the U.S.

Safeway's Private Label products are leading in health and wellness. We currently have over 2,000 SKUs in natural and organic, nearly 4x more than our largest supermarket competitor and over 8x our largest mass competitor.

Sales of Open Nature products increased 38% in the second quarter and 42% year-to-date. We currently expect to exceed $200 million in sales in these products in 2013. The 100% natural Grass Fed Angus Beef is now available in 600 stores.

Now as most of you know, we completed an initial public offering of Blackhawk stock during the quarter. A total of 11.5 million shares were sold to the public at $23 per share. Safeway received $238 million in cash proceeds from the sale and, after taxes and other expenses, expects to net $155 million. As a result of the IPO, Safeway now owns 73% of Blackhawk. And beginning on April 20, a 27% minority interest is represented on the income statement as a line item entitled noncontrolling interest.

Blackhawk reported its second quarter results this morning. Adjusted operating revenues increased 21% and adjusted net income increased 18%. Safeway's 73% stake in Blackhawk is worth approximately $900 million.

We received a number of questions regarding our Canadian pension plans and ongoing pension obligations in the U.S. Although we addressed some of these questions in an 8-K filed on June 19, I thought I would summarize a few points on this subject.

At the end of the first quarter of 2013, the corporate pension and post-retirement obligations in Canada were underfunded by a total of $194 million. Sobeys will be assuming the underfunding amounts. Sobeys will also be responsible for future multi-employer pension plan contributions in Canada, which totaled $48.7 million in 2012. In the areas in which we operate in Canada, an employer's obligation on multi-employer pension plan benefits is limited to the contribution amounts in the labor contracts. Safeway's U.S. multi-employer contributions was $261.3 million in 2012, which was slightly below the $262.7 million contributed in 2011. These amounts are determined through collective bargaining, and our overall contract settlements have continued to be reasonable. Even when our contributions to these pension plans increase, there are often offsets in other parts of the contract settlement.

With the help of the Pension Protection Act, we typically have 10 to 13 years, or longer if needed, to fully fund these plans. Recent improvements in the U.S. equity markets may help reduce the underfunding. We continue to believe that this is a very manageable situation and the one that we work closely with our bargaining partners to resolve.

And on a separate note, Barry Libenson joined us on July 1 as our new Chief Information Officer. He came to us from Land O' Lakes, where he was a Senior Vice President and CIO. We are pleased to have him leading our IT organization and helping us to provide solutions to grow our sales and operate more efficiently going forward.

I'd now like to ask Pete to cover the financials and our guidance.

Peter J. Bocian

Thanks, Robert, and good morning, everyone. As Robert mentioned in his opening remarks, this is an interesting quarter to report. Basically, with the signing of the agreement to sell substantially all of the net assets of Canada Safeway to Sobeys, we're now required to report continuing operations, which includes our U.S. grocery business and Blackhawk separate from discontinued operations, which is basically Canada and a small piece of Genuardi's from last year. All of my remarks today will be in the context of continuing operations, unless specifically called out as discontinued.

Total sales for the quarter declined slightly 1.6% due to lower gasoline sales in 2013 and the disposition of Genuardi's stores in 2012. This decline was offset in part by an ID sales increase, excluding fuel, of 1.2%.

As a note, the shift to generic drugs in our pharmacy business impacted U.S. ID sales by about 0.8%. Without this generic drug impact, U.S. ID sales would be about 2%.

We continue to see some softer trends at the end of the month when many consumer budgets are stretched, and we had 2 holidays this quarter that occurred at the end of the month, Easter and Memorial Day. During the second quarter, cost increases were largely passed along by both us and our competition. This is in contrast to the first quarter when there's a lag in passing these cost increases along.

The gross profit margin increased 29 basis points in the quarter. Excluding fuel, it declined 3 basis points. The decline is explained by higher shrink, price investments, higher Blackhawk revenue as a percent of total revenue and the Blackhawk IPO expense, offset somewhat by reduced advertising expense.

Last year, we were rolling out Just for U and had elevated levels of ad spending. The O&A margin increased 28 basis points. Excluding fuel, it decreased 21 basis points. This decline is due to lower property impairments and store occupancy expense, offset by higher labor expense to support the increased sales and increased legal reserves.

Our operating profit margin increased 2 basis points to 1.59% in the second quarter of '13 from 1.57% in the second quarter of 2012. Excluding fuel, operating profit increased 18 basis points.

Interest expense declined to $64 million from $73 million in last year's second quarter. The $9 million decline was due to $777 million lower average borrowings as we continue to pay down our debt.

In the quarter, taxes on continuing operations increased to 35.8% from 31.5% in Q2 of '12. Last year's rate was lower due to several individually immaterial items. The 35% rate is more representative of our expected rate going forward on continuing operations.

Free cash flow year-to-date is $210 million versus a negative $128 million last year. This $338 million swing is largely explained by lower capital spending.

Safeway has invested $257 million in CapEx year-to-date Q2 of '13 compared to $490 million in 2012 largely due to timing.

With this earnings release, we're initiating guidance on continuing operations. ID sales. We expect ID sales of 1.5% to 2% for the year. Year-to-date, we're at 1.5%, and ID sales in 2012 were 0.6% in the U.S.

EPS. We expect adjusted diluted EPS in the range of $1.02 to $1.12. Prior year was $0.99. And year-to-date, we're at $0.41, excluding the tax items from Q1 and the 3 items called out in today's press release.

We expect Q3 to be somewhat softer than prior year given the ramp of our investment in the key sales initiative and, in 2012, some gains on sale.

To bridge back to prior guidance, if you adjust for discontinued operations and the Blackhawk IPO and the tax item included previously in guidance, this brings you at the lower end of previously provided guidance of 2.25% to 2.45%, driven mainly by Canada and, to a lesser extent, lower U.S. IDs than originally planned.

Given the timing of the proceeds from the Canada sale, these numbers reflect no impact from share repurchase and debt repayment beyond the use of the 2013 free cash flow. Robert will talk through how we see the EPS ramp as we reduce interest expense and share count.

The operating margin, excluding fuel, for the U.S. business in 2013 is expected to be up 15 to 25 basis points versus 2012.

To provide better visibility to the business, we'll start to provide guidance on EBITDA. We believe this metric can provide operational insight into the quarter-on-quarter and year-over-year progress for the company.

For 2013, we expect EBITDA in the U.S. to be in the range of $1.7 billion to $1.73 billion, which compares to $1.74 billion in 2012. As a note, we have not given credit to continuing operations for the royalty previously paid by Canada, nor have we charged out U.S. allocations to Canada nor have we provided credits for any transition services to be provided post closing.

Capital spending for the U.S. operations for 2013 is expected to be between $900 million and $950 million, which reflects no change in guidance, excluding Canada. In 2012, capital expenditures in the U.S. were $837 million. We expect free cash flow also to be consistent with prior guidance with the U.S. free cash flow between $600 million and $700 million. The uses of free cash flow continue to be to fund the dividend and then for debt pay-down. We expect to use the free cash flow from our Canadian operations through closing towards the repayment of the outstanding Canadian debt.

And now, Robert will provide some concluding remarks.

Robert L. Edwards

Thanks, Pete. I'd like to finish our prepared remarks with just a few comments. Our U.S. IDs are running well above last year at 1.5% year-to-date, and we expect them to ramp over the balance of the year with the implementation of the sales initiatives I mentioned earlier.

The EBITDA of our U.S. business is expected to stabilize in 2013. And with the sales initiatives, we expect to be fully operational in 2014, as expected to grow. The sale of our Canadian operations is expected to be accretive in the short to medium term after we pay down debt, repurchase shares and modestly grow earnings. We expect to continue to generate strong free cash flow from continuing operations.

And finally, actions taken during the quarter demonstrate our commitment to creating shareholder value and at the same time enhancing our credit metrics to ensure ongoing access to capital at attractive rates.

And with that, we'll be happy to answer your questions.

Melissa C. Plaisance

Okay. Shirley?

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Operator

[Operator Instructions] Our first question comes from Scott Mushkin.

Scott Andrew Mushkin - Wolfe Research, LLC

Yes, it's Wolfe Research, and thanks for taking my question. And, hey, Robert, it's nice to see you at the CEO position and doing the conference call. So congratulations.

Robert L. Edwards

Scott, thank you very much. I appreciate it.

Scott Andrew Mushkin - Wolfe Research, LLC

So I just wanted to touch on comps, I guess, first and then also inflation. Maybe you can kind of give us some flavor on some of the initiatives. Are they in place yet? Are they having any influence on comp? Where are things running right now? And I think inflation is seeming to, wanting to come down. And what's your thought process as we go through the year?

Robert L. Edwards

Well, the U.S. sales increase -- ID increase in the quarter is 1.2%. Volumes were actually flat during the quarter. Now just to focus on volumes somewhat. If you look at volumes year-over-year, that represents a 130 basis point improvement in volumes. And then, although volumes were flat, we quoted the market share gains. Those were all volume -- market share gains. And so, if you look at the Nielsen data for the supermarket channel and for the all outlet channel, yes, we gained 20 basis points of share in the supermarket channel and 2 basis points in the all outlet channel. So I think we're doing well on volumes. And so, for the balance of the year, we're looking at something in inflation in the range of 1% to 2% for the balance of the year. Now if you look at our original guidance -- and again, that was for the combined company early on, and you look at the guidance now, the primary difference in the U.S. IDs is less inflation than we initially had anticipated. So that's the primary driver, the reduction in IDs of the U.S. operations, less inflation. And I think we and, I think, most people anticipated when we put our plan together. So for the second half, Scott, it's going to be somewhere between 1% to 2%.

Scott Andrew Mushkin - Wolfe Research, LLC

And where are you running right now? Are you running similar to the 1%, 2%? Or do you want to give us any thoughts there?

Robert L. Edwards

Yes, Scott, I mentioned in my comments, we're actually running north of that. We're at 1.4% non-fuel IDs quarter-to-date in the third quarter.

Scott Andrew Mushkin - Wolfe Research, LLC

Great. Sorry for missing that. And then, I have one on strategy, if I could, Robert, then I'll yield. I was just kind of -- maybe going forward, you sold Canada. It's obviously a very profitable operation. I think we understand why. As you look at the rest of the U.S. portfolio, there is clearly some banners that are a lot smaller, don't have market share. How do you feel -- what's your strategy going forward with the U.S. operations with some of the -- I'd say, some of the less effective banners?

Robert L. Edwards

Well, Scott, no specific comments today on the balance of the portfolio. I mean, the focus for the last 5 or 6 months has been to respond to the offer we got from Sobeys, to think through what the highest and best use of that asset is for our shareholders. And we looked at all the range of opportunities, and this has been an issue for a number of years. We've had expressions of interest over a long period of time and lots of rumors and speculation about the asset. And so, as we thought about what's happened, the interest we've seen for years and we looked at all the different alternatives. And looking at the after-tax proceeds, we believe that this is the highest and best use and creates the most value for our shareholders. Now as you said, obviously, we've got a number of divisions in the U.S., but no announcements at this time. And from time to time, we think about various things that we've mentioned in the past, and we'll continue to do that. But as you saw in the numbers this morning, continuing operations, meaning the U.S. operations, earnings are improving. And as you -- as Pete mentioned, the operating margin for the quarter for continuing operations, x fuel, was up 18 basis points. And I spent quite a bit of time, Scott, going through the various sales initiatives. They had really kind of a minor impact in the second quarter because we're really ramping up, and I think you'll see increasingly the benefit from the center store project, the premium stores we're doing and other initiatives in the third quarter and the fourth quarter. So we're quite optimistic about the continuing operations in the United States. And from time to time, we'll think about various things, but no announcements today.

Operator

Our next question comes from John Heinbockel.

John Heinbockel - Guggenheim Securities, LLC, Research Division

Guggenheim. So, Robert, when you think about some of those initiatives -- I wanted to talk specifically fuel and Just for U. To your point on ramping, we should get correct -- particularly fuel, we should get a much greater contribution in the back half of the year, And that one in particular kind of jumps up because of the geometric increase in the attractiveness of your offer. So is it merely the inflation plus macro is less accommodating than you thought it would be? And is the macro less accommodating?

Robert L. Edwards

Yes, I would say yes, John. The inflation is less than we anticipated, and I'd be surprised if that's not consistent and then also the macro environment. And although you read lots of somewhat positive reports, it's still a bifurcated and slower-than-anticipated recovery. And for many consumers, and this is not particularly just to Safeway, toward the end of the month, as you know, people change their buying habits. And the increased -- the payroll tax change clearly was not helpful. And with high fuel prices, most consumers are stretched at the end of the month. And so, the macroenvironment has not been particularly helpful relative to our initial plans for the year.

Peter J. Bocian

And I would add that, first of all, 2012 was very strong if you look at the '11, '12 comparable. And then, if you really break down the delta in the $0.03 we lost in fuel, it was half price per gallon and half gallons, which speaks to Robert's point about buying consumption but also says, as cost increased, people didn't pass it through with price. The good news is we absorbed the $0.03 and still made the $0.28 on the continuing ops. So that's the way to also look at it.

Robert L. Edwards

So I think, John, Pete's making a very good point. The gross margin on our fuel business cost us $0.03 a share in the second quarter compared to the year-ago period. And despite that, our operating margin was good.

John Heinbockel - Guggenheim Securities, LLC, Research Division

I -- maybe I missed it, but where are we now with the Wellness initiative? And I guess that's not going to -- that was supposed to help you. I guess that's not going to help by very much this year.

Robert L. Edwards

John, good question. We still anticipate rolling out the Wellness initiative, spending quite a bit of time on it still. But today, we're not providing any specific dates for launch, and we'll update you as we continue to make progress. So we still anticipate rolling that out, but no specific update today.

John Heinbockel - Guggenheim Securities, LLC, Research Division

And then, lastly, how much flexibility do you have? When you talk about accretion from the sale of Canada, how much flexibility do you think you have in redeploying proceeds and executing the buyback, i.e., could you spend more than $2 billion on the buyback? And are you thinking about ways to accelerate the process, so that you can get more of the benefit in the first part of the year and you don't have to do it slowly, gradually in the open market?

Robert L. Edwards

Well, John, as you know, there are a range of alternatives to execute stock buyback programs. Our historical pattern is for us to control that. But as you know, there are ways to accelerate that. As we get closer to the end of the year and closer to when the cash proceeds will actually show up, we'll spend time reviewing those various options and then talk about that further later in the year or early in the next year when that's possible. And then, as we've mentioned a number of times, in 2014, if you separate the proceeds from Canada, which we've indicated that our current thoughts on how we'll allocate that cash, we expect strong free cash flow in 2014. At that time, our current audits will return to our historical pattern of returning the vast majority of that free cash flow to shareholders. So in addition to the proceeds that will be available for stock buyback from the Canada transaction, that will also have the free cash flow available from continuing operations to return to shareholders as well.

Operator

Our next question comes from Shane Higgins.

Shane Higgins - Deutsche Bank AG, Research Division

It's Deutsche Bank. Robert, can you just give us some color on your thoughts on CapEx for the U.S. business going forward? And the reason I'm asking this is I've had some investors say that people believe that you guys have been under investing a bit in the U.S. assets. And just give us your thoughts on the need to potentially have to reaccelerate CapEx in that area.

Robert L. Edwards

Well, I think the comments you've been getting from investors is just not accurate. If you look at historic -- at our prior Investor Conference Meetings. I think -- I don't think we did it this year. But on many occasions, we demonstrated how much we're spending on CapEx as a percent of sales relative to our key competitors. And the conclusion from that analysis is that we have spent more than our conventional competitors on our assets. We believe we have the best conditioned assets in the United States. And when we started Lifestyle on our stores in 2004, we accelerated those investments. And so, we were spending very heavily for a number of years now. And now, we have -- roughly 90% of the assets have been Lifestyle. And so, if you look at the condition of our box versus our competitors, I think we got the best conditioned assets in the industry. So the point that we've been underinvesting is just not true. And we prudently manage capital. And I think we're adequately investing. And actually, we're benefiting now from all the investments we made in the Lifestyle stores. And one of the benefits from the improvements we made beginning in 2004 is the quality of the materials we've used. It's lasting longer and is more applicable today than some of our prior remodels. I mean, historically, you had to remodel your stores every 7 to 10 years. But based on the work that we did, it's -- you don't have to remodel them, it's 10-plus years now. And so, if you want to come out, bring the people who are concerned about that, we'd love to take you through our stores and then visit a few of our competitors. And we believe we have the best assets in the U.S. And we are not underinvesting. I mean, actually, Shane, I'd say it's a strength. I mean, our ability to generate free cash flow going forward on a relative basis, I think, is actually even better than our competitors because we have invested more on a relative basis than our competitors have. Therefore, our ability in the future to generate free cash flow, I think, is actually a competitive advantage.

Shane Higgins - Deutsche Bank AG, Research Division

That's great. And just one last thing, if I could jump on there, Robert. PDC is going to start turning cash flow positive at some point. Is that going to help bring down the net CapEx for the U.S. business a couple of years out?

Robert L. Edwards

It depends on how you consider net CapEx. Now just talking about PDC, pleased with the progress. Again, similar to, I think, the CapEx and our ability to generate free cash flow as the relative strengths of the company, I think our real estate expertise and the people that we have is -- in real estate is a competitive advantage. And pleased with how PDC is doing. We are batting a very high average in PDC right now and, I think, creating shareholder value. And so, it will just depend on the opportunities going forward. But right now, we're very pleased with what PDCs are doing for us. And again, we're leveraging an existing asset, which is part of -- if you look at the various strategies that we execute, the first rule or guiding principle is that it has to leverage an existing strength of the company, and PDC does that. And it's similar to one of the reasons Blackhawk was -- has been and is so successful is we're just leveraging one of the existing strengths of the business. In Blackhawk's case, it was the millions of existing customers we have in our stores already.

Operator

Our next question comes from Edward Kelly.

Edward J. Kelly - Crédit Suisse AG, Research Division

Crédit Suisse. Robert, could you talk about the gross margin a little bit? Fairly stable this quarter, how should we think about it for the remainder of the year? And maybe just wrap in, sort of, what you're seeing from a competitive standpoint?

Robert L. Edwards

On a competitive standpoint, no real change in the competitive environment. As you probably kept track, we get that question at each call, but I would say relatively consistent on competitive behavior. Now from 1 quarter, 1 week to another week and 1 market, you'll see changes in behavior. It's just the nature of this business. But if you step back and look over the full quarter, I would say really no change in the competitive environment. Actually, good quarter on gross margin, x fuel, only down 3 basis points. And because Blackhawk is growing faster than the core business and it's a lower gross margin business in the core, just the Blackhawk impact is greater than the 3 basis points. So a good quarter going forward on gross margin. Now for guidance, a number of years ago, we gave guidance on gross margin. And at this point, we're just giving operating margin guidance, but very pleased with gross margin in the quarter.

Edward J. Kelly - Crédit Suisse AG, Research Division

Okay. And I'd like to follow up on just a question that Scott had. If you think about your business and the cash flow you're going to generate this year, the proceeds from Canada and where are the markets valuing you at this point, I mean, it looks like you could probably think about a number of around 4x EBITDA if you hit your guidance. I guess, the question is would you agree with that? And then, related to that, with Canada, you are obviously open to opportunities to unlock value. And do you think about the U.S. business in a different way for some reason than the way that you've thought about Canada in that regard?

Robert L. Edwards

Ed, we couldn't hear -- you faded out when you mentioned the 4x. I wasn't sure what that meant. But just to address the question, generally, I mean -- and I had that in our prepared comments, if you look at the action that we took both in terms of monetizing Canada or the agreement to monetize, it's not closed yet, and the IPO that we did with Blackhawk, I think those are 2 significant milestones demonstrating our commitment to shareholder value. And if you couple that with our historical pattern of giving -- returning a significant amount of our free cash flow to shareholders, we are focused on creating shareholder value. And so, as you think about the U.S. operations, we're pleased with the growth that we saw in the quarter. We're optimistic about the future. But our job as stewards of our shareholders' capital is to act on their behalf. And so, we look at things -- various things from time to time. But consistent with the actions that we've taken, we still have that mindset as we look at all of the rest of our assets. But having said that, we're very pleased with the ongoing operations, and we're bullish about the future.

Edward J. Kelly - Crédit Suisse AG, Research Division

And just one quick follow-up on that, Robert. How do you specifically view the importance of scale in general? Meaning, we have to have a certain number of stores as opposed to local scale and what's more important?

Robert L. Edwards

Well, obviously, they're both important. Because of the -- I mean, at the end of the day, this is a local business. And increasingly, you're going to hear us talk about the concept of localization and how important that is to our future going forward. In the works that we're doing on the center store projects, on the premium projects, on the number of other initiatives, put it in this category of localization, and we need to be relevant to consumers in each market. And we have a broad geography to look at, many ethnic groups that we cover. We're blessed to have such great demographics in the markets that we serve. And so, increasingly, we're going to be focused on localization and increasing our relevance to a diverse group of consumers. And so, local market share is very important, and we're working on that concept right now. But scale is also, if you look at it on a total basis, is important. And the scale we have with continuing operations is just fine. Given the size of the business, we have all the scale we need on a macro basis, but it's also important what local market share is and, increasingly, what we're going to be focusing on local market share as well.

Operator

Our next question comes from Meredith Adler.

Meredith Adler - Barclays Capital, Research Division

This is Barclays -- Meredith Adler from Barclays Capital. And I will repeat what Scott said. Congratulations.

Robert L. Edwards

Meredith, thank you very much. I appreciate it.

Meredith Adler - Barclays Capital, Research Division

Sure. I want to go back to -- first, just to make sure I heard something you said about the use of free cash flow once you complete the sale of Canada. Do you then believe that you can -- you're pretty much done paying down debt and that you can use future free cash flow to buy back stock?

Robert L. Edwards

If you look at our historical pattern, Meredith, before we embarked on the accelerated program, about 75% of our free cash flow was returned to shareholders either through dividend or stock buyback and 25% was for debt pay-down. Once we complete the transaction on the Canadian operations and use those proceeds consistent with what we've talked about. So if you look at -- let's just assume 2014, you look at the free cash flow we'll generate from continuing operations. It's our current anticipation that we'll return to our historical pattern of something in the range. We're not making specific commitments today. We'll update you when we give our guidance for 2014 probably next March at the Annual Investor Conference. But my assumption right now is we'll return to that pattern of about generally 75% of free cash flow return to shareholders and about 25% for debt pay-down.

Meredith Adler - Barclays Capital, Research Division

And that's even though, I think you still will end in a different debt position than you had been historically. I mean, I think there is some chance that -- your debt ratings are lower, that's not going to factor into it.

Robert L. Edwards

Well, clearly, the debt ratings will factor in. So that we have ongoing dialogue with the agencies, and that dialogue will continue and they are a stakeholder in the process. And our goal is to be mid BBB in terms of the ratings. And so, we work closely with them, we listen to their concerns. We'll continue to do that. And they do have a stake in the business. And we'll listen to their thoughts and we'll incorporate that, as we always do, in our decisions about how we allocate our resources.

Meredith Adler - Barclays Capital, Research Division

And then, I have another question about -- you talked about sequential improvement in comps for the course of the year. I think you're also beginning to see a lessening -- sorry, a lessening headwind from pharmacy. Do you anticipate that, that will continue to be a factor in your comps and it will be less of a headwind?

Robert L. Edwards

Very good observation, Meredith. Less the impact of generic, let's just look at 2013 right now. In the impact in the first quarter, it reduced IDs by 88 basis points. In the quarter that we just reported was 78 basis points. And so, again, if you look at our U.S. continuing ID of 1.2%, you exclude the negative impact from generics -- or essentially the 1 -- we're close to 2% ID in the quarter. So in quarter 3, we think the negative impact from the move to generic drugs will decline from -- again from 78 basis points in the quarter. We just completed 234 basis points. So a big improvement, a reduced headwind, consistent with what you said. And then, that will continue the benefit. As we look at Q4, our projection for the negative impact of generics in Q4 is only 24 basis points. So if you compare that to the impact we just had in quarter 2, when you got a 64 basis point improvement just from lower negative impact from generics in quarter 4 relative to quarter 2. So you're exactly right, the lessening impact of generics will help IDs in quarter 3 and quarter 4.

Meredith Adler - Barclays Capital, Research Division

I just have 2 other questions. The cash flow that you have guiding us to for this year, the free cash flow, do you view that as representing a kind of stable level of free cash flow? Or is there anything that's in those numbers that you would describe as unusual?

Robert L. Edwards

No. I would say no. We've -- I think you've -- I hope you'll observe in the press release and Pete's comments that we're trying to calling out kind of one-time items. And so, I would say it is, although -- but because of all the work required to separate continuing from discontinued and its significant effort, our finance and accounting people have worked long hours to complete this. What I may say -- I'll pronounce that as a simple exercise of just subtracting Canada. It's quite complex, actually. And so, yes, we'll spend some more time thinking about this and on the next call and clearly at the Investor Conference next March, we'll have a lot to say about this. But in my concluding comments, I made the statement about -- and we expect to continue just to generate free cash flow going forward. We're very bullish about the company's ability to generate cash going forward. I think it's one of the strengths of the company, and we expect it will continue to be. Generation of cash is a very important objective for the management team because it's important to our shareholders, and we expect to do well going forward here.

Meredith Adler - Barclays Capital, Research Division

I guess, my final question, somebody did ask you about cash -- CapEx and I know you have -- you feel very good about the condition of the stores. Is there now that -- the first set of Lifestyle remodels were done 9 years ago. Is there some schedule that you think is appropriate? I think there were, from memory, closer to 150 stores done. Is there some schedule that you do think is appropriate for starting to reinvest in the stores? Or are you just going to do it case-by-case, depending on their volumes and their conditions?

Robert L. Edwards

Meredith, we've been upgrading the stores for years. Now we haven't really -- we haven't talked about that and focused on that. But if you look at the total amount of CapEx for the company, we've been upgrading the initial stores for some time because the initial Lifestyle stores we did 2004, 2005, if you'll think back to prior earnings calls, we evolved what Lifestyle meant as we move through time. And it's like everything you do. You start something and then you improve it, that becomes the new standard, then you improve that. And so, as we've moved through time, we've been spending money to upgrade those initial stores. I can think of the Redwood City store, it was one of the early stores that we did. We've gone back and upgraded a number of things. We improved lighting as we -- in the stores as we moved through time. We've gone back and enhanced the lighting in that store and many others. And so, CapEx in 2008, 2009, '10, '11, '12, part of that capital has been to improve the initial Lifestyle stores to the standard that we evolved to. And so, I don't think it's going to be a major step function increase. It's just been part of our ongoing budget to refresh those stores. We've been doing that for some time.

Peter J. Bocian

[indiscernible] we've got center store as an evolution of the Lifestyle concept, right, because it's the next rev on how we're laying out the store. And so, the numbers that Robert talked about, call it, the capital investment towards, call it, next-generation lifestyle.

Robert L. Edwards

And it's an interesting point that Pete brings up on the center store. Meredith, when we took you through the Blackhawk store, when we did the Investor Conference in March, I mean, one of the great things about that concept is it's significantly less CapEx to do that relative to a Lifestyle store and a significant sales benefit. And so, the actual returns that we're seeing right now are actually higher than we did with the Lifestyle stores based on the returns we're seeing. But again, we think our stores are in very good condition. We continue to improve those, the initial remodels. And so, we got money budgeted every year to improve stores. And we just don't talk about that, we view that as just sort of the ongoing almost kind of maintenance spending. But I'd like to take any analyst, any group of shareholders to our stores compared to our competitor stores. And I just think of all of the money we spent here in the Bay Area, in northern California, significant improvement on our asset base and a very good market for us. So if there are a number of people who have concerns about this issue, we'd be glad to walk some stores.

Operator

Our next question comes from Chuck Cerankosky.

Charles Edward Cerankosky - Northcoast Research

Northcoast Research. A couple of things on Just for U at this point. Could you give us maybe anecdotally some of the accumulated wisdom you're getting from it at this point in the year as well as where you stand with the improved vendor participation?

Robert L. Edwards

Well, Chuck, the program, as you know, just continues to do well. We've got 5.9 million registered users. The sales per user is still strong. Engagement is strong, and it's interesting. I think we talked at the Investor Conference about how mobile users were using the site more frequently [ph], spending more money than those who are accessing the technology on a desktop computer. And so, we are spending incremental resources focused on mobile. We had one comment about the iPad app and we're making a number of enhancements there. We're very pleased with this technology. I think a part of the future of retail, Chuck, I think, as we talked about, going forward is relevant, personalized offers. And I think we are best-in-class because of the technology that we have, and we're enhancing that all of the time. And so pleased with the effort here, and -- but we're always improving the technology that we have here. And just very pleased with what we're doing and particularly the mobile aspect of this, and we have some great participation from our CPG vendors. And the more I think that they look at the results that they are achieving and can achieve, we're increasingly getting incremental resources from the major CPG vendors because of the ability to target their investments, and they are seeing very good incremental returns from the spending that they're allocating to this technology, and I think that, that will continue because, as we spend more time, we have more success. I mean, the success that we're having is generating more success both for our CPG vendors but for our shareholders as well. And so, I think it's a win-win both for our shareholders and our CPG vendors as well.

Charles Edward Cerankosky - Northcoast Research

Robert and Pete, if you're looking at your segment reporting, you allocate all the corporate overhead or corporate admin expense into the U.S. part of it. How much of that just goes away? You hinted at it, but you haven't included it in any guidance. But what part of that goes away when the Canadian transaction is closed?

Peter J. Bocian

Yes, as we identified, we got a $40 million, $42 million, $43 million royalty and about $28 million of allocations to Canada. We're working on it. So it's not in the numbers, so as we're talking about stabilizing EBITDA in the $1.7 billion to $1.73 billion, that would have upside as we work through cost take-out opportunities. So we'll give you ongoing updates. But that's the way to think about it.

Charles Edward Cerankosky - Northcoast Research

Okay. And the royalties from what? [indiscernible] that attached to?

Peter J. Bocian

Sorry. There was -- royalties were paid from Canada to the U.S.

Charles Edward Cerankosky - Northcoast Research

Yes. But on brand licensing, things like that?

Robert L. Edwards

Just a number of items that we put in the category of intellectual property.

Peter J. Bocian

Yes, intellectual property from the parent.

Robert L. Edwards

I think one of the things, I think, to keep in mind here is that the -- when we close the transaction with Sobeys in the fourth quarter, we'll be providing transition services to them in a number of areas, particularly in IT. This was done in every similar kinds of transaction. And so, that will factor into the issue that we're talking about here. But we'll be doing that for some time, and they'll be compensating us for that.

Charles Edward Cerankosky - Northcoast Research

All right. Okay. What would you estimate would be Safeway's average replacement cost per U.S. store?

Robert L. Edwards

Chuck, I don't have that number on the top of my head, and it varies by market and real estate. If you're looking at the land cost in Honolulu versus Las Vegas, it would take some quite a few calculations to come up with an average. And so, I would not venture into that right now. I would have [ph] to make quite a few assumptions to get there. But just one comment on that. We have great real estate that has significant value, and without giving you a specific number to replace our stores, we are blessed with great assets and great markets.

Operator

Our next question comes from Todd Duvick.

Todd Duvick

Wells Fargo. A quick question on the balance sheet. I know you've indicated $2 billion of divestiture proceeds are going to be used for debt reduction. And I think you indicated on the call when you close -- or when you talked about the Canadian divestiture, another $700 million of free cash flow could be used towards debt reduction in this quarter -- or in this year. I guess, what I'm asking is how are you thinking about what debt is going to be paid down between commercial paper, bank debt and bonds? And with respect to bonds, if you're thinking primarily of bonds on the short end of the maturity spectrum?

Melissa C. Plaisance

We're working on that right now, Todd. We don't have a specific plan to share with you today, but we're working with our banking partners to decide what makes the most sense, and there are a lot of different objectives that we'd like to satisfy. When we're ready, we'll announce that to the market.

Robert L. Edwards

And as a point, the other $700 million was -- this combination of this year's free cash flow and also the proceeds from the Blackhawk IPO. So that's the piece outside the $2 billion that we've -- that we're adding up.

Melissa C. Plaisance

And the Blackhawk piece adds $100 million, so it's $800 million, Todd.

Robert L. Edwards

But, Todd, we feel good about paying off the debt that we talked about. Melissa and her team are looking at a range of different alternatives to focusing in on what's the right strategy. But we'll get that done.

Todd Duvick

Okay. And in terms of the timing, do you anticipate that before the transaction closes or after the transaction?

Melissa C. Plaisance

After we get the cash.

Operator

Our next question comes from Jason DeRise.

Jason DeRise - UBS Investment Bank, Research Division

It's UBS. I want to understand the EBITDA and EPS guidance in a little bit more detail, specifically the EBITDA -- adjusted EBITDA calculation. It looks like it's removing the impairments for properties, but it's not removing any other gains. And then, it also looks like it's adjusting for share-based compensation. So I kind of wanted to understand the rationale for those adjustments. And as a follow-up to that, to understand the EPS guidance, does that include the PDC gains? And has there been any change in that guidance since it was disclosed at the Investor Day?

Peter J. Bocian

Yes. So we've been clear on Table 4 and consistent in what we're adjusting to get from the income from continuing ops to the pro forma adjusted EBITDA. So it is comparable for the 24 weeks and comparable for 2012 moving into 2013. So different companies have different adjustments. This is consistent with how we reported it, and we'll be consistent going forward. So expect that the guidance will be calculated at the same way. Making the guidance of the $1.7 billion to $1.73 billion will be consistent with this methodology.

Robert L. Edwards

And I think most of those -- there's some one-time items. There are standard adjustments to get from income to EBITDA. So it's not like we're doing something unusual there. And then on real estate gains, one of the things I've learned about real estate over the years is you're never there until something closes, and there's always uncertainties to timing of when things happen. So we're generally in about the same range we were at the Investor Conference, but there's a range there. One of the reasons we've got a range on guidance is that you're just never sure when things may or may not close. And we close them when the value is there. And so, timing can be affected and move -- it can move quite a bit actually. And so, that's one of the reasons we've got a range there.

Jason DeRise - UBS Investment Bank, Research Division

Okay. And just to come back -- I mean, obviously, it's a new management team, so you guys are entitled to your own views. The prior CEO often said that impairments and gains were 2 sides of the same coin. So I guess, what's different about that view?

Robert L. Edwards

The -- again, I think if you'll look at Table 4 -- and if you've got further questions, I mean, we could do it after the call with Melissa and Christiane. But I think the items listed on Page 12 in the press release on Table 4 are normal items to adjust from income, which is a P&L number, to get to EBITDA. So maybe we could do that after the call, if you got further questions.

Peter J. Bocian

And impairments are noncash.

Robert L. Edwards

Exactly. That's what I'm trying to get at.

Jason DeRise - UBS Investment Bank, Research Division

Right. No, that's fair. And can I ask also -- there's great disclosure given in the last 10-Q about the gross margin breakdown, and it looked like it was roughly a 60 basis point investment in price that was partially offset by -- I'm rounding here. I think the number was close to 40 basis points, somewhere between 35 and 40 basis points of generic gross pharmacy benefit. Can you break out that info for this quarter, so we can understand the price investments that correspond to the more like 2% same-store sales, x pharmacy?

Robert L. Edwards

Well, I think that the -- we're working on the Q now. It will be filed in a number of days, and we should have the same kind of disclosure in that Q that was in the prior Q.

Jason DeRise - UBS Investment Bank, Research Division

I appreciate that. And one last question, if I may. Would you share where the breakout is of the real estate that you own? I know that it's a bit over 40% overall of the properties you own. Is there any concentrations of that by region, say, in the Northwest or is it spread out more evenly?

Robert L. Edwards

Jason, we have -- historically have not given a lot of details by geography. But if you, I mean, just want to get a rough approximation, look at our store count by geography. Obviously, the percent ownership varies, but there -- but I think that would -- use that as approximation. But again, you would have to -- if you're trying to get to real estate value by geography, you'll have to look at relative real estate assumptions by market, but I would just start with our share count. But historically, we have not given ownership of stores by geography nor have we broken out the P&L by geography as well. So the treatment there is consistent.

Operator

And our final question comes from Andrew Wolf.

Andrew P. Wolf - BB&T Capital Markets, Research Division

BB&T. Robert, so the -- with the recent increase in the comp to 1.4% and I assume with inflation is probably less or the same as it was during the quarter, I just wanted to confirm -- and I would assume the volume trends have gone slightly positive?

Robert L. Edwards

We're not giving -- we're pleased with where we're at on volumes. Again, it's early in the quarter. And again, Andy, I would look at the volume -- the market share numbers are all volume-based. It comes from Nielsen. And so, they're industry data that we just received. So for a number of quarters now in a row, we are gaining share on a volume basis, both through the channel and then across all outlets. So that's everybody. And so -- and with the initiatives that I talked about, center store premium, we're pleased with our volume growth.

Andrew P. Wolf - BB&T Capital Markets, Research Division

Okay. So what -- you did say during the quarter -- I think you said, towards the end of the quarter, sales got better. And now, they are at 1.4%. So I was going to ask you, what particular company -- of those company-specific initiatives would you attribute that to? Or are you trying to tell me that's more noise, it's too small a change?

Robert L. Edwards

No -- the improvement IDs, you're talking about, Andy?

Andrew P. Wolf - BB&T Capital Markets, Research Division

How many IDs you referenced?

Robert L. Edwards

Yes. Well, the -- it's the -- when you and I chatted at the Blackhawk store, you saw some of those. I mean, we're benefiting from Just for U. We're benefiting from fuel. The John -- the question that John have asked about earlier. But in incremental to that, we're benefiting increasingly now from the work that we're doing in center store, from our premium projects and we're also benefiting from our consumer brands. We didn't talk about those much. I had some comments in our prepared remarks. But we're very pleased with the progress that we're making in our consumer brands portfolio. As you know, we got a very strong group of products there, lots of innovation going on there. We got a very good management team focused on that piece of our operation. So we're very pleased with the growth there. So it's a combination of all the things that we've talked about. And I think you'll see increasingly the benefits that -- of those initiatives as we move through the balance of the year.

Andrew P. Wolf - BB&T Capital Markets, Research Division

Okay. That helps. And my last question is -- I think, Robert, you referenced expectation for positive EBITDA growth in next year. So what is the level of ID sales the company needs in order to achieve that?

Robert L. Edwards

Well, It would be, I guess, probably premature now, Andy. I think that that's a topic that we -- that's frequently been asked and we've addressed in a number of prior Investor Conferences and so -- and maybe we'll put together some information and share that with the group in March of next year.

Andrew P. Wolf - BB&T Capital Markets, Research Division

Just to follow on. As I sort of backward engineer your guidance for the back half, it looks like if you hit the 2% -- what I know is if you hit the high end of EBITDA guidance, EBITDA will be slightly positive for the back half. I assume that's mainly linked more to ID sales gains than it is to the real estate swings?

Robert L. Edwards

Yes.

Melissa C. Plaisance

Thank you, everyone, for joining us today. Christiane Pelz and I will be available for any follow-ups.

Operator

Thank you. And this does conclude today's conference. We thank you for your participation. At this time, you may disconnect your lines.

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