Safeway - A Bad Business With A Weak Balance Sheet At A High Price

Oct.11.13 | About: Safeway Inc. (SWY)

Safeway (NYSE: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

2008

2009

2009

2009

2009

Revenue

37,299

34,476

34,204

36,171

36,573

Revenue growth

-7.6%

-0.8%

5.8%

1.1%

Operating income

1,559

609

790

686

665

Operating Margin

4.2%

1.8%

2.3%

1.9%

1.8%

Click to enlarge

Safeway Domestic, ex Blackhawk

2012

2013

for 9 months

Revenue

25,058

25,208

Revenue growth

0.6%

Operating Profit

350

317

OPM

1.40%

1.26%

Click to enlarge

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 (NASDAQ:WFM), The Fresh Market (NASDAQ:TFM), or Sprouts Farmers Market (NASDAQ: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 (NYSE:WMT), Target (NYSE:TGT), Costco (NASDAQ: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?

Share price

33.5

after hours price on 10/10/13

Shares outstanding

242.6

Market Cap

8127.1

+Debt

5568.3

-Cash

-309.1

-Blackhawk Market Value

-750

Safeway owns 75%

-Proceeds from Canada

-4000

after-tax

-Other

-250

cash tax benefit from Chicago sale less

PV of quarterly cash payments for multi-employer pension plan

Enterprise Value

8662.4

EV/ EBIT

13.0

Click to enlarge

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?

Operating Profit

665

Associate Income from Blackhawk

49.5

assume 75% of 100 taxed at 33%

Interest Expense

-157.5

assume 3500 in debt after $2 billion pay down at 4.5% interest rate

Taxes

-167.5

assume 33% on pre-tax, ex Blackhawk

Net Income

389.525

Shares outstanding

170.4

Assume $2.4 billion buyback at $33.5/share

EPS

2.29

So 14.6x P/E

Click to enlarge

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:

Company

EV/EBIT

P/E

Wal-Mart

10.0

13.0

Target

9.6

12.9

Kroger

10.5

12.9

Safeway

13.0

14.6

Click to enlarge

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:

Company

Net Debt/EBITDA

Wal-Mart

1.3

Target

2.2

Kroger

1.8

Safeway

2.1

Click to enlarge

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.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SWY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.