Safeway, Inc. Q3 2009 Earnings Call Transcript

Oct.15.09 | About: Safeway Inc. (SWY)

Safeway, Inc. (NYSE:SWY)

Q3 2009 Earnings Call Transcript

October 15, 2009 11:00 am ET

Executives

Melissa Plaisance – SVP, Finance and IR

Steve Burd – Chairman, President and CEO

Robert Edwards – EVP and CFO

Analysts

John Heinbockel – Goldman Sachs

Chuck Cerankosky – Northcoast Research

Scott Mushkin – Jefferies

Karen Short – BMO Capital Markets

Charles Grom – JPMorgan

Deborah Weinswig – Citi

Ed Kelly – Credit Suisse

Andrew Wolf – BB&T Capital Markets

Meredith Adler – Barclays Capital

Joe Parkhill – Morgan Stanley

Bob Summers – Pali Capital

Neil Currie – UBS

Operator

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

Melissa Plaisance

Good morning, everyone and thank you for joining us for Safeway's third quarter conference call. With me this morning is Steve Burd, Chairman, President and CEO, and Robert Edwards, Executive Vice President and Chief Financial Officer.

Let me remind you that this 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 topics.

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 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.

With that let me turn the call over to Steve Burd.

Steve Burd

Thank you, Melissa. Let me start with net income. Net income for the quarter was $128.8 million. This compares to $199.7 million in the same quarter in 2008. When you express that in earnings per share, we earned $0.31 a share this year versus $0.46 a share one year ago. As expected our earnings this quarter were well below last year's third quarter, but as you can see they are above the consensus estimate which were at $0.29 per share.

The earnings shortfall or difference from 2008 level was largely the result of three factors. The largest factor is represented by expense increases that are unrelated to third quarter sales and I'll cover that in more detail when we talk about the O&A expenses. Most of which these increases will not be repeated in 2010.

The second, the decline in volume obviously had an effect on the quarter and then third is deflation which happened in a number of categories but the most pronounced deflation was in produce and dairy, in fact much greater than we had even in the second quarter and more than we had previously forecast. These three negatives were partially offset by a very aggressive cost reduction effort.

But turning first to sales, total sales decline 7% versus last year's. The decline in total sales is explained by lower fuel prices, fuel prices are down 34% from last year. Secondly, a reduction in average ring per item. Some of that's trading down, some of that is deflation and then finally a decline in the Canadian exchange rate.

ID sales excluding fuel which is the number I think people are most interested is were a negative 3% of the quarter. While our volume levels are still negative, our trends continue to improve. Our perishable volume is now positive and was the best result we've had in perishables in some 11 quarters.

Our non-perishable volume while still negative represents the best result in non-perishable volume in some five quarters. The negative ID of 3% was largely the result of deflation, trading down and price investments. In fact if you bundle all those together, they explain more than 250 basis points of the 3% decline in sales.

Deflation as expected increased. We contemplated that you'll recall a quarter ago when we announced the second quarter we said that we thought produce deflation would be greater in the third quarter and then began to subside in the fourth quarter and that certainly played out in Q3 and we're seeing evidence of the decline in produce deflation in the early part of Q4.

We also experienced an increase in dairy deflation. The dairy deflation has let up a little bit here in the fourth quarter but not as much as produce, and then if there was a surprise in the quarter on the deflation front it was actually in the meat category, very modest deflation in quarter two and then that picked up significantly in quarter three and has frankly picked up in the early part of Q4 as well.

Our transaction counts which have been positive for several quarters continued to get better. Household counts which have also been positive for several quarters improved just slightly. Items per transaction which has been the main reason why non-perishable volume continues to be down, remained negative but continued to improve so, we think all the trends are certainly working in a positive direction.

Turning to gross margin, our total gross margin rate increased 78 basis points from last year, more meaningfully, when you exclude fuel sales. The gross margin on non-fuel business declined about six basis points. Now, the six basis points decline in gross margin is relative to quarter three of 2008, and while that may appear to some to be a quite modest decline in gross margin, when compared either to quarter three or to quarter two of 2003. You need to keep in mind that we're lapping really the start of very heavy investment in price, which occurred in the third quarter of last year.

In addition, our price in advertising investments were masked by several enhancements to gross margin and I'm going to first give you a comparison to last year, which is what that six refers to and then I'll give you a comparison to the second quarter just to kind of give you a sense for the enhancements.

In terms of the comparison to last year, the biggest improvement came in the LIFO expense area. You'll note we didn't have a LIFO expense this quarter and that's a very positive comparison to a year ago, which of course is reflective of the kind of deflation that we're experiencing.

Transportation expense which is included in the gross margin calculation improved considerably because energy costs are down. And then, we've had a long-term effort to improve our cost of goods through working different elements of the supply chain and that was the third major contributor.

And then a fourth contributor was really progress in shrink. Now you haven't heard us talk about making progress in shrink for the last couple of quarters and that's because it's very difficult to improve your shrink results in a deflationary environment, but we were able to do that in Quarter three. And if you add up all of those elements plus a few others, that explains about 36 basis points, so had we not had those improvements in gross margins instead of being down 36, we would have been down 42, which might have been what some of you were contemplating.

Now, just to compare it to the second quarter, if you look at our shrink results, they are dramatically different between the second quarter and the third quarter and they explain the vast majority of the enhancements and then the supply chain explains about an equal amount and LIFO explains a much smaller amount, but those three things in combination explain about a 31 point difference in gross margin between really the third quarter and the second quarter.

So bottom line, shrink plus LIFO plus the fact that the big price investments really started in the third quarter of last year. And I think it's also indicative of how much effort we have yet to apply to get to the price position that we need to get to achieve our goal.

In terms of O&A expense, O&A expenses increased 164 basis points from last year's third quarter, and when you exclude the fuel sales, the O&A expense, the sales ratio increased 89 basis points. The largest component of this increase really results from cost elements that are unrelated to really the operations this quarter. Another way of saying that is there are some lumpy costs which are obviously a part of how we run the business, but not necessarily related singularly to the third quarter.

The largest of that is the negative swing in property gains and losses. There is always quite a swing if you look quarter-to-quarter and in fact I looked over the last couple of years and between the lowest quarter of property gains and losses and the highest quarter in '07 there was a 30 basis points difference, and then also in '08 and in '09 you're also seeing a big swing.

So, it's my way of sort of saying you take some of these, sometimes you take impairment charge which relates to you make the decision in the quarter, but it relates to a long-term decision about the value of the assets going forward and then in a down real estate market, you aren't going to have as much on the gain line.

Depreciation, which is really the result of two factors, it's with a negative swing this quarter, one is it reflects the heavy capital investment that we had made for the last several years and then with sales and volume being down from a basis point standpoint that becomes pretty serious number, but that this depreciation number is essentially going to be there whether sales are up 2% or down 2%. And then there was a timing change in our bonus accruals, you would expect with the performance.

Our bonuses are down very significantly on the year but the accrual process sometimes creates some lumps along the way, and then there were also some lumpiness to the benefits clause and then finally, the pension expense, which we have been tracking our way through this year, that went up largely as the result of change in interest rates and again unaffected by sales, but the basis points of that is affected by sales but the actual cost is not.

The second largest component is really the decline in volume, which as I indicated is occurring only in the non-perishable area. These first two elements of cost increase were partially offset by cost reduction in several other areas. The utility costs are down considerably, wages are down considerably with volume declines, other store related expenses are down, and those begin to offset some of the other increases ending up with about an 89 basis point increase in O&A.

Turning to interest expense, interest expense declined modestly, less than $2 million, due to lower average borrowings offset by higher borrowing rates. The average debt outstanding declined $460 million. So our debt today stands at just under 5.4 billion while the average borrowing rate increased 38 basis points from 5.96 to 6.34.

During Q3, you may have taken notice that we did a debt offering of $500 million. We elected to go out for a 10-year term, feeling that there would be some interest rate rise over that 10-year period and we managed to get that money at a 5% rate. We took that in early, because we thought that was the best timing to go to the market and that basically was in place to require $500 million worth of debt, which we did on September 15 which, is a fourth quarter event. And so we retired 7.5% debt with 5% debt, and then added the extension of another five years. So that should create a nice arbitrage for future earnings.

We continue to have access to commercial paper. We ended the quarter with a zero balance of commercial paper but we tend to be a borrower in the fourth quarter. Our overnight rate is currently at 30 basis points and our 30-day rate is at 40 basis points, so again very good rates. Our next debt maturity for those of you who are keeping track would be 500 million due in August of 2010.

Turning to capital expenditures, we completed five new stores and 16 remodels in the quarter. Year-to-date we've completed seven new stores and 62 remodels. As a result we now have about 78% of our stores which are currently in the Lifestyle format, stayed a little bit differently. We have 1345 stores that have the identical look and feel, which we never had in this Company, and we think that helps brand the Safeway shopping experience. Year-to-date, we've invested $603 million and are on track to spend around a billion dollars this year opening 10 new stores and completing 85 remodels.

Turning to cash flow, free cash flow for the quarter was 455 million. That's contrasted with free cash flow last year of 261 million. Free cash flow for the first 36 weeks is 865 million compared to 499 million last year. Our cash position was further enhanced early in Q4 by $223 million by reducing this year's cash tax. So that when you consider the tax refunds that we've gotten earlier in the year, you're pushing $400 million in tax benefits this year. This particular improvement in cash tax does not flow through the income statement and create any earnings effects, however that cash is available to pay down debt and buy stock, which means it will ultimately have an earnings effect as we move forward.

During the quarter we repurchased 10.2 million shares of stock at a price of $18.84 for a total of $192 million and year-to-date we've purchased 23.1 million shares at $19.21 per share for a total of $442 million spend. We've also reduced our debt on the year-to-date basis, a $132 million.

Just a few brief comments on Blackhawk. The face value of all gift cards sold, had an increase of 21% during the third quarter. On a year-to-date basis, card sales have increased 24% and at this point, we believe we're on target to achieve our planned results for the year.

Just a couple of comments on guidance. You'll note in the press release, we reconfirmed the earnings range of 170 to 190. We also confirmed the free cash flow range and you should think that we would clearly be on the upper end of that range as opposed to somewhere in between, so we purposely did not comment on ID sales because it is so dependent on what deflation is.

As I indicated earlier, volume trends are good, transactions good, households and I just wish we could predict deflation a little bit better. We still believe it will subside but we've been surprised early in the quarter by the deflation in the fresh meat category. And as I commented earlier capital spending will be around a $1 billion.

I wanted to make just a couple of comments because people are starting to look at 2010. We don't intend to provide any formal guidance for 2010 until we complete our fourth quarter. And so the earliest that we would provide guidance would be when we report our fourth quarter results which is early next year and the latest that we would provide guidance would be at our investor conference, which will be shortly after we report our fourth quarter results.

At the same time, I think people or some people at least are acknowledging the fact that we had an extraordinary tax benefit this year of $0.18 a share and are trying to figure out how we sort of overcome or climb that hill next year. So, I thought I would just give you a couple of comments to help people through the notion that that's not a tough hill for us to climb and there should be a lot of good things going on in 2010.

So, if you think about the tax benefit is worth $0.18 of enhancement in 2008, we have quite a track record reducing shrink. We've been challenged on the shrink front this year, although we rose to that challenge in the third quarter producing positive results. If deflation goes away as we all expect it will, in fact most of it is expected it will be replaced by some modest inflation. If deflation goes away, for us to be able to do $50 million of shrink improvement, which is roughly $0.08 a share, is not a tall order for this organization.

Depreciation, we're going to start benefiting from depreciation next year because of the slowdown in capital spend. While we haven't done the pension calculation for next year, if interest rates were to hold that's going to be a positive surprise without doing any work. The exchange rate even if that drops back a little bit that will be a positive surprise relative to 2008 and then at the rate of growth of Blackhawk, so all of these things, but for shrink completely unrelated to supermarket operations, those things would easily cover $0.18 a share.

The other things that will benefit us next year, deflation, if you've done the math has a powerful effect on earnings because your cost of goods is down, if you have the identical margin rates the gross margin dollars are down, it has a more powerful effect on earnings in many respects than it does on ID sales and so if deflation goes away, that's a big plus, if a modest amount of deflation returns that's an even larger plus. Volume trends continue and you get even a low positive volume number, that's a big plus and then fuel this year has not been good for us.

Fuel margins are down and it's been good on fuel expenses for our own transportation but in our standalone fuel business, last year in the second half of the year as prices begin to come down, that's when we make good margins. This year, believe it or not there's been a steady rise in fuel and that actually squeezes margin.

So this might be the first year that we have not in the aggregate produced a standard fuel margin. It's hard to imagine that will happen for two years in a row. So those are just a series of positive numbers that I think will give you a sense for how we're feeling about things. Obviously, there will be when volumes go up, costs go up there will undoubtedly be contract negotiations that will have some effect on all of this, but at least that gives you a sense for how we start to look at 2010. So with that, I'm ready to take questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from John Heinbockel with Goldman Sachs. You may ask your question.

John Heinbockel – Goldman Sachs

Well Steve, a couple of things. I know every market is different, but if you thought about where your pricing is today versus where you'd like it to be ideally, how far on the journey have we gone number one and then two, do you think the returns on what you're investing in are getting better or you're getting smarter about how you spend that money?

Steve Burd

John, in terms of the first question, I would tell you that as of today, we would probably be in the US, we would probably be I'm going to say 80% complete with that journey. And then, I do think that we spent a lot of time this year examining the efficiency of our spend and I think some of what you see reflected here in the third quarter, is a much more efficient spend and I think that's something that if you're really smart about it, you can harvest that for a long time, particularly in a sector and in a Company that's been so promotional. So, we think we're getting smarter about it and should be reflected in the gross margins.

John Heinbockel – Goldman Sachs

Now, if you're 80% of the way there, do you think that target is a moving target for whatever reason, but because of what competitors do or the consumer or what have you, or do you think it's more of a stable target so that there really is only 20% to go?

Steve Burd

I don't think the target stays still, okay. I think it is a moving target, but we've contemplated that movement all along. I think I commented on the last call that we had invested twice as much this year that we had contemplated. Part of that was to get to the finish line quicker and part of that was in reaction to competitive response. The factor that I think makes the competitive reaction soften a little bit is we had a prolonged recession. We've got some highly leveraged companies out there. We've got some people that are really have liquidity issues and frankly, I can think of a market where we changed our prices and we got too far below our competition, our conventional competition and it's because when we went down, they went up for, I can only think of cash and earnings squeeze. And so, I think that while it is more competitive than it has been in a long time, I commented on that at the last call, I would tell you, here in the third quarter that has not stepped up vis-à-vis the second quarter, and if anything, it's probably softened a little bit.

John Heinbockel – Goldman Sachs

One final thing, do you think as we look at it, it looks like for all of you private label pricing is probably at its widest level versus branded in a while. Do you think private label pricing is too low or do you think we start to see or have we started to see vendor allowances, vendor spend on the branded side step up and will it step up more in 2010?

Steve Burd

I think that in this kind of environment where what preceded this was a rapid run up in cost of goods, driven by commodities but then no change when commodity costs came down, and so I think virtually anybody with a respectable private brand offering elected to exploit that, if you went back to similar circumstances whether they be recession driven or not, I think that is always the case so we have widened up the distance between ourselves and corporate brands, but there's no question that we have in some cases probably lower than what we need to be. I can think of some items that we have such a hard time keeping in the stock and when you go look at the stock position, you'll look at the national brand item next to it that might be selling for $2 more and it hasn't moved. And so I think that, we frankly enjoy selling the private label and the extra margin it gives us. And lastly, John, we just beefed up that area by hiring a guy that just came from Frito Lay to go in and he's just going to be a great asset to the Company and I think help us grow that brand, private brand even faster.

Operator

Our next question comes from Chuck Cerankosky with Northcoast Research. You may ask your question.

Chuck Cerankosky – Northcoast Research

Good morning, everyone. Steve, I've got a couple of questions. First, can you put any numbers on some of the volume gains and then household traffic improvement you've seen and talk about that a little in anymore detail?

Steve Burd

I'm reluctant to put numbers on it, but I think that I said on the household count that they had been positive for a long time and it got slightly better. I'll give you that number, its north of 2%.

Chuck Cerankosky – Northcoast Research

North of two? Okay.

Steve Burd

And on the transaction trends, it's North of one.

Chuck Cerankosky – Northcoast Research

Okay. Well thank you. Looking at your store counts, it's continued to decrease for some time and this is more of a strategic question that I'd like you to think about is part of growing sales and holding market share and rebuilding it is adding stores, not just average size of the store. How are you thinking about that going forward?

Steve Burd

Well I think that obviously, when we did the Lifestyle remodel that's when we made a dramatic cut back in new stores. If you look at this year and if you look at 2010, because people need to get building permits and you have a pretty good sense for what competitors are doing in the marketplace. We and all others have had very few store openings in 2009 and 2010 and the market doesn't look like it will be any larger. Our 2010 program will be larger than it was in 2009 but we're still not back to the 2003 levels. And I think that if we weren't in a recessionary environment you'd probably see us do on the order of 25 to 30, and we might increase that over time. We did open our second small store format and we're still trying to figure out whether that becomes a growth vehicle on a go-forward basis, but with unemployment where it is and competitors not investing heavily in new stores, it's not the best time to go ahead and build a lot of new stores. At the same time, we are taking advantage and getting control of real estate and so we have a number of projects that frankly include more than just stores. You'll see us play a much larger development role a feeling that we create the value for the center, so why not harvest some of that value?

Chuck Cerankosky – Northcoast Research

Thank you, and when you look at 25 to 30 stores sort of as the normalized number in normalized times, what kind of store closing number would go along with that?

Steve Burd

We haven't even contemplated that. Historically, about 50% of our new stores have tended to be replacement stores and so if that pattern were to hold, 30 stores might involve 15 closures and then there could be a couple other dribblers along the way for reasons that if we lose the lease or reasons that it's no longer a good market for us, but since we haven't looked at it I couldn't begin to try to bring that down for you.

Chuck Cerankosky – Northcoast Research

But the fact that you're doing some projects indicates there's a pipelines building and you can control how fast the openings come out of the other end?

Steve Burd

That's correct.

Chuck Cerankosky – Northcoast Research

Then finally, Steve, how is Basic Red doing as a brand?

Steve Burd

I think it's early. I think that it's the right offering in this kind of environment and I think it will be a good offering for certain budget conscience shoppers, even during good times. So we're going to be careful about the skews. We don't start with a large, our best product here. So we're going to be very thoughtful about the skews we add to that but it's just early in the game and again, I think with Joe on Board now, I'll have a better view of the growth of that probably a quarter or two from now.

Chuck Cerankosky – Northcoast Research

Thank you.

Operator

Our next question comes from Scott Mushkin with Jefferies. You may ask your question.

Scott Mushkin – Jefferies

First, I wanted to go a little bit longer term, Steve. We're down now in the mid threes from an EBIT margin perspective. Any thoughts you want to give us on where you think your Company can operate on a longer term basis? Do we go back into the low fours as things rebound or do you have any thoughts on that?

Steve Burd

We just haven't looked at that and for me I've always looked at EBITDA because I guess I'm old fashioned as opposed to EBIT. So that's my framework. I think what we could do is commit to commenting on that, got at the investor conference because I think we've just been focused on other stuff but keep in mind, the effects of deflation and the effects of volume declines are pretty dramatic, and if deflation gets replaced with inflation you have a pretty dramatic swing in operating profit there. Throw a little volume on top of that and you can have a big change in earnings performance and therefore EBIT.

Scott Mushkin – Jefferies

Great. And then my second question really has to do with the change in your strategy in California, seen in California the way you're going to market, sharper every, day low prices. I was wondering if you could give us some color, it doesn't have to be Southern California or Northern California specifically but how that the markets that have gotten a new pricing strategy and a new look in the store, slightly different look in the stores are doing in comparison to markets that maybe haven't gotten it and what percentage of the markets have the new pricing and strategy?

Steve Burd

Let me go back to the last question first. Rather than kind of giving you the percentage of markets, my answer to an earlier question saying we're about 80% of the way we need to be there, that would translate pretty well into geographic or store counts if you will. I've commented on the every day items and I'm sure you know this but for the benefit of everybody on the call, the objective here is not to fashion ourselves as an every day low price leader.

The objective here is to take the items that consumers purchase most often and have a very good, very competitive every day price. We'll still be I think a bit more promotional than most of the conventional players we deal with and more promotional than the non-conventional players, but it's not an attempt to say that we're now about every day price and you won't see promotions there but that combination will be there but the distance between our everyday price and our promotional price, either the distance will be different or the frequency promotion will be different and then the look in the stores, part of that look you can appreciate is transitional and as you basically communicate to consumers what your new promise is about the value they can get regardless of whether something is on sale, but the shelf tags that you've seen that show the old prices and the new price, the expectation is that that you're going to see that for a long time, but at some point some of the signs and banners will evaporate and you'll see more of the traditional look of a lifestyle store.

In terms of how the markets where we've done this compared to the markets that we have not yet gotten to, it's a little hard to answer that question only because part of the response you get is a function of how much price you had to invest and so we've got some markets that we haven't got to where there's not much to do and then we have a market or two where we have more work to do. What I would tell you is that we're now in, let's see, we're in about effective today, I think we've got three markets remaining in the US, so we're in six markets and two markets launched just today. So I don't have any data on those. And then in the other four markets, I would tell you that the common perception is it takes time to get a shopper perception that things have really changed. In three of those four markets, we got a very good immediate response and in the other markets, got some immediate response and then softened up a little bit. So, I would say in the main a very good response which is partly reflected in the numbers for the third quarter and should be reflected in the numbers for the fourth quarter.

Scott Mushkin – Jefferies

I have just one more and then I'll turn it over. You didn't mention anything about and at least maybe I missed it, trade down trends having a competitors of yours, Cosco made comments to that effect I believe. Have you seen any having of the trade down where people maybe returning to old shopping habits, the $10 bottle of wine going to $15?

Steve Burd

I'll give you a couple of comments. I'll give you some on the trade down and when I was in New York last, people asked if I had seen any others trade down or trade up. I am going to tell you we've seen both. In some of the trade down and I commented last time that I thought the trade down was pretty universal across all categories pretty plaque, but we had a drop in the cost of pork, which then created a lot of demand for pork which reduces demand for some other products and people started switching to a much higher fat content ground beef. So, we saw a little trade down in the beef category but there's more deflation there than there is pure trade down. Since, I've got all these questions in New York, I decided to look at any evidence to trade up and I would give you two things. One is a category you just mentioned. As we entered into the recession, the percentage of premium wines that we sold, that percentage declined. Our wine category has been a fabulous category for us for years, but we saw a mixed change with a reduction in premium wines. We've now seen that reverse itself. Now, at the same time, if anybody that buys premium wines, the price of premium wines has also come down, and so not pure, but it does indicate a willingness for people to do that and I actually think part of the wine categories success even in soft business times, people are eating at home more and it actually becomes getting together with friends is a form of entertainment that's a lot less expensive than going out. The second area of trade up that we've seen when we went into the recession we saw a change in the mix of Lattes versus coffee, and now we've seen, it's early but we're seeing a trend back to Lattes. So maybe two points of trade up and one point of trade down might suggest that we're at or near the bottom of this whole thing and that would be good for all of us if that's true.

Scott Mushkin – Jefferies

Thanks a lot. I appreciate the detail, but generally, my impression is you feel a little bit better about your business today with that answer than you did on the last conference call. Is that fair?

Steve Burd

That's correct.

Operator

Our next question comes from Karen Short with BMO Capital Markets. You may ask your question.

Karen Short – BMO Capital Markets

A couple questions just on sales, I guess could you maybe comment on the cadence of sales during the third quarter and if you said anything about the trends so far in the fourth quarter, could you give us some color on that?

Steve Burd

In terms of the third quarter, I didn't pass out the third quarter and give first four weeks or anything in the middle. Bottom line is that the third quarter was if you adjust for deflation was substantially better and deflation more than doubled the quarter and so, volume was substantially better the third quarter than in the second quarter. In the fourth quarter, consistent with what Scott just mentioned on his last comments, we're feeling good about our ability to drive volume transactions in households in the fourth quarter. The fourth quarter started a little bit slow, but it picked up with each passing week and part of the reason for that is the third quarter actually ended for us on a holiday week. And so, any time you follow a holiday that next week is a softer week, and then shortly thereafter, we got to the end of the month and the end of the month is a much more pronounced down than it was during normal business time. And so again, we don't see anything that would dissuade us from thinking that we're going to have a good fourth quarter.

Karen Short – BMO Capital Markets

So if I look at your earnings guidance for the year at the low end of the range, I mean this is excluding the tax benefit, I'm kind of at a $0.49 number for the fourth quarter on the low end. What would be kind of the factors that would get you from the low to the high?

Steve Burd

I don't know from the low to the high, I don't know the fourth quarter sort of numbers in the low and the high range. Let me just tell you the things that would cause the quarter to be better rather than worse. I think if deflation were to subside faster than we think, it would be better. If we got good immediate responses in the remaining markets, things would be better. Flipping that around, if deflation were to get worse then those numbers would get worse so deflation is probably the single biggest factor and it's an unknown. It affects more than ID [ph] sales. It affects profitability. So, we didn't bother to adjust the range. It's a broad range and the consensus estimate is near the bottom end of that range as opposed to the top.

Karen Short – BMO Capital Markets

And then I don't know if you could maybe make some comments just on what you're seeing in tonnage in branded versus private label. I mean, Kroger made some comments on seeing an improved tonnage in branded, just wondering what you're seeing there.

Steve Burd

No. We're seeing same thing, well I'm not sure, we're seeing volume increases in our own brand and volume declines in the branded numbers. So the gap there is in favor of branded or excuse me, our own brands.

Karen Short – BMO Capital Markets

But has it widened or is it flat?

Steve Burd

It's narrowed a little bit.

Karen Short – BMO Capital Markets

And then just last question, wondering if you could give an update on the Denver situation?

Steve Burd

There's not much to report. We've been in bargaining for a long time since May. That's not completely uncommon and I think I once made a comment on one of these earnings calls that it is more common to go beyond the contract expiration dates through negotiation than it is to get them done before or on time and so it's not the only market that has gone through its expiration date. That doesn't create any particular worries for us. It happens all the time and I think several calls back I think I mentioned that the average time is sort of like eight months or something after the expiration. And it's pretty extended so we won't know until it's over with but we always expect that we'll get a good result.

Operator

Our next question comes from Charles Grom with JPMorgan. You may ask your question.

Charles Grom – JPMorgan

Hi. Good morning, just last quarter you kind of broke down some of the pressures between deflation, trade down and price investments and I think you said combined this quarter that was 250. I just wonder if you could parse that out for us again.

Steve Burd

Rather than piece it out and all of its component pieces, let me just say this, it was dominated by deflation and then the second biggest factor would be what we call trade down, and maybe that was almost equal to price investment.

Charles Grom – JPMorgan

Fair enough and then last quarter you also broke down a lot of different categories and then in the deflation you saw milk down 27, eggs down 15. I was wondering if you could give us a little bit of color on what you're seeing here and what you saw in the third quarter and maybe a little bit just to get a little bit more granular on your fourth quarter comments, what you're seeing so far in the first month here?

Steve Burd

I'll give you broad categories. Okay. If you look at the produce category, I'll give you essentially three numbers. In the second quarter deflation was 7.5, in the third quarter it was 11.2 and quarter to date, we're just a nudge under eight, okay. So still higher than second, but we would expect that number will continue to come down, but we've been surprised before. In the dairy category, I think last time I specifically singled out milk. I think that, I looked at milk just the other day and I think last time we gave you a number in the 24 plus range and milk is about 19% down quarter-to-date, but the dairy category which is much broader, which includes eggs, cheese and everything else; the dairy category was 9.3 in the second quarter, 12.3 in the third quarter, and stands at 11.6 on a quarter-to-date basis. Now again, that number should come down. I think in the last couple of weeks, there was a cost and follow on price increase. So that number should come down when we look at it say next week.

Charles Grom – JPMorgan

Then just sort of philosophically as you're looking at 2010, you're alluding to some inflation tailwind, just historically if you look back, is there a rate of inflation that actually becomes detrimental to the model. You guys always spoken to sort of like a one-ish percent tailwind as being the ideal structure but at what rate does it actually hurt you or could hurt you?

Steve Burd

Yes. I think that inflation becomes demand dampening, probably when that number gets, it's not a firm line, but if you get inflation in the 4% to 5% range I think that hurts you from a volume and sales standpoint. I don't know about sales, but certainly volume. When you get any level of deflation, you probably, when you get deflation, probably in excess of 4%, you probably get demand enhancing, but you at the same time have a top line sales call. And you have a bottom line earnings call. So I've always said that if inflation were in that 0% to 1% range it's kind of a non-event, but if it's in 2% or 3% range I think that's probably good for the business.

Charles Grom – JPMorgan

Okay, great. Thanks for the color.

Operator

Thank you. Next question comes from Deborah Weinswig with Citi. You may ask your question.

Deborah Weinswig – Citi

Steve, just one question, first of all are you guys doing flu vaccinations and is it driving traffic and along those lines I know that you've really been trying to be more of a destination for healthcare and that has been an important initiative within your corporation as well. So, can you please elaborate on what you're doing for your employees as well as for your customers?

Steve Burd

Sure. We've been in the flu shots business for a long time, virtually every pharmacy in the company has people trained to give these flu shots and unlike some of our competition, it's not two days of the week or during these scheduled hours. You come in and you can get a flu shot. We also do other vaccinations and so I don't have a number to give you except to tell you that the regular flu vaccinations are up considerably for us this year and we get an opportunity to see a lot of people that are not a regular customer, so that is traffic, that's people we don't normally serve, sometimes in our pharmacy or in the store and we see that as an opportunity to capture some business. For our own employees, some of the union contracts actually cover the flu shot in the healthcare plans and where they don't we're giving the flu shot to our employees for free. You run the math on that and you'd rather have them not be sick for which you have to scramble and probably pay overtime. So, it's a real easy call and then I think given the high profile position that we as a company have taken in healthcare and healthcare reform, it's a pretty natural follow on that to protect your employees for the flu season, you'd certainly encourage them to have a flu shot and then follow on to the normal flu will be, the flu shot will be the H1N1.

Deborah Weinswig – Citi

And then we've actually heard from two retailers in the past week that they expect a near term inflection point and have a CPG (inaudible) passing back the benefits of deflation with a move towards lower list prices versus promotional dollars. Can you please share your outlook with us and do you really have a preference for one way or another?

Steve Burd

To me, money is money. So, I think that I'm a big fan of having it basically in the cost of goods is easier to manage, but we've seen more of allowances than we've seen of change in list prices, although we've seen both. So I guess, I would probably have a slight preference for the price reduction, but at the end of the day we can manage it either way.

Deborah Weinswig – Citi

Great. Thanks so much and best of luck.

Steve Burd

Thank you.

Operator

Our next question comes from Ed Kelly with Credit Suisse. You may ask your question.

Ed Kelly – Credit Suisse

Yes, hi, good morning, Steve. Could you update us with your thoughts on the Blackhawk business? Now that the markets have improved and discretionary stocks are certainly getting better multiples than you are today, is there any interest in monetizing this business and getting more appropriate value for it and if not maybe you could just help us understand why?

Steve Burd

Well, I think that our position hasn't changed and we are determined over the long-term to make sure that the value of Blackhawk is properly deflected in our share price. I think it's fair to say that that's certainly not the case today and given the fact that it's a much higher growth company, it would be deserving of a much higher price earnings multiple if it were a public company. We have chosen to keep it in this current form for now because it allows us to really build this business in a way that gives it a high degree of installation without having to reveal a lot of metrics about the business including its profitability, so we could very easily reach a time where we think, okay, very secured business, it's not properly reflected in our valuation and maybe we now need to do something about that and I've always thought that there are two things you could do, one is you could reveal a lot more metrics about the business, and the other one is you could try to create, you could share the ownership so to speak and let the world know how that gets valued either privately or publicly. So, I think that we think about it. We think about it a lot, but right now, we like building this business kind of in privacy.

Ed Kelly – Credit Suisse

And could you share with us the run rate of operating earnings of that business currently?

Steve Burd

The only thing we've said historically, of course, you don't have the benefit of the base is that it's growing; earnings are growing well north of 50%.

Ed Kelly – Credit Suisse

Okay. And then my second question for you is on shrink control and expense reduction. Do you feel that you are leaving any sales at all on the table, with some of the work that you've done on that side or is that not really an issue at all?

Steve Burd

We're confident we're not leaving anything on the table and I'll give you some factors that should add to your comfort. Our in-stock condition which we measure constantly several times a week in our stores is the best it's been probably in five years and considerably better than any of our competition. And then if you then go back to some earlier comments I made the next thing you will have to ask yourself what about the perishable area? Are we doing things that would impede sales growth there? And the fact that the perishable volumes are positive and quite positive suggest that you couldn't have that happening if you didn't have a good in-stock condition there with quality product and we believe that the best way to control shrink and perishable department is to sell the product, and so no, we don't think we're leaving anything on the table.

Ed Kelly – Credit Suisse

All right. Great. Thank you.

Operator

Our next question comes from Andrew Wolf of BB&T Capital Markets. You may ask your question.

Andrew Wolf – BB&T Capital Markets

Thank you. In the three markets where you've had success with your pricing programs, could you comment on overall as the volume trending is it up? And are you able to discern whether the volume being better, whether that's more from increased penetration with existing customers or are you actually seeing customers that might have gone elsewhere returning to the stores?

Steve Burd

What we measure is the volume trends improving in those markets. What we are seeing in terms of the dominant improvement is coming from people that are not high volume shoppers with us. So, it's coming not from the highest volume shoppers who have been loyal for a long time. It's coming from the next two or three rungs down. And to be candid, I haven't looked to see whether or not there's any returning efforts [ph]. So, I haven't done that slice, but we basically look at our customers and identify them by share of wallet, so the highest share of wallet is pretty stable and the next two or three levels of share of wallet that's where the business is coming from.

Andrew Wolf – BB&T Capital Markets

So, it's safe to assume that the rate of increase or improvement in volume is better than corporate whether it's positive or not? Much better than overall?

Steve Burd

Yes, you have to say that because that's where we've made our investments and that's where we're spending our marketing spend.

Andrew Wolf – BB&T Capital Markets

I just want to test that way to see how effective it is. Let me ask this in another way, are you surprised either way on the kind of velocity you're seeing, change in velocities when you do bring down the shelf prices and shout it out the way you've been doing it.

Steve Burd

Yes, I would say that we've been pleasantly surprised not blown away. We had an expectation and we've done better than that, but keep in mind what we've done, before some of these efforts that you're referring to, we've been lowering prices all along. It's just that the most dramatic, the highest number of price reductions happened just preceding the marketing campaign. So, that is a more pronounced price reduction than what we've done. We've lowered our private label prices more than a year ago. And so, you're affecting a lot more items in the store. So, you should get a better response.

Andrew Wolf – BB&T Capital Markets

Okay. In the perishable area where the volume is up, are there any subcategories or even specific items where pricing might affirmed or actually pricing might have actually turned up and what's happening with volumes there? I'm trying to discern whether there's been this volume, value seeking behavior where customers are basically buying what's either deep on sale or where the deflations occurred, and where the pricing is starting to firm up, are the volumes maintaining or are they just switching their purchasing behavior to other items let's say in the department?

Steve Burd

Essentially what we've done, the big price changes are about the every day price then we still go to market promotionally. And so, when you look across the perishable categories, obviously, there are some differences, some growing faster than others, but in the main it's an across the board effect and I haven't really looked to see if somebody has decided to go with Bagels instead of donuts, but I think that it's affecting all of the perishables in virtually all of the departments and the numbers are positive and the trends have picked up substantially.

Andrew Wolf – BB&T Capital Markets

But you're sounding pretty confident that when inflation returns that you're not going to see a big adverse effect on the volumes, is that right?

Steve Burd

Yes, I think that's true as long as inflation is a modest rate and I define that to be probably in the aggregate 3% to 4% or lower, okay? But we experienced, as you know, we experienced some very significant cost increases in the dairy category more than a year ago and also in the produce category and when you get increases of 12% and 15% that is demand depressing. And I don't think, historically I've been at this for 17 years and I've only seen that kind of gyration once and I saw that in 2008 and then I saw the flip side of that in 2009. So I'm really not expecting that to become the normal behavior going forward and it's driven by supply and demand factors.

Andrew Wolf – BB&T Capital Markets

Okay, just lastly, could you clarify that comment you made in talking about guidance where you referred to the high end? Was that just for cash flow or is that just for both cash flow or free cash flow and earnings per share?

Steve Burd

That's for free cash flow, helped out by what I commented on the early part where our cash tax balances considerably and we've done a very good job of managing our cash and we continue to see opportunities in inventory levels and so we feel very good about the free cash flow number. That's why I tried to give you some indication that it should be on the top end of that range.

Andrew Wolf – BB&T Capital Markets

All right. Thank you.

Operator

Our next question comes from Meredith Adler with Barclays. You may ask your question.

Meredith Adler – Barclays Capital

Oh thanks for taking my question. I'd like to just talk a little bit more about the impact of deflation on profit. Burd, actually my first question related to that is are you actually seeing deflation in dry grocery at all?

Steve Burd

Well we have seen some deflation in dry grocery. It is predominantly in the perishables, but there would be some categories for which there would be deflation, and but think about it, Meredith as it's predominantly in the perishable arena which tend to be commodity-driven, which now are just on the flip side of the commodity-driven cost increases.

Meredith Adler – Barclays Capital

Yes, I know the magnitude in the perishables is much, much higher but would you say in aggregate the dry grocery is now deflationary?

Steve Burd

I don't think I would say that. I think I'd feel more comfortable saying it's not inflationary. I think but I would not refer to it in the aggregate as deflationary.

Meredith Adler – Barclays Capital

Okay. So my question is you were talking about the impact on fuel margins when fuel prices went down that you picked up margin and I'm having trouble understanding other than competition why when prices go down in other items and volume goes up, why wouldn't penny profit also go up, unless competitively you can't do it. I don't understand why it's automatic that gross profit dollars or penny profit would be down in a deflationary environment?

Steve Burd

Let me try to explain it this way. Let's talk first about fuel. In the fuel business, it is not a gross margin business. Fuel is a penny as a profit business, not just for us, but for anybody who is in the business. And so the reason our pennies are profit on a per gallon go up when the cost comes down is we sell a lot more fuel, maybe three times as much as the average station out there, which is often a branded station which is not owned by a branded player, but by an entrepreneur, okay? And so when the cost comes down, we don't immediately respond to lowering of retail even though we're buying cheaper fuel. We're priced at a competitive marketplace. And so the exact opposite happens when prices are rising, cost of goods are rising because we're replenishing our fuel station three times faster than they are, but we always have to price competitively. So the marketplace determines our price, but we experienced an early cost decline when it goes down and we experience the early cost increase when it goes up.

So that's the fuel business. In most of the items, which are in the supermarket, it's not a penny to profit business; it is more of a gross margin business. And so when the cost of goods go down, I'll oversimplify this thing and you apply the same gross margin, you are applying it to a lower cost, and therefore, you're getting not only lower sales, you're getting lower gross margin dollars and given that there are high fixed cost in the business, you haven't really altered your fixed cost and you've lowered your gross margin dollars, there's a material effect on earnings. If you play with a couple of numbers after this phone call, you can see the leverage associated with it and I would invite you to simply look at something like take our total sales, assume that produce is around the 11% of total sales and then look at an item that might be priced at $1, take a gross margin rate then lower the cost of goods by 12% and recalculate the gross margin dollars and you'll see a pronounced effect on gross margin dollars and there for income.

Meredith Adler – Barclays Capital

Yes, I've done that math, but I remember you telling us when we had big inflation in these perishables that in fact for things like milk, dairy, produce, you actually manage gross profit dollars or penny profit. I understand dry grocery which is the most items in the store tend to be percentage markup, but I thought for perishables you were able to really manage the penny profit.

Steve Burd

No. I think that what I've isolated in the past is milk. Milk which is a high volume item for us, milk is something that historically was a penny as a profit business, it behave more like fuel. But I commented and probably going back almost a year that at least for the last year and maybe this is an artifact of recession, people have used milk as a traffic block, similar to the way they might use carbonated beverages and so the penny as a profit protection has not been a practice of food retailers for at least a year with respect to milk. The center of the store is always a gross margin business and I would tell you that we put milk in the center of the store, but I've just isolated that historically, but in the perishable areas it basically is a gross margin business, certainly today.

Meredith Adler – Barclays Capital

Okay, and then my other question is just about multi-employer pension expense, I think that my research says that expense is likely to go up. Do you anticipate that that will be somewhat of headwinds to earnings next year?

Steve Burd

Historically what we've done as we go to the bargaining table, we look at pension expense, health benefits and labor costs as a pooled cost and we managed the pooled cost, and so anything that causes either healthcare costs to go up or pension to go up necessarily, the absorption factor happens to be wage increases and so that's been the pattern not only for us but it's been the pattern for the industry and so in bargaining, and I can't recall if we've talked about this in the past on the earnings call, because it's a pension reform legislation that was passed a couple years ago, there are some automatic things that happen in bargaining. And if you have an underfunded say multi-employer pension plan, then there has to be a reduction in benefits coincident with maybe an increase in the contribution, and if the two parties can't agree on a reduction in the benefits there's even a provision in the law that says all right, here is what you have to do to benefits, in other words there really isn't any choice there and these are considered sort of discretionary benefits. So, the bottom line is that we had quite a session with S&P where we spent probably a couple of hours taking them through our history, how this thing is managed, and got them quite comfortable that this is not something that should affect our credit rating and from a P&L standpoint the cash flow is quite manageable. And as the market recovers, that helps these assets a lot. So we don't see that as a big issue and we'll be able to manage it.

Operator

Our next question comes from Mark Wiltamuth with Morgan Stanley. You may ask your question.

Joe Parkhill – Morgan Stanley

Hi, this is Joe Parkhill for Mark. I have a follow-up to Meredith's question. I was just wondering if you thought that deflation has in fact caused more intense price competition and secondly do you believe that price competition would ease in an inflationary environment?

Steve Burd

As a matter of fact I do think that deflation has created more price competition and I think the reason it has and I'll go back to something that Meredith raised in her question, I don't think the industry was all that cognizant about inflation and frankly deflation until we started talking about it over the last year plus. So if you're looking at your sales and they're declining and you're not paying any attention that the CPG world is experiencing tonnage declines you get worried that somebody else is taking that business and you'd say well what can we do and you might try to get sharper on price. So, I do think that in a deflationary environment, things tend to get a little more competitive. At the same time, I have not witnessed a deflationary environment of this magnitude in my entire career. So, I'm drawing that judgment from a data point of one year, but we've experienced a little inflation in the past and a great deal in 2008 as we look at it in hindsight and I think you have called it correctly.

Joe Parkhill – Morgan Stanley

Then also just we've heard from some other retailers of California kind of turning in the last month or two, was wondering if you could make any comment about that geography?

Steve Burd

It's a geography where we have a lot of stores and its relatively high unemployment in the north and what we call our Northern California division. We operate with very strong market shares and we think that helps us a lot and then when you go down south and you look at conventional players, it's almost a three way tie in the market share so I don't think, I think if you were a small player in the market with some real economic adversity, I think that would be a bigger problem than if you're a large market share player.

Joe Parkhill – Morgan Stanley

So, it sounds like things have pretty much stayed the same then and not improved?

Steve Burd

I mean the unemployment certainly hasn't improved. The economy is what it is, but we don't think that gets in our way.

Operator

Thanks. And our final question comes from Bob Summers with Pali Capital. You may ask your question.

Bob Summers – Pali Capital

Just wanted to circle back to the vendor issue real quick, I mean arguably a lot of the vendors have volume issues. What happens if we see acceleration in allowances or price list reductions and how does that impact how you think about '010 inflation?

Steve Burd

I'm not anticipating that we're going to see large price reductions. We have dribbling improvements and allowances. I pretty much describe, the center of the store is a pretty flat in inflationary environment. It's normal to have inflation in the center of the store and so my expectation is you will basically see an end to deflation in the perishable areas in 2010, and I expect you'll see modest inflation in the center of the store. In fact, we've seen some increases in cost in the third quarter.

Bob Summers – Pali Capital

Then on a broader basis, as we go from this environment characterized by pretty significant deflation to inflation, what are some of the challenges? Will there be issues in terms of passing through price increases because of the overall competitive and consumer backdrop? What do you really anticipate that?

Steve Burd

Again, as long as it's in the range of a low number, I don't see that as an issue. I think those things generally get passed along. Just in mind, even though supermarkets tend to be resilient during business downturns, we do have a lot of fixed costs, and so I think that creates pressure to try to do better at times get better so, and it also happens with individual items and individual categories so it's not like it happens all at once, and therefore, it's pretty, it's not highly noticeable when you get this modest amount of inflation, and the average worker in this country gets a wage increase annually in the 3.5% range and that's why there's no demand dampening effects. Now, a lot of companies that didn't happen in 2009 but I expect that that will happen again in 2010.

Bob Summers – Pali Capital

Then with respect to the comp that you showed us today, it's ex-Canadian currency. I think it's been a while since you kind of separated that out. Could you frame the size of that for us?

Robert Edwards

Bob, I think we actually broke that out in the press release with that.

Melissa Plaisance

We've always reported our comps in local currency.

Robert Edwards

Then the IDs exclude any effects of currency, Bob.

Operator

We have a question from Neil Currie with UBS. You may ask your question.

Neil Currie – UBS

I just wonder if I could get your comments on the M&A situation in the market right now, from both points of view. Are you happy with all of the markets you're in right now and secondly, there must be some very struggling smaller regional players and there must be some really good opportunities to pick up some market share at low evaluations. Do you anticipate the number of distressed sellers picking up and would you be interested if that was the case?

Steve Burd

For the last several years, we've not been highly acquisitive, at the same time, we always look at assets that we think might be in-market and available, adjacent and available. It has to be a pretty unique asset if it's out of market for us to get attracted to it. But we look at things all the time. I think that if you see continued softness for a while, you may see some fragmentation where people are getting out of submarkets and that kind of thing. But so we're always, if it improves shareholder value or has the prospect for doing that we'll look at it, but we actually feel very good about our ability to grow the earnings of the company within the geographies that we have.

Neil Currie – UBS

Okay. My other questions have been answered. Thank you.

Melissa Plaisance

Okay, thank you, everyone for participating. Sorry, it ran a little bit longer we wanted to accommodate as many questions as we could. There may be some others that crop up, feel free to call me or Christiane Pelz over the balance of the day. Thank you.

Operator

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

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!