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Safeway, Inc. (NYSE:SWY)

Q4 2009 Earnings Call

February 25, 2010 11:00 AM ET

Executives

Melissa Plaisance - SVP, Finance and IR

Steve Burd - Chairman, President and CEO

Robert L. Edwards - EVP and CFO

Analysts

John Heinbockel - Goldman Sachs

Karen Short - BMO Capital

Mark Wiltamuth - Morgan Stanley

Scott Mushkin - Jefferies & Co

Edward Kelly - Credit Suisse

Chuck Cerankosky - Northcoast Research

Meredith Adler - Barclays Capital

Charles Grom - J.P. Morgan

Andrew Wolf - BB&T Capital Markets

Deborah Weinswig - Citi Group

Neil Currie - UBS

Operator

Welcome to the Safeway Fourth Quarter 2009 conference call. (Operator instructions). I would 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 our fourth quarter and year end 2009 conference call. With me this morning is Steve Burd, Chairman, President and CEO and Robert Edwards, Executive Vice President and Chief Financial Officer.

Before I turn the call over to Steve, let me remind you that this conference call may contain forward-looking statements. Such statements may relate to topics such as sales, margins, earnings, earnings growth, operating improvements, cost reduction, capital spending, debt financing, dividends, free cash flow, growth of Blackhawk, depreciation, product development, Lifestyle stores, additional growth vehicles, guidance and other related subjects.

These statements are based on Safeway's current plans and expectations and are subject to risks and uncertainties that could cause actual events and results to vary significantly from those implied by such statements. Please 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 10-Q.

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

Steve Burd

Thank you, Melissa. I feel compelled to start with a brief medical report. I’m suffering from a cold. The last time I had a cold, several people had right out suggested that I really seemed down on the call. So that’s why I start with that medical report. I’m not down. I’m just a little sick.

So let me start with the numbers for the quarter. Our fourth quarter results were negatively impacted by a non-cash goodwill impairment charge of $1.818 billion. This charge is a direct result of the decline in year-over-year share price. The divisions affected were primarily bonds and eastern. They represented 99% of the charge. The goodwill originated from previous acquisitions.

Now this created a reported quarterly loss of $1.609 billion. Excluding the non-cash impairment charge, net income for the quarter, was just a touch over $209 million and this compares to the $338 million from the same quarter a year-ago.

Expressed in terms of earnings per share, we earned $0.53 on the quarter, as contrasted with $0.79 a year-ago. Kind of a footnote to that $0.53, it did cost us about a penny in the quarter to - these would be ratification costs as a result of a couple of labor agreements recently ratified.

It was a very challenging quarter, but results were in line with our expectations and just based on the numbers, appear to be in line with expectations of the consensus. As expected, our earnings this quarter were well below last year’s fourth quarter. Now this shortfall from last year was largely the result of a sales shortfall, which was driven predominantly by deflation and secondarily by a decline in volume.

We also had one less week this year as well as the higher tax rate, but these were offset by other positive items. You can think of the earnings per share shortfall, absent this ratification cost as essentially being the result of deflation and a decline in volumes versus last year.

Turning first to sales, our total sales declined 8.1% versus last year. This decline in total sales is explained by one less week as well as a decline in ID of 4.1%. The ID’s ex-fuel which is that negative 4.1% are what I will expand on a bit. Total company volume was negative and was essentially equal to quarter three results.

On the good news side, volume continued to show improvement in the U.S where I am happy to report we are now at price parity with our primary conventional competition. I think for several months now, people have been saying, “Well, where are you in this baseball game”. And I am now telling you the game is over in the U.S and we won.

So we are at fully price parity with our primary conventional competition, which puts us well below our secondary competitors in virtually every market.

The other thing I would tell you is that while the volume was slightly improved in the U.S, it showed a marked improvement in the last four weeks quarter, which I think is indicative of how the marketplace is digesting the price movements that we made particularly in the third and fourth quarters of last year.

At the same time, our volume declined in Canada where we have not yet launched our price and what we call our promise campaign to consumers. Our perishable volume in the U.S is the best it has been in 12 quarters and has been a very healthy positive number now for two consecutive quarters.

Our non-perishable volume in the U.S had its sixth consecutive quarter of improvement, but is still running negative to last year. As expected, deflation accelerated in the fourth quarter and explains the entire difference in ID sales reported between quarter three and quarter four. So it’s essentially volume was flat with quarter three.

Turning to gross margins, our total gross margin rate decline 14 basis points from last year’s fourth quarter. When you exclude fuel sales, the gross margin declined 16 basis points. Now this decline in gross margin rate was largely the result of making investments in everyday price and obviously a setup in advertising to support and covey that message of lower everyday prices.

Now those were essentially partly offset by a much lower LIFO charge, which I think you saw in the details of our report, and obviously in the fourth quarter, improved gift card sales. We also had a modest improvement in shrink, which is an extraordinary result given the magnitude of deflation that we've been experiencing.

To be able to have an improvement in shrink in that kind of deflationary environment indicates an extraordinary amount of good work on the side of shrink.

Turning to O&A expenses, O&A expenses increased 92 basis points from the last year’s fourth quarter. When you exclude fuel sales, the O&A margin rate increased 90 basis points.

Now, the 90 basis points decline was essentially a sales decline and we reported in our press release that we had an increase in property impairments, which affected that number. We had lower gains from sales of properties, which you could appreciate given this real estate environment and a pension increase. But those were essentially more than offset by improvements in workers comp and utility comp.

So given the fact that workers comp, the utility costs were overshadowed with those negatives, we would have had more than a 90 basis point decline were it not for that. It is very instructive here to understand the role of deflation. Normal price per item inflation in this business as I looked over the last decade is about 3%.

And what we experienced in the quarter was about 240 basis points of deflation. So if we had had no deflation, our O&A would have increased 30 basis points and in fact if we had normal inflation, our O&A would have improved 44 basis points.

So for those of you that either listen in or come to the investor conference, you are going to hear a story about what an extraordinary year we had on controlling costs.

But that gets masked by the lack of normal price per items inflation, which is really important to understand. And in the 17 years I've been in this business, the kind of deflation that we experienced in the fourth quarter, it’s unprecedented, it’s never happened.

Turning to interest expense, interest expense declined $14.5 million due most to lower debt outstanding and a reduction in our average borrowing rate. The average debt outstanding was lower by $633 million. Our average borrowing rate declined by 14 basis points. We actually decreased our debt outstanding from quarter three by some $466 million. So it was an extraordinary free cash flow quarter.

We continue to have great access to commercial paper and in fact our overnight borrowing rate, which is not available to everybody, certainly not a lot of small or independent grocers that we compete with, is now some 25 basis points, which I guess is equally unheard of, certainly in my business career.

Capital expenditures. We opened one new store and completed 20 remodels in the quarter. In 2009, that brings our new store openings to 8 and Lifestyle remodels to 82. Now this bring our total Lifestyle count to just under 1,400 stores, exact count is 1,366 or 79% of our store portfolio.

Turning to the full year results. Due to the non-cash goodwill impairment discussed earlier in this call we had a reported loss of $1.97 billion. Excluding the goodwill impairment, net income was $720.7 million or $1.74 per share.

Total sales decreased 7.4% due primarily to three factors, one was lower fuel cost, second is the decline in ID sales and third would be one less week in 2008.

Now our ex-fuel growth margin rate, meaning, excluding fuel, declined 35 basis points while our O&A margin, again excluding fuel, increased 60 basis points, again largely due to deflation.

Our free cash flow more than doubled. In fact our free cash flow was up 119% to a $1.490 billion from last year’s $681 million. The big contributors to the increase were lower CapEx and lower tax payments.

As a result we were able to lower total debt on the year $598 million. We also used a lot of that free cash flow to purchase a total of 42.5 million shares at a cost of $885 million with $443 million of that money being spent in the fourth quarter. And then we also paid a dividend this year, as you know, of $153 million.

A brief update on Blackhawk. In spite of the environment, Blackhawk continued to experience strong growth. The face value of all car sales increased 21% during Q4 and 22% for the year.

Other significant news, I know some of you have expressed a lot of interest in a couple of labor contracts which have been a bit up in the air. We actually ratified the Phoenix contract in the fourth quarter and then more recently here in the first quarter, the Denver contract was also ratified. And that was a bit of a peculiar circumstance because our key competitor had theirs ratified well in advance of ours. But essentially we ended up with the same deal.

In terms of guidance, which I sometimes comment on, on this earnings call, given that the investor conference is only a couple of days away, we’re going to wait for the investor conference before providing 2010 guidance.

So by way of summarizing the year, first I would start with the fact that we achieved price parity with our key U.S conventional competitors by the fourth quarter of 2009. That to us is a major milestone which builds a foundation for growing sales and market share in 2010.

We've seen our volume improve steadily each quarter in the U.S with no real improvement in the economy and I think most of us think the economy will begin to see some improvement in 2010.

We continue to lower operating cost in what we are confident is a sustainable fashion. We've completed a record year of free cash flow, essentially a $1.5 billion during a period of unprecedented deflation.

We continue to operate with the best condition assets in the conventional supermarket space with 79% of them completely Lifestyle remodeled. Strong balance sheet with access to low cost borrowings and next week we’ll discuss why we believe we are well positioned for future growth.

So with that Melissa, I’m ready to take questions.

Question-and-Answer-Session

Operator

Thank you. We will now begin the question and answer session. (Operator instructions). Our first question comes from John Heinbockel - Goldman Sachs.

John Heinbockel - Goldman Sachs

Steve a couple of things. You had said that volume had improved in the final four weeks of the quarter. So two things, does that mean comps also improved in the final four weeks? And then what’s been the performance thus far in the first quarter? Has improvement continued?

Steve Burd

In the last four weeks, we had a nice improvement in volume, which did not translate into necessarily an improvement in comp because the deflation was so severe in the fourth quarter.

If I look at the first quarter, I have to be very thoughtful about the numbers. And what I have to do is I have to divide the first quarter into three discreet chunks. The first chunk is the first three weeks of the quarter, the second group is weeks four through eight and then the third chunk yet to be started, is weeks nine to twelve.

And the reason I divide it that way, you may recall at the end of the first quarter last year when we reported our earnings, we had an 86 basis points decline in gross margin. And what we talked about on that call, was that about 38 basis points of that was associated with an effort on our part, starting with Super Bowl to really spike demand. And what we confessed on that call was that we didn’t really get a sales response.

As it turned out, we got an extraordinarily powerful volume response. We got a volume response in excess of 500 basis points. But deflation in the first three weeks of last year, I’ll express it in terms of price per item. In the first three weeks last year price per item was up 5% and then in the next four weeks it basically dropped to zero. And so the volume increases that we experienced last year were entirely offset by a price per item decline.

All right, so with that in mind, we actually saw acceleration in the volume improvement in the first three weeks of the quarter. I mean price for now, continuing what we saw in the last four weeks.

Then because we are up against this extraordinary event, where we spent in excess of $30 million, but in hindsight got our volumes up but no resulting sales increase, we’re up against that volume, artificially driven volume improvement last year in weeks four through eight.

So we expect weeks 9 to 12 are going to look like 1 through 3. And then frankly, our expectation is that with everything that we’ve done and continue to do, we should see continued improvement through the second quarter in volume.

We essentially in the last four weeks of the year, we got a bit of a market share decline in our space, but we had that market share decline in the last four weeks of the quarter and in the first three weeks of Q1.

John Heinbockel - Goldman Sachs

So I guess if deflation is not getting worse, may be it’s getting a little bit better but more to come and volume is still improving. The fourth quarter should represent the low water market at a negative four. I don’t know what the rate of improvement is going to be, but that should be the low water mark and we improve from there, do you think that’s right?

Steve Burd

My judgment is your right, and I will give you a couple of facts on that. The only hesitation in my mind is what the economy is going to bring. But there is a dramatic change in deflation that has already occurred between the fourth quarter and the first quarter. And so I don’t think you’re going to see from us anything like a negative 401 going forward.

Deflation I think in the first 8 weeks of the quarter, we’re running more like a negative one instead of a negative 240. And then as we look at last year, and I going to spend a serious amount of time on this in the investor conference so that everybody understands the source of the deflation. I think you’ll be able to see why I'm predicting that we’ll actually see moderate inflation in 2010. And so I think you're assessment John is right on.

John Heinbockel - Goldman Sachs

Secondly, you said your pricings are at parity now. What's your thought on whether this is a moving target and you'll be parity in three months or six months? That the investments are completely done. I suspect it maybe a little bit of a moving target.

Steve Burd

I mean price is always a moving target. But I think that if you - we got to where we are on the parity front two ways. We got there by making some extraordinary price investments and as you know accelerated because we said, “Look this soft economic time is going to be around for a while. Lets not end the year with any deficit there”.

So we got there by making extraordinary price investments and seeing some of that competition frankly elevate those prices. Simultaneous to that we saw the secondary competitors basically ill equipped to do anything about it.

And so we have really widened the gap somewhat unintentionally with the secondary competitors in each of those markets, which to me suggests that tough times have been pretty tough on them and a lot of these companies are cash-strapped, some of them have declared bankruptcy.

And so I think that you could see some investments in price next year. We expect to be able to cover that by the combination of cost reduction that we make both in the supply chain as well as the O&A side.

So, we think that this long awaited event to get to price parity is essentially overgrown. And we’re determined to stay at a point of price parity because now with the economy recovering, now our points to difference really matters.

John Heinbockel - Goldman Sachs

And then I guess finally, if you think about what comp you need to get expense leverage? So you said that if you had normal 3% inflation, you would have got a lot of leverage versus the negative 24, which sort of means that - and I want to see 3%, but it sounds like you probably do need at least flat to get some expense leverage but may be not a lot more than that. Do you think that’s fair?

Steve Burd

Yeah we probably need to be just slightly over flat.

Operator

Your next question comes from Karen Short - BMO Capital.

Karen Short - BMO Capital

Just wondering, first if you could talk a little bit more into the comp just in terms of a little more color on traffic versus basket versus unit and then some comments on household accounts in the quarter and then also the same thing for trends that you’ve seen in the first quarter so far?

Steve Burd

Most of the year what we saw was increased transactions, increased households and still a negative basket size, which is I think a symptom of economic circumstances where people are being very careful with their money and maybe shopping multiple channels and so on.

In the fourth quarter it was predominantly about increasing household, still some negative relative to last year on items per basket and we had a little down shift in the fourth quarter in terms of transactions.

In the first quarter I haven’t committed to memory where exactly we stand on those metrics. And you'd have to also split the quarter into those three chunks. But I may have that information before the call is completed.

Karen Short - BMO Capital

And what about tonnage in branded versus private label? What are you seeing there?

Steve Burd

We’re still seeing an improvement of private labels over that of national brands. Maybe not as strong as in previous quarters, but still an improvement there.

Karen Short - BMO Capital

And then, I'm just wondering when I look at your gross margin, when I back out the benefit of the LIFO credit, gross margin declined. And I guess you talked about more price investments but I mean I guess the gross margin decline was a little bit in contrast to what other retailers have been reporting, because they seem they’ve kind of been holding other retailers. So am I to understand that you did sequentially accelerate your price investments in the fourth quarter?

Steve Burd

Well we made price investments in the fourth quarter, it is the completion of, really I might even argue, a four year effort that was finished off in the fourth quarter. So the fourth quarter was a quarter of price investment.

Let me go back to your first question, again I’m only looking at the first three weeks quarter for the reasons I cited earlier, we actually saw positive transaction for household and positive item per transaction. And that was those were all good strong elements.

Karen Short - BMO Capital

And then, the last question is looking at earnings for this year and this quarter, you kind of said that earnings did come in line with your expectations. And you did on the last quarter loosely comment that you were okay with where consensus was for fiscal 2010. Would that indicate that you’re probably still feeling kind of comfortable with fiscal 2010 consensus just given that the quarter came in in-line?

Steve Burd

Well, first of all I don’t think I commented on 2010 in the last earnings release. And then we’re going to detail the 2010 guidance on the third. So I’m going to hold off until the third before I do that.

Operator

Thanks your next question comes from Mark Wiltamuth - Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

Steve I wanted to dig in a little more on Blackhawk since this is their big quarter. How much of the gross margin swing did you get out of Blackhawk and give us a general idea of what the operating income for that business looks like? I know some at one point you broken it out around a $100 million a couple of years ago?

Steve Burd

Yeah, I think that we get questions from time to time on the Blachawk contribution. We have not revealed the pure Blackhawk contribution and don’t assume to do it on this call.

Let me just clarify the $100 million that you remember, because we did cover that in an investor conference a couple of years ago. What that represented was really three things. It represented the stand-alone income of Blackhawk.

It represented the income that Safeway generates on the cards it sells as a distributor of Blackhawk. And it represented a whole series of income producing things that Blackhawk had done prior to really making the gift card in prepaid business, their primary business.

So we took those other things that they had done and folded those things back into the core, and so that’s the source of the $100 million from a couple of years ago. And we’re not prepared to sort of breakout what Blackhawk is either in terms of gross margin contribution or in terms of its total contribution. We think we benefit a lot by building that business in the early stages by not sharing the details of that information.

Mark Wiltamuth - Morgan Stanley

Okay I guess what I was trying to get at indirectly was what do you think your pure grocery gross margin was for the quarter, up or down?

Steve Burd

Well, if I answered that, it would give you some insight into Blackhawk, I’m going to leave that out too.

Mark Wiltamuth - Morgan Stanley

Okay, and then if we look kind of category by category around the store, there are some signs of perishables starting to improve on price. Could you talk about that a little bit like which categories are starting to move for you, and are you passing those cost through, in other words trying to see some movement on commodity cost?

Steve Burd

It's pretty customary and in the produce area like that its cost a lot for down margin rates tend to remain relatively constant. And so that if you have a cost of goods increase because of lack of product of somewhere that's going to get reflected immediately in the retail of that product.

Mark Wiltamuth - Morgan Stanley

In which categories have you start to see some movement?

Steve Burd

Well, I'm not sure so much if it's movement or if it's still the lack of movement from the comparison in other words what you had in really week five of last year was a pronounced decline, let's say in the cost of prototype.

So now we see a slight increase there. It's not so much of a big increase it's just going off again a pretty low base. And I think you'll see gradual improvement. If you recall last year, the deflation was essentially lead by milk, egg, cheese, and produce, means that was I think more than 60% of the entire deflation.

Mark Wiltamuth - Morgan Stanley

What's your outlook, as we get back to inflation you think you'll be able to pass that all through because we have that some quarters back in '04 and '07 where the industry had trouble passing through inflation?

Steve Burd

I think the normal thing is inflation gets pass through again, I'll show some numbers at the investor conference and I think they will demonstrate that in the main inflation did pass through. That certainly been in the history there.

What you saw happen in 2009 was some extraordinary thing. You saw people desperate for traffic, my own personal belief is that we were among the first to really dissect the sales numbers into the elements of deflation, inflation.

And I think as people didn't see that and they saw their sales decline, a report of sales decline they reacted and some of them chose to use the commodity like milk to drive traffic, whereas it never been a traffic driver in the past. So the retails on milk for 16 years if the cost went down $0.30, the retail went down $0.30. If the cost went up $0.30, the retail went up $0.30.

In 2009 that wasn't true, cost went down $0.30 the retails went down more than $0.30. But in the produce area, that it generally was not the case and so I'll show you some numbers next week, we'll see that when you do experience inflation those numbers get past along.

Operator

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

Scott Mushkin - Jefferies & Co.

You purchased a tremendous amount of stock in the quarter, but still 1.3 billion left. You also have 500 million I guess due in a note in August. I was wondering as you look at next year and kind of the cash flows which are likely to be in excess of a billion. Do you feel like you need - you can roll that note and dedicate almost all the money for stock repurchase or where is your head?

Steve Burd

Well Scott, right now we’re thinking in terms of the debt financing that we would like to repay and somewhere all that 500 million that is due in August.

Scott Mushkin - Jefferies & Co.

Any comments on the stock repurchase plans.

Steve Burd

Yes we never really comment in advance of what we are going to do on stock buyback. Next week we will talk about priorities with use of cash.

Scott Mushkin - Jefferies & Co.

Trade down, I know we’ve talked about this on other calls and I think Steve mentioned there is some tentative signs in the third quarter that people were getting back to at least somewhere normal buying patterns with (inaudible) but I can’t remember.

As we look into next year, the trade down has been such a big factor and you guys tend to skew a little bit higher quality product and with the gross margins investments now largely behind you, do you think you could actually see a scenario where gross margins could actually go up a little bit if you got the right mix and sales picked up quite a bit.

Steve Burd

I think it could and it’s not just a trading up tick of results in that. We have a lot planned next year on the supply chain which would be positive to gross margins. I think as we look at the numbers, increasingly we’re seeing other categories that indicate that there is some trading up going on, I think about the floral category is being outside of Mother’s Day and Valentine’s day, this is pretty, where I consider those non-discretionary spends, I mean those are sort of must do’s.

But we’ve seen our floral volume pick up dramatically and of course we’re a very large floral player. I mean floral to us is a more important category as virtually anybody in our space.

And you need look no further then just compare our floral department to anybody else’s. We look more like a florist they look more like a grocer. But we’ve seen a dramatic change in floral sales versus a year ago.

And so and we’ve seen a continued up-tick in the Starbuck business and we’re the largest licensee of Starbuck in the world. And then I’ve commented before, but it continues, while premium lines are all lower priced than what they were a year ago, we’ve seen a step up in that business.

So I think that, in combination with some other cues that we and, probably you, have gotten from the marketplace suggest that there seems to be a gradual improvement here in consumer confidence and I think that’s reflective in the mix of business.

Scott Mushkin - Jefferies & Co

So just to sum it up, so your ex-fuel gross margins, which have been under a tremendous amount of pressure, you’ve gone through this investment program, as we look out probably are flattish to maybe to, great scenario, maybe up a little bit. And thinking to John Heinbockel’s question you said SG&A dollar growth, my interpretation would be kind of flattish you said you needed about zero comp to lever. It sounds like if sales would return that you would have a decent amount of P&L leverage. Is that accurate?

Steve Burd

That’s accurate. You’re good with math.

Operator

Your next question comes from Edward Kelly - Credit Suisse.

Edward Kelly - Credit Suisse

Steve, could we just go back to the gross margin for a second this quarter, and I know Karen mentioned this but if you back out the big LIFO credit that you got this quarter, it looks like your FIFO gross margin is actually down about 50 basis points, it was only down 6 basis points last quarter.

Last quarter you did a good job of sort of bridging the gap sequentially and why got better, can you maybe do the same for us this quarter and just sort of help explain why it was down a lot more than what it was last quarter?

Steve Burd

Well, one of the reasons for it is the increase in advertising that is associated with communicating your price division, was pretty material in the quarter. And there’s also a gross margin hit that you take when you lower the prices and now that hit is actually pretty temporary.

I used to be good at explaining the accounting reasons for that but basically it work its way out in about 4 week to 6-week period. So price investments made in the fourth quarter coupled with heavy advertising sort of explain a big piece of that.

Edward Kelly - Credit Suisse

And then you were talking about the gross margin for next year and it sounds like there is maybe some hope that we could see a flat to positive gross margin but is that the reality if we look at the environment the way it stands today and assume a gradual recovery? If that's the case, are we still looking a modest decline?

Steve Burd

Well, keep in mind that our efforts next year will be supported by a lot of work that we're doing in the supply chain. I think when you look at gross margin and it goes up or goes down, there is an assumption because we don't provide all the detail that up or down is driven by price.

But there's a tremendous amount of work going on in costing in the supply chain that can elevate or deflate those numbers. And I think if that work together with the O&A work that we'll do, that really gives us the confidence, plus the fact that we're at price parity, that we should have a pretty normal year in 2010.

And they were predicting very modest inflation. When you see some of the history that I will show next week, you will predict even greater inflation than me. And I think that it could happen, we're going to try to be thoughtful in our predictions here.

Edward Kelly - Credit Suisse

All right great. And just last question for you. I fully agree that we'll probably see re-inflation next year and maybe more than what you just talked about. But does it matter where we see the inflation? If it's dairy and produce as opposed to the grocery? Because I don't think center of the store we're going to see much. Is there a difference with how it impacts your P&L?

Steve Burd

I don't think there is a real difference.

Operator

Your next question comes from Chuck Cerankosky - Northcoast Research.

Chuck Cerankosky - Northcoast Research

Well just a house keeping thing first for Robert. In the comment on the OG&A talking about property impairments, that's completely separate from the goodwill impairment charge, correct?

Robert Edwards

Correct.

Chuck Cerankosky - Northcoast Research

Steve, when you are talking about deflation and price investments, could you sort of balance between the effect on sales from cost of goods, deflation, price investments and trading down? Could you maybe weight those things and how they are appearing in the revenue line of Safeway?

Steve Burd

Yeah, we'll try to give you a look, see at that next week. There is an element of judgment, which you can appreciate in trying to differentiate that. But we'll try to lay that out for you next week.

Chuck Cerankosky - Northcoast Research

I'll look forward to it. One category I am interested in, around the trends you are seeing say to the fourth quarter and into the current period. What do prepared foods look like and what kind of price points are people drifting towards?

Steve Burd

Our prepared foods business has actually really done well for us this year. If you go back I think it probably was two investment conferences ago, we actually served a number of our prepared meals to everybody at the investor conference. And at that time we were pretty excited about it and had it in only a sampling at stores.

We struggled to really make that a profitable business because we had relatively short shelf life and we had a lot of shrink. And at that time we probably had a lot of SKU’s. So that business has been completely reengineered giving us extended shelf life without sacrificing quality.

And in that business today we’ve gone from zero to more than $100 million in sales in a relatively short period of time. And so, in terms of overall price point, I’m not sure if those price points have materially changed. We have certain on tray items that are actually designed to feed as many as four people and others design to feed as little as one.

And so the price points can be quite varied. But I think that the vision that we had a couple of years ago has finally been realized and that business is growing nicely.

Chuck Cerankosky - Northcoast Research

Last question Bob, can you give us a view on the acquisition environment right now with the assumption on my part that certain people might be or certain owners might be a little more amenable to selling than they were six to nine months ago.

Robert Edwards

I guess what I would say is that maybe there has been a moderate up tick in interest but not - I wouldn’t say its material, I think that what you saw happen over the last 18 months to a year is a lot of people not having our balance sheet, our strength really struggled with this economic downturn.

And so these can be 20 store chains, 50 store chains, that kind of thing. And so I think that they are much more amenable to considering a sale. But I don’t see anything on a sort of a transformational scale out there that grabs our attention.

Operator

Our next question comes from Meredith Adler - Barclays Capital.

Meredith Adler - Barclays Capital

You know what’s exciting to hear that you feel that you finished your price investments. I was wondering what customer research says. Is the perception of price now matching where you think that you are?

Steve Burd

The quick answer is no. The longer answer is with each passing month there is an improved perception on the part of the customer that our prices are better. I think I’ve said this consistently for a long time that when you change price, you get more of an immediate customer reaction to change in price than if you do a survey and ask them, what’s happened to price.

In other words perception could take a full five years to change and foot traffic in high velocity items can take a couple of weeks. Now we lowered prices during the worst of times.

And remember we lowered everyday price. So we lowered everyday prices when consumers were focused on promotion. So the vast majority of our competitors actually saw a spike in the percentage of their sales sold on promotion whereas we actually saw in increase in the amount of our business sold at everyday price.

So had our price investments went primarily out of promotional characteristic, we would have gotten a better demand response. I think actually the perception of overall price wouldn’t have improved as well as it has, given that we changed everyday price.

I’m not trying to confuse you here but in essence foot traffic behavior, in my experience, has always been quicker than sort of winning the survey. But we’ll show at the investor conference how those perceptions are changing as time elapses from what we call our launch dates, unlike you expect.

Meredith Adler - Barclays Capital

Okay and then just like tied into that did you actually change - you’ve always been very high low did you become - I mean you said that you’ve lowered the high, but did you also reduce the promotion or make them less low?

Steve Burd

In essence what we did was we lowered, we spent most of our time lowering the everyday non promoted items and then kept the promotional calendar and price point look pretty similar because when you promote, particularly when you advertise this fact in your ad, you can't promote at a price point that is elevated to that of your competition.

So what you'll see, I will show you both the change in everyday price and show you the change in overall what we call shop-to-shop price.

Meredith Adler - Barclays Capital

And then I just have one more question, you were talking about the comparison - the Super Bowl last year around that period and that it was -- you got a big volume increase last year.

I'm actually little bit confused because when I go back and look at what you said in the first quarter, you said you were not happy with the results of the promotion that you did but you just now described a very big improvement in volume. So what am I missing, were you expecting a much bigger improvement in volume?

Steve Burd

No, what we were not happy with was the sales response. The sales response was basically a nonevent but it was driven by - I mean I’ve never seen a 500 basis points decline in price per item from one week to the next, we never really saw that but it didn't get any better and it got worse as we moved through the year.

So the four week period in which we spent a lot of money produced virtually no sales improvement of any consequence, but when you look through all the details it was a pronounced improvement in volume masked by this decline in price.

And so what I commented on last quarter was we spent this money expecting to get an ID response, it didn't get the ID response and frankly understand deflation better today than we did it that time. And at that time, I mean if you want to go back and look at your note, we started talking about deflation easily two quarters before anybody. And now regardless of class of trade, they have been talking about deflation.

Operator

Your next question comes from Charles Grom - J.P. Morgan.

Charles Grom - J.P. Morgan

On the last call you talked about the $0.18 tax benefit and how you expected benefits from lower shrink and less depreciation and more favorable pension to, I think you said easily cover the $0.18. I guess, my question is, one do you still believe you can do that?

Then there is a lot of talk about having gross profit margins flat next year, but technically you will need to have gross profit margins up to offset that $0.18 tax benefit. So I was just hoping you could reconcile it for us.

Steve Burd

I think a lot of this gets reconciled next week at the investor conference. I think your note taking from third quarter was pretty good.

Charles Grom - J.P. Morgan

So you do believe that you can offset it than still? Is that a fair statement?

Steve Burd

Let’s say you took careful thoughtful note.

Charles Grom - J.P. Morgan

Okay, fair enough. Then in the past couple of quarters you talked about deflation getting a little bit better and I think in the third quarter you went through say eight categories of deflation and then you give us a little bit of color on the third quarter, can you give us what you've seen in the fourth quarter and then essentially what you think for 1Q or what you are seeing, you talked about the 110, I think 100 basis points relative to 240. Can you give us a little bit by category?

Steve Burd

I probably can't give you the category details today. I didn't bring those with me, but I can just kind of give you directional what we had in the fourth quarter was most of those categories got worse and then what your now seeing going on in the first quarter is for the most part happened in weeks four through eight and that will continue through the balance of the quarter. So I actually believe that it will probably be at less deflation at the end of the first quarter than what we have seen today, which is hovering in that 1% range.

Operator

Your next question comes from Andrew Wolf - BB&T Capital Markets.

Andrew Wolf - BB&T Capital Markets

High level take away, I just want to run it by you and make sure my interpretation jibes with what you are putting out there. It sounds like your volumes continue to improve. It’s still led by perishables despite some incremental pick up in the perishable and perishable shelf pricing, is that what is happening in the stores?

Steve Burd

The incremental pick up in perishables would be again more of a reflection of this lapping of deflation last year beginning in about week five. So that does reflect a tick up because it is if I recall correctly produce is a positive number, not a large positive number, but a positive number and that has not had a dabbling effect on demand.

I do think and I’ve said this before on the call that I think there is a level of inflation that is demand dampening and I think there is a level of deflation that is demand stimulating. And I think there is a level of inflation that is kind of normal and I’ll even define that is around 3% that is kind of neutral on the demand side.

Andrew Wolf - BB&T Capital Markets

Since Safeway publishes it’s vendor allowances in your Qs and K which we all appreciate, last quarter the vendor allowances were up 4% despite you’ve still talked about CPG branded business being down.

Like can we infer from that that branded players have come around to help with the promotions that, obviously are needed to get their products moving and if so what was the cadence to that quarter and what are you expecting out of the CPG companies this year?

Steve Burd

I think that, it’s hard to read into that vendor allowance number because there is so many different ways that we can buy products. We can buy product that is free of allowances and the cost is reflected in the invoice and then we can buy product where the invoice is one thing and the allowance is a fact.

I do think so part as much as I think everybody kind of want to look at those numbers and read into it. I don’t think you could read much into the vendor allowances. I do however think that your basic assumption is that with, private labeled brands having had a bit of heyday here, that the CPG world is interested in driving their units and are therefore more accommodating.

I think that’s true. I don’t you can necessarily pick that up from the vendor allowance information that’s filed quarterly.

Andrew Wolf - BB&T Capital Markets

Okay and just my last question is on fuel sales, in terms of profits I think this was the quarter where last year you had a really -- October was sort of historically high profit quarter and you didn’t - I don’t think I heard you call out any impact - was there a material impact from that?

I mean in other words was the fuel business down on profits because last year was so good?

Steve Burd

Margin was about flat, year over year quarter.

Andrew Wolf - BB&T Capital Markets

Was it in the third quarter where the tough comparison showed up because you’re --?

Steve Burd

Last year, we did have very good last year. We did have some promotions; issued some markdown promotions last year or every year, even this year and actually the pricing in Q4 2009, the average gallon price was higher than last year. So net net in terms of margin it was about flat.

Operator

Your next question comes from Deborah Weinswig - Citi Group.

Deborah Weinswig - Citi Group

So first can you talk about how you succeeded either for the year or the quarter in terms of cost reduction efforts specifically around markdown reduction and labor, and those are two big efforts for you.

Steve Burd

Can you repeat that for me just for a second?

Deborah Weinswig - Citi Group

I know two of your big cost reduction efforts have been around markdown reduction and labor and can you maybe just talk about your success during the year on this?

Steve Burd

Yeah, I think that again some of that will get details that at the investor conference. But one area of real concentration for us this last year, which you may have thought of as markdown, we spent as a previously highly promotional operator, we hang a lot of shelf debt on a weekly basis.

By converting a lot more of our operation to everyday good value we hang fewer shelf debts. And then there were a bunch of efficiencies associated with that and that did represent in fact, a major area of cost reduction for us in 2009. It had been on our radar for a couple of years and we just were determined in 2009 to get that done and we actually exceeded our goals there.

Deborah Weinswig - Citi Group

And there is also been a lot of work bringing down with regards to labor reduction and improving efficiency there?

Steve Burd

A tremendous amount. I mean to the extent that we were able to -- with work removals and with greater discipline on some already existing systems, some additional efficiency, we were able to essentially neutralize what was going to be a relatively large increase in labor and benefit costs in the year 2009.

Now I say that, I'm going to qualify that a little bit. It wasn't a large increase that resulted strictly from wage and benefit increases. We go through an up and down cycle where you might have a healthcare plan that might have excess reserves in it. And then that gets - you reduce your payments there. And if you are going up against that the following year, then that creates a quantum increase.

So we had some of that activity going on in 2009. And so, what was expected to be a relatively big hit year in terms of labor cost increases was completely negated by some of the efficiencies that I just talked about.

Deborah Weinswig - Citi Group

Something else I’m focused on the healthcare company, I think my notes say that it was expected to be profitable in 2009. Can you update us on that?

Steve Burd

Yes, the quick update is, it has gotten off to a bit of a slower start than we expected. Again we don't have extraordinary resources devoted to it. So it does not show a profit in 2009 nor does it show a loss, which is even fine, because it’s incontestably small. But we still think we’ll be successful there.

Deborah Weinswig - Citi Group

Okay and then in preparing for today's call, I dug back a few years. And at your 2007 analyst meeting you were forecasting 10 basis points of gross margin improvement annually. Is that what we should still be thinking about in a more normalized environment or based on a lot initiatives could we expect that should be higher?

Steve Burd

I think you are going to have to wait for the investor conference. And again we have stopped forecasting independently for public consumption in the gross margin and the O&A because it just gets really difficult particularly with deflation. But we will try to give you some comfort on the operating margin side.

Deborah Weinswig - Citi Group

Okay and then one housekeeping item, can we see a private label penetration in dollars and units for the year?

Steve Burd

We haven’t revealed that.

Deborah Weinswig - Citi Group

And then just lastly, can we get an update on the center store initiatives?

Steve Burd

I think the quick update is that we learned a lot from the small stores that we built and we’ve incorporated that kind of thinking into our category management. So I think as we roll through 2010, it won’t be as easily seen.

But I think on the store floor, we will try to feature some things so you can tell what we’ve sort of done there. And it involves essentially rationalizing the (inaudible) in the category specific to a store.

Robert Edwards

If I could clarify one item, the comments we made earlier on fuel profitability was on per gallon basis, which was flat. Because gallons were down in the fourth quarter of ‘09 versus ‘08. Total gross profit from fuel was down somewhat.

If you look nationally at consumption of gasoline, even refinery utilization was down and then there was a bit of demand production but (inaudible) true promotions we did. So in total, gross profit dollars from fuel was down a bit, per gallon basis was about flat.

Melissa Plaisance

We have time for one last question.

Operator

Our final question comes from Neil Currie - UBS.

Neil Currie - UBS

Just wanted to ask about the goodwill impairment charge. If I look back over the last year, your share prices have actually gone up. So is this more of a reflection of what happened in 2008 or is it a reflection of your expectation of cash flows from these businesses in the future?

Steve Burd

It's really the stock price change Neil. We are required by GAAP principles to test this once a year. We do it based on the prices really at the end of third quarter. And if you look the price at the end of the third quarter was $26.75 a share in 2008.

The price at the end of the third quarter this year was $20.20. And so there is a defined methodology for then how you have to value the business based on the change in market GAAP. So it's almost entirely due to the change in market GAAP from the end of the third quarter to the third quarter of this year.

Neil Currie - UBS

And the entire 459 that's a full goodwill impairment? There wasn't any tangible asset write-down there?

Steve Burd

No it's goodwill.

Neil Currie - UBS

Finally in terms of - most of the questions have been asked, but in terms of future competition I notice looking at Fresh&Easy's web site they have lot of openings planned in the Sacramento Area, the Bay Area, they are opening in Fresno now. Are you still finding that you're not being too impacted by Fresh&Easy openings?

Steve Burd

Right.

Melissa Plaisance

And thank you everyone for participating in the call. If there are a follow ups Christiane Pelz and I will be available through 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.

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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.

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Source: Safeway, Inc. Q4 2009 Earnings Call Transcript
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