Safeway (SWY) shares were up strongly after-hours Thursday as shareholders applaud the exit of their troubled Chicago locations and anticipate a $2.4 billion buyback (30% of shares outstanding) which the company noted has yet to begin. Shares have had a great run this year (+80%) as Safeway listed Blackhawk (gift card business), sold Canada/announced a large buyback, and inadvertently attracted activist shareholder Jana. For whatever reason, shareholders seem to be giving the company yet another pass on continued weak operating results including low growth (1%) and a 14 basis point decline in operating margins (which is very significant for a business which earns sub 2% operating margins). While momentum players bid shares up in anticipation of a buyback, long-term fundamental investors are being given an excellent opportunity to short shares of an overpriced, leveraged, structurally disadvantaged business which will destroy (not create) value by buying back shares. Further, listing Blackhawk (gift card business), selling Canada, and doing a leveraged buyout on the remaining company will leave Safeway with few strategic options going forward. At a P/E of 14.6x and EV/EBIT multiple of nearly 13x, shares look to have at least 38% downside.
With Canada nearly gone and Blackhawk listed, let's have a look at the domestic grocery business of Safeway:
Safeway US, ex Blackhawk
Safeway Domestic, ex Blackhawk
for 9 months
This is a pretty ugly picture. And if you go back further, the trend looks even uglier. Were you to go back to 1999-2000, you would see that Safeway was earning 6-7% operating margins, similar to Whole Foods (WFM), The Fresh Market (TFM), or Sprouts Farmers Market (SFM). As an aside, at that time brokers were writing about how margins would go to 8% and that Safeway should receive a 20x P/E multiple instead of the 18x or so it was fetching. What actually happened? Wal-Mart (WMT), Target (TGT), Costco (COST) and numerous dollar-store chains attacked from the low end whereas Whole Foods and the like attacked the high end. This lead to same-store sales declines, price cuts and margins plummeting to less than 2%.
While I would agree with bulls that we are unlikely to see another massive fall-off in operating margins, I don't believe that the grocery business has gotten any easier. Consider that (1) Whole Foods is looking to nearly triple its store count over the coming 10-15 years and is becoming more price competitive (2) Target is filling in its store network with smaller format Citi Targets which also carry groceries (3) in addition to continuing to expand its large format general merchandise/grocery store hybrids, Wal-Mart is operating 300 or so Neighborhood Market stores which it is looking to grow 3-4 fold over the next 10-15 years (4) Amazon.com is rolling out a delivery grocery service - while many have failed in this area, given that Amazon is a) a superior operator and b) seems to have an infinite horizon across which it is willing to lose money/breakeven while growing revenue, this is a real threat and (5) numerous chains have come public (and smaller ones have raised private equity) and are growing their store-count rapidly in order to attempt to satisfy their investor's expectations. I seriously doubt we will see a significant rise in operating margins going forward.
Based on this, I will generously assume that Safeway is able to earn a normalized operating profit of $665 million going forward (so say 2014 is in line with 2012). I'm effectively assuming that while 2014 will benefit from the soon-to-be-gone 'Chicago lost nearly $35 million in the first 9 months of 2013,' I'm ignoring the underlying decline in operating margins (which as you can see above fell another 14 basis points or a decline of $33 million. Importantly, I'm assuming that somehow Safeway can offset the continuing competitive pressure highlighted above.
So what are investors paying for this $665 million in operating profit?
after hours price on 10/10/13
-Blackhawk Market Value
Safeway owns 75%
-Proceeds from Canada
cash tax benefit from Chicago sale less
PV of quarterly cash payments for multi-employer pension plan
Note that I've excluded some $800-900 million in unfunded pension liabilities as I believe this is properly taken into account through the income statement. So we've got the EV/EBIT multiple of 13, what about P/E after taking into account the $2 billion buyback?
Associate Income from Blackhawk
assume 75% of 100 taxed at 33%
assume 3500 in debt after $2 billion pay down at 4.5% interest rate
assume 33% on pre-tax, ex Blackhawk
Assume $2.4 billion buyback at $33.5/share
So 14.6x P/E
Paradoxically, the higher Safeway's share price goes, the lower next year's EPS will be. How does Safeway's valuation compare to industry peers? Let's look at Kroger, Target, and Wal-Mart:
Is Safeway's valuation premium warranted? First let's consider operating performance. As we saw above, the domestic profit of Safeway (ex-Blackhawk) fell 55% between 2008 and 2012 whereas Target's has increased 20%, Wal-Mart's has increased 22%, and Kroger's is up 4%. Safeway also has the weakest balance sheet. Following the divestiture and share buyback, Safeway will have net debt /EBITDA of 2.1x which doesn't compare favorably to its peers:
Given its weaker operational performance and weaker balance sheet, I think Safeway should trade at a material discount to Wal-Mart and Target. Given that they are selling at ~10x EV/EBIT and 13x P/E, I think a fair multiple for Safeway is 7xEV/EBIT and 9x P/E (30% discount to Wal-Mart and Target). Using these multiples I get a fair value range of $15 (EV/EBIT) and $20.70 suggesting downside of 38-55%. This assumes the company can maintain its current level of operating profit - based on history there is no evidence of this. Safeway looks like a good short to me.