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Safeway (NYSE:SWY)

Q1 2010 Earnings Call

April 29, 2010 11:00 am ET

Executives

Melissa Plaisance - Senior Vice President of Finance & Investor Relations

Steven Burd - Executive Chairman, Chief Executive Officer, President and Chairman of Executive Committee

Analysts

Alex Bisson - Northcoast Research

Mark Wiltamuth - Morgan Stanley

Karen Short - BMO Capital Markets U.S.

Joseph Feldman - Telsey Advisory Group

Alton Stump - Longbow Research LLC

Edward Kelly - Crédit Suisse First Boston, Inc.

Susan Anderson - Citigroup

Charles Grom - JP Morgan Chase & Co

Bakley Smith - Jefferies & Company, Inc.

Neil Currie - UBS Investment Bank

Andrew Wolf - BB&T Capital Markets

Operator

Welcome to the Safeway First Quarter 2010 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 First Quarter Conference Call. With me this morning is Steve Burd, our 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, uses of free cash flow, 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. 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 report on Form 10-Q. And with that, I'd like to turn the call over to Steve.

Steven Burd

Thank you, Melissa. Let me start with net income. Net income for the quarter was $96 million. This compares with $144.2 million made in the same quarter one year ago. Expressed in terms of earnings per share, we made $0.25 per share versus $0.34 a share in 2009.

I just want to make a couple comments on the earnings before getting into the details. While the earnings per share number of $0.25 is below consensus estimates, it essentially met our expectations and represented our target for the quarter. You may recall at our investor conference, we suggested, especially in the first quarter, that the consensus estimates were high in the first half of 2010, and frankly, low in the second half of 2010. That was our first opportunity to really comment on any expectations or any estimates that people have made.

While there were some changes, as a result of that investor conference, to the Q1 estimate, the consensus changed by only $0.03 per share, which was not nearly enough. There are several reasons that we expect earnings per share, relative to 2009, to be much lower in the first half of 2010 than in the second half of 2010.

So let me begin with the fact that we expect to experience deflation in the first half of 2010, and inflation in the second half. Again, that was covered in some detail at the investor conference in March.

Secondly, our tax rate is expected to be considerably higher than 2009, in the first half of 2010, and then marginally lower in the second half of 2010.

Third, we accelerated our price investments, as most of you know, in the second half of 2009, so we could end the year at price parity with our conventional competition. And it's like lowering the water level in a glass. That now has to play out in the first couple of quarters of 2010, which it, in fact, is doing. And in essence, that puts downward pressure on gross margin in the first half of 2010.

Fourth, our cost reduction efforts, and this is no change from the last several years, are typically stronger in the back half, as we put things in place and we gain momentum.

And then the last thing I would mention, which again, was covered in the investor conference, is that volume is expected to get progressively better as we move through the year, now that we've got a very strong price position.

So looking at some of the details. Let me first talk about sales. Now if you look at total sales, total sales increased 1% versus last year. This modest increase is explained by higher Canadian exchange rate, coupled with a higher fuel sales increases, which are driven by the average price per gallon. And then offsetting that, in part, are volume declines and continued deflation.

While the identical store sales declined 3.1% in the quarter, we were actually quite pleased with our volume improvements demonstrated in the quarter. And frankly, their continuation in the early part of quarter two. With deflation at 1%, our volume decline was 2.1% in the quarter. This volume decline is expected. It was explained almost entirely by weeks four through eight, where we were comparing to last year's excessive promotions, beginning with Super Bowl week. It was for that reason, at the investor conference, I talked about the importance of looking at the quarter in three bite-sized chunks: the first three weeks; then the excessive promotion period weeks four through eight; and then finally, weeks nine through 12.

If you look at the combination of weeks one through three and nine through 12, we actually had a very modest decline in volume, registered at a negative 0.3%. When you look at the U.S, which is where the excessive promotions occurred last year, this same seven-week period, I'll call it the two bookends, experienced a volume increase of 0.3%. Again, we would attribute a good deal of that to the pricing decisions that we made in the back half of 2009.

Now during the first four weeks of quarter two, our volume increases are running a positive 0.5% in the U.S. And when you incorporate it in Canada, which just made its price investments at the beginning of the second quarter, we're running the total company almost flat, actually a negative 0.1% in volume. So a very significant difference from the volume decline of 1.8% in the fourth quarter, which avoids having these sort of bookend descriptions.

Turning to gross margin. Our total gross margin rate declined 31 basis points from last year. When you exclude fuel sales, which we commonly do, our gross margin declined only five basis points. While we did not have the extraordinary promotions that we had last year in weeks four through eight, we had the negative margin effects of several factors.

First of all, we had a higher advertising spend to support our lower everyday price position, which was expected. Secondly, the first quarter impact of lowering prices, pretty dramatically, in quarters three and four of last year, is playing itself out. And then the third element, is that even though we've seen cost increases in some key commodity areas, like milk, eggs and meat, for competitive reasons, we have not been able to pass all of those cost increases along. Again, we think it's a matter of time, but people are still using milk, eggs and meat as a way to attract customers to the store. And so you're not seeing retails advance at the same rate as costs. Again, I think that's a bit of a short-term phenomenon.

These negative effects in gross margin were partly offset by positive changes in mix. Stated differently, a stronger mix in private label, reductions in shrink. We're really pleased with our shrink progress, because despite deflation of the last three quarters, we have demonstrated improvements in shrink, each of those quarters, which is pretty hard to do in a deflationary environment. We also have lower cost of goods, as a partial offset. And finally, what you saw was a reduction in LIFO expense.

Turning to O&A expenses, O&A expenses increased 44 basis points from last year's first quarter. When exclude fuel, O&A expenses, again, expressed as a percentage of sale, increased 83 basis points. Now this increase is largely the result of the deleveraging that results from both the deflation and volume decline. The larger dollar increases in O&A costs came from wages and benefits, and asset impairment charges. While there were numerous cost reductions to offset many of these increases, they were insufficient, due to deflation and volume decline.

With normal inflation, which I discussed at some length at the investor conference, if you look over the last several years, normal inflation, looking at price per item, is about 3%. Again, if we had normal inflation in the quarter, and I believe we ultimately return to that, but probably not until 2011, O&A costs would have actually declined, as a percentage of sales.

Turning to interest expense. Interest expense declined $8.5 million, due both to lower average borrowings and a lower average interest rate. Borrowings were lower by an average of $402 million, and interest rates were down from 6% last year to 5.76% this year.

Turning to capital expenditures. We completed nine Lifestyle remodels in the quarter, and spent a total, which includes other forms of capital investment of $192.6 million. Now this compares with $243 million that we spent in the first quarter last year, when we built one new store and completed three major remodels.

Looking at free cash flow. Our first quarter, which is typically a negative free cash flow quarter, certainly, it has been true for the last five years, it remains a negative free cash flow quarter, but so much better than in the first quarter of last year. Our negative cash flow in the first quarter was at $58.4 million, compared to a year ago, $186.7 million.

And then it's my custom to make a couple of brief comments on BlackHawk. The face value of cards sold, which is a metric we've been discussing now for several quarters, increased 28% over last year's first quarter. Now this increase is larger than any quarter in 2009, and represents a significant acceleration from what we experienced in the fourth quarter of 2009. Again, I would attribute a good piece of that to the fact that I think we're seeing a bit of a recovery in the U.S. economy. And I believe it's slow, but I think that is indicative of some of the numbers we see coming from BlackHawk, and some of the numbers we see in some other aspects of our food retail operation.

Other notable events. We repurchased 4 million shares of Safeway stock at an average price of $24.78 per share, for a total cost of $99.2 million. Our tax rate in the quarter was 35.3%, which compares with 29.5% in the same quarter of last year. Looking forward. We now expect the full year tax rate to be about 35.3%. That would be our working number.

Just a couple of comments on guidance. Our guidance for 2010 remains completely unchanged. Just to reiterate a couple of those guidance numbers, our investor conference provided guidance on earnings per share, with a range of $1.65 to $1.85. We said that we thought that sales would come in somewhere between zero and a positive 1%. And we said that free cash flow would be at $0.9 billion to maybe $1.1 billion.

And the reason it remains unchanged is what I said at the outset of the call, we're not surprised by our results in the first quarter. We are exactly on target with our expectations. So that guidance contemplated that we would have a quarter exactly like the quarter we just turned in.

In terms of progress that we're making in volume, we're very encouraged by what we see on volume, and frankly, market share. And keep in mind that the market share definition that we've been describing to all of you, for really several years now, is market share within the supermarket channel, for which we don't have to guess what some of the other out-of-channel competitors are doing. So our information here about supermarket channel share is very accurate.

For the last eight weeks, beginning with week nine of quarter one, our U.S. volume changes have been positive. This represents a near 200 basis point improvement over both quarters three and quarter four. Our volume market share trends in the U.S. have also been improving steadily since quarter two of last year.

When you exclude last year's excessive promotion period, market share changes in the U.S. were positive in quarter one and remain positive through the first four weeks of quarter two. The source of these improvements in volume are largely improvements in transaction per household, and even more, improvements in items per basket, which is really the intent of our competitive pricing position to get more items in the basket for the shoppers that are coming in on a regular basis.

We just completed our pricing investments in Canada and launched our Promise campaign with the start of the second quarter. So while it's very early in that process, we're encouraged by the numbers we see flowing from Canada. When you compare our volume changes in quarter two, admittedly, only four weeks, with our volume changes in quarter four, which is a nice, clean quarter and fairly recent, all 10 operating areas of the company are showing improvement, which is something I have not been able to say in a long time.

Finally, we still believe that consensus estimates are high in the first half. And given that we just reported the first quarter, they're high in the second quarter and they remain low in the second half for all the reasons that I cited on the front part of this call.

In addition, I might give you some new information. We're engaging in a, what we call, an employee buyout. We've done them before. We've done them in lots of divisions. And it's our expectation that, that will get completed and that will affect us by $0.02 a share in the second quarter. So with that, Melissa, I'm prepared to take questions.

Melissa Plaisance

Shirley?

Question-and-Answer Session

Operator

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

Bakley Smith - Jefferies & Company, Inc.

This is Bakely, filling in for Scott. I'm with Jefferies. Just wanted to dig into traffic. You talked about volume, which is helpful. Can you talk about transaction count and how trends were in 1Q, and how they are, so far, in 2Q?

Steven Burd

You're looking for traffic?

Bakley Smith - Jefferies & Company, Inc.

Yes, like...

Steven Burd

Yes, traffic was down slightly, but the volume increases were coming from increasing transactions per household, and then more importantly, more items per basket. So that's the source of the volume.

Bakley Smith - Jefferies & Company, Inc.

And is there any change Q2 to date, or is that sort of trending?

Steven Burd

The Q2 trends in the U.S. are considerably stronger than that bookend description I gave in the first quarter.

Bakley Smith - Jefferies & Company, Inc.

And can we talk a little bit about the Promise marketing campaign, just where it's been? And so you talked about it recently launched in Canada, but what kind of results are you seeing in the geographies where it's been the longest, considering the effect that you hoped for?

Steven Burd

I think that the results we're seeing are reflected in both the numbers I described in the first quarter, as well as in the second quarter. So there's a momentum that's building, especially across those market. Again, the volume changes that occurred geographically are as much a function of how much we had to alter price. And if they are, how long price has been altered? So it's not sort of fair to simply time to mention this thing. In markets where the adjustment was greater, you had a much larger response on volume. But when you compare our volume performance, as I just did in Q2 with Q4, the fact that every single market is running higher volume is indicative of what's happening to price perception and consumer behavior. So price perception continues to improve. We survey that on a periodic basis. And each survey shows that more and more consumers perceive this to be a price parity with conventional competition.

Bakley Smith - Jefferies & Company, Inc.

You've talked in the past about trade-up activity, the lattes comment. Could you comment briefly on trade-up activity, especially outside your higher net worth market, like your more posh district?

Steven Burd

What I would tell you is it's pretty much more the same. I mean, I've commented in the past about Starbucks. And I think you saw Starbucks' independent sales results. For us, that reflects a stronger mix of a higher ticket item in Starbucks, as well as increased traffic to our in-store kiosk. Florida, like coming in the past, a pure discretionary category, but with few holidays and showing very strong results. And then we see it in the wine category. There aren't that many items in our store that we can classify as purely discretionary. And so it's not easy to point to items that show people sort of trading up. Now the fact that the volume in private label continues to outpace that of national brand, suggests that people are still looking for value.

Operator

Our next question comes from Ed Kelly.

Edward Kelly - Crédit Suisse First Boston, Inc.

Crédit Suisse. Steve, the color that you gave on the volume trends was definitely helpful. Can you talk about the cadence of IDs? Should we just imply from all this that your IDs are currently running down 1% or so?

Steven Burd

Yes. Let me comment on that. As I indicated, our deflation in the first half was 1%, which is remarkable in that, that's what we have predicted. I'm not sure I will ever be that accurate again on something like deflations. It's still that Bureau of Labor and Statistics would probably want to employ me somehow. In the early part of the second quarter, we've seen a bit stronger deflation. Now we do believe, because of the comparisons with last year, that, that begins to soften up as we move through the quarter. But at the investor conference, I had forecast that you would see about 0.5% positive inflation in the second quarter. I now don't believe you'll see something that strong. I think it will be either marginally negative or maybe close to zero. So I think I will miss that prediction in the second quarter. What's creating that is that we were pretty confident that we would see inflation in cost of goods. And all you have to do is open the newspaper and read about that. It's happening across a lot of categories. But because I think we're still in a relatively slow economy, we have not been able to immediately pass on those cost increases in the form of higher retails. Again, I think that's a temporary phenomenon. But if we were able to do that, I probably would be equally accurate in the second quarter, or close to it on inflation. But then, I don't think you can contain that for the second half. I think the second half will clearly have inflation in it.

Edward Kelly - Crédit Suisse First Boston, Inc.

Based on the comment on inflation then, are you able to maintain gross profit dollars? Or is there also an impact to gross profit dollars right now?

Steven Burd

It depends on the area. If I were to -- if you take a look at something like milk and egg, we're not maintaining the gross profit dollars. And so there's a hit in that category. And we've experienced some rather significant increases in the cost of those items. That's also true in the meat category, but there has not been an immediate change in retail. So there's been some sacrifice, clearly, in the first quarter. And there's been a bit more of that in the early part of the second quarter. But again, I think that will improve as we move through time, because I also made comments at the investor conference, we continue to see a lot of weakness in the market on the part of many of our competitors. So we've done a terrific job managing our costs. We've done an extraordinary job producing free cash flow. We invested way ahead of the curve, which allows us to continue to run very strong free cash flow. And the vast majority of people that we compete with in our segment haven't done any of that. And so when you go into their stores, you can actually see the effects this is having on them. So I think, from a competitive standpoint, I think that it won't be long before the retails reflect cost of goods increases.

Edward Kelly - Crédit Suisse First Boston, Inc.

Now Steve, I assume that when you gave the guidance at your analyst meeting, that you felt that you wouldn't be able to obviously pass through these price increases. I guess, is that fair? And then secondly, how long can the current environment last before we actually may see some risks to numbers?

Steven Burd

I've been through, I think, about four recessions. And so I don't think that the pattern we're experiencing is all that different during the past. And so I believe that what we're seeing here on the cost and retail inflation is a short-term phenomenon. And one piece of evidence on that, it's not really true across all retailers. And so what's happened to us is that we have significantly improved our price position vis-à-vis secondary competitors. And I think that before too long, we'll be able to reflect rising costs in retail. And I don't see it right now as a problem in hitting our earnings guidance for the year.

Edward Kelly - Crédit Suisse First Boston, Inc.

When you talk about this second quarter's Street estimate being a bit too high, are we talking a few cents, $0.02, $0.03, or are we talking like $0.05?

Steven Burd

No, I don't want to comment on that. But I think, if you think back about the investor conference and the earnings effect, and everybody used to focus on the sales effect of deflation, the earnings effect is quite pronounced. And if you went back and looked at my forecast of deflation and inflation, and I didn't commit all the numbers to memory, the second quarter, though, was positive 0.5%, bring that number down to no higher than zero, and it could be a little lower than that. And then bring up the inflation expectations for quarters three and four, and end at the same point that I did in the investor conference, and that'll probably give you a good mechanism for adjusting your quarterly estimate.

Operator

Our next question comes from Karen Short.

Karen Short - BMO Capital Markets U.S.

BMO Capital. Couple questions, sorry to belabor this, but also your comment as it related to the second quarter being too high, that was including or were you trying to specify whether that included or excluded the additional $0.02? Meaning, if it was $0.05 too high without this labor buyout?

Steven Burd

I think that the labor buyout information is new news. It doesn't affect our overall guidance. So you should take that $0.02 off, merely because of the new news I gave you. And then make these kinds of adjustments I just described.

Karen Short - BMO Capital Markets U.S.

And then can you just remind me, when you refer to deflation or inflation, are you referring to retail price deflation or product cost?

Steven Burd

I'm referring to retail price. And again, we covered this in detail at the investor conference. But just as a reminder, we're using price per item changes, relative to the previous year. And so embedded in that price per item is a combination of mixed change favoring private label, some element of generic drugs favoring over branded drugs, some real price deflation, coupled with the investments that we made. So we could be experiencing a different level of price item deflation than some of our competition if they didn't lower their prices or didn't have a need to lower it.

Karen Short - BMO Capital Markets U.S.

And all of your deflationary comments include Canada, correct?

Steven Burd

That is correct, unless in my formal remarks, I said U.S. I think, relative to deflation, I did not make a comment in my formal remarks. I talked about volume. So it would be a combination of the two. But what you're experiencing is a very modest amount of inflation, almost nonexistent in Canada, price per item. And so it's basically driven by the U.S.

Karen Short - BMO Capital Markets U.S.

And then when you talked about inflation in the meat, and I guess, eggs, dairy category, but not being able to pass it all on, I guess, I just had two clarifications. I mean, based on CPI data, it would seem that, I guess, only produce has seen some increase, and that's only in the most recent months. But I guess, if you are seeing inflation in those categories, can you maybe just elaborate on what you've been able to pass on? And I guess a follow-up on that is, if you couldn't pass it all on, should we extrapolate that to imply the competitive environment has gone worse or tie in comments on the competitive environment?

Steven Burd

I don't think the competitive environment has gotten worse. I think that you are in a slow economy, where I think people are a little slow to make price movements that might further disturb volume. And so they make their price movements with much greater care. And they probably adjust everyday resales more quickly than they adjust promotional numbers. And so it's just the way you come out of a recession. I don't think it is reflective of competition being any greater now than it was in the third and fourth quarters. I would also say, I don't think it saves less, but I would say it's about the same.

Karen Short - BMO Capital Markets U.S.

And are you seeing inflation in the meat, eggs, dairy produce category as a whole?

Steven Burd

Yes, the answer is yes.

Operator

Your next question comes from Mark Wiltamuth [Morgan Stanley].

Mark Wiltamuth - Morgan Stanley

Steve, I wanted to ask a little bit about the negative operating leverage. You talked about volumes and price being a factor there. When do you think you can start showing some positive operating leverage? Do you have to get back to a flat comp, or is it just a matter of lapping out of the price pressure from a year ago?

Steven Burd

Yes, I think that in order to show positive leverage on the O&A, you've got a couple of volume increases with price per item increases. And that's not likely to occur. To really get the positive leverage there, probably before any time in the fourth quarter, I would put that late in the year. But I do think because we'll be lapping gross margin investments of the year ago, the overall operating margin improvement will come from the gross margin area more quickly than it will come from the O&A area.

Mark Wiltamuth - Morgan Stanley

The unit gross margins could actually be up a little bit as we get into third and fourth?

Steven Burd

Well, they're going to improve pretty dramatically because the investments were made in the second half of last year. And then if you recall from the Investor Conference, we made some extraordinary progress on cost reduction last year. The good chunk of which was in the gross margin category. And we have -- if you look at our cost reduction efforts this year, which we keyed up again at the Investor Conference, that was heavily focused on things that improve gross margin. So it was focused on cost of goods, of supply chain and elements like that. So again, gross margin comparisons should improve as you move through the year.

Mark Wiltamuth - Morgan Stanley

So it's not that prices will be up, you're just making some improvements on COGS, on shrink and some other factors?

Steven Burd

I think it's both.

Mark Wiltamuth - Morgan Stanley

And then back to the inflationary categories. Would you say this, it's largely centered on the commodity areas, and the center of the store is still deflationary?

Steven Burd

No. I wouldn't say the center of the store is deflationary. I think the center of the store is probably pretty stable. I wouldn't describe it as deflationary.

Mark Wiltamuth - Morgan Stanley

So it's just a matter of keeping an eye on these inflationary commodity categories where you're having trouble passing it through?

Steven Burd

Yes. If you think about it -- I mean, the commodity area are the ones that you can have just enormous volatility. And couple the volatility with a little sensitivity on the part of retailers to not scare away the volume. You end up as you get cost increases, you end up being just a little bit gingerly on the retail side. But at the end of the day, you got to recoup it.

Mark Wiltamuth - Morgan Stanley

And lastly, just housekeeping. How was the Easter shift and how much of that help the comp in the quarter?

Steven Burd

There was no Easter shift. This is a rare moment that Easter stays in the same quarter two years in a row. It happened in the last week of the quarter. The pre-Easter shopping was a week off.

Operator

Our next question comes from Andrew Wolf [BB&T Capital Markets].

Andrew Wolf - BB&T Capital Markets

On the commodity re-inflation, how would you compare this to other periods where you know the business environment on the cost side switch from deflation back to re-inflation? And obviously, it's easier, so maybe compare it to other recessionary periods. Is it a lot worse because of the period we're coming out of?

Steven Burd

Yes, well, I guess, here's what I would tell you. I didn't pay as much attention to inflation and deflation in volume in the prior recession. I've become bit more of a student of the inflation, deflation here in the last 18 months. But here's what I would just tell you based on a feel for history versus current events. We had some extraordinary inflation that occurred in 2007 and 2008, which don't normally go along with a business downturn. And so now we're seeing, I would say, stronger inflation in these commodity areas than would be normally associated with the business downturn. Those things are driven by supply-demand factors. And I think one of the reasons why they get, I guess, pronounced in a downturn, in a recovery, as people cut back on the production of commodities, as business turn down, now these commodities are a bit more scared, which has driven up their price. And so the supply chain can't react fast enough to some of these areas in order to moderate that cost inflation. And so I look at a category like meat. And that's not an easy thing to sort of produce overnight. And so that kind of inflation should be with us for the balance of the year. And I don't think that people are going to eat that inflation for the year.

Andrew Wolf - BB&T Capital Markets

And a follow-up on your last answer where Karen

was asking you similar questions. I think I heard you say the shelf prices, the cost inflation has been reflected in shelf prices, but the promotional environments seem pretty hot on these commodity items. Did I hear what you're trying to say right?

Steven Burd

So what I said is that if you look for how these things will most logically play out. It is more logical for people to reflect cost inflation first in their everyday retail than in their promotion, and then it comes secondarily in promotion. And it's because the promotional program is basically intended to attract customers. And if the last price on a rib eye was $4.99 and the cost has gone up, people are little thoughtful, because people have burned in that $4.99. So I'm not saying we recovered the cost in our everyday retail, I'm saying as I look through this to work its way through, I think it works its way through their first, and then it works its way into promotions.

Andrew Wolf - BB&T Capital Markets

Myself and others have doing a lot of price work on Wal-Mart versus conventional such as yourself. And you know we all look at limited data and look at limited markets. But it seems to be that, at least my work is showing, that the price spreads between Wal-Mart, despite their increased promotionality, the price spreads on a full market basket really haven't changed much. And I know you and the operators have much richer data. Would you be willing to tell us what you're seeing in your research again?

Steven Burd

Now you're saying change from -- you're asking for the change relative to what appears to be the marketing plan?

Andrew Wolf - BB&T Capital Markets

Here's what I'm getting and you can speak to it, I guess, for Safeway, although I know you get other price from your competitors as well. The price spreads that Wal-Mart has to its conventional competitors and at limited markets I looked at have not changed basically in the last month. Those relative spreads. In other words, they haven't increased their market basket position advantage to the conventionals that I've looked at. I'm asking what Safeway's recent history might be.

Steven Burd

I would say this, the price action that we took in the second half of last year narrowed at relative position to the non-conventional. And then we would basically agree with your comment about the last month, we don't really see any change.

Operator

Your next question comes from Charles Grom [JPMorgan].

Charles Grom - JP Morgan Chase & Co

Just to follow-up on this 2Q issue on the margin front. So if I look at it, you've got higher deflation, you're unable to pass on price inflation because of the competitive environment. And looking back, you face some more difficult comparison on the core from 1Q to 2Q of about 40 bps. Is it safe to say that you think 2Q GPM at the core will be worse than what you did here in the first quarter because of all these factors?

Steven Burd

I think it's fair to say -- I think you've nailed it correctly. In other words, we were down five basis points on growth in the first quarter. But remember, we had the excessive promotions last year of 34 basis points. And so if it were not for that, that number would've been 39. And so we would expect that the gross margin and quarter two relative to last year would be down more than you saw in the first quarter, because you're always comparing the last year. And that's consistent with the comments I made early on in this call of why we think the first half of the year as a different earnings pattern relative to 2009 in the second half is where the water glass is still maintaining that level has to play itself through two quarters.

Charles Grom - JP Morgan Chase & Co

You spoke to the margins squeeze from the rising milk, eggs and meat prices as short term in nature. How confident are you that this issue won't spread to other categories as we progress through the year?

Steven Burd

Well, it's my view that the market can't afford it. And that's why I don't think it spreads, and that's why I think it gets better. In other words, what we have to do is, we have to go to market everyday with a competitive price position. And we didn't work so hard in the last couple of years to suddenly give that up. When we did that, we did it to be at parity with our primary conventional competition in each market, and the secondaries were left behind, most of -- so we've widened the gap with them. So they're certainly not going to be encouraged to not recover their cost increases and I think nor will anybody else. Call it 17 years worth of experience, it's just my experience is that cost increases always get reflected in retail.

Charles Grom - JP Morgan Chase & Co

Just to follow back on I think it was Ed's question regarding the 2Q IDs, and there's a lot of moving parts with volume and such. Is it safe to say that from a total ID perspective that your sales quarter-to-date are consistent with what you guys did in the first quarter, in other words, down roughly 3%? Or have they bounced back a little bit sort of all in, x gas, obviously.

Steven Burd

Yes, I think I said earlier that deflation measured as price per item is actually greater in the first four weeks of the second quarter than it was in the first quarter. So while volume is better, deflation is a little greater. But again, we think that's a short-lived phenomenon. And we think that it gets better as we move through the quarter, we should end the second quarter with less deflation than we experienced in the first quarter. And then with volumes improving, that should yield a better ID sales number.

Operator

Our next question comes from Neil Currie [UBS].

Neil Currie - UBS Investment Bank

Just wanted to try and complete the loop and ask about private label growth and also pharmacy, and what impact that had on sales. Has private label growth slowed down given the economy marginally improving? Has the market share gains in private label been steady or even improved?

Steven Burd

I would tell you that our private label growth is strong, but not as strong as the first quarter the year ago. And so that slowed a little bit, but still quite strong. On the generic side of the business, a lot of what you saw happening in 2009 and even earlier in 2010 was blockbuster drugs going off patent protection. And so the generic effect, I don't think it was as strong -- it's about as strong than it was in 2009, so that's still creating an effect that 2009 in the first quarter about equal. But I think we believe it'll have less of an effect as we finish the year just because of the number of drugs that have come off patent.

Neil Currie - UBS Investment Bank

And would you say volumes, you talked about moving into slightly positive territory on volumes recently. Do you think that would apply to both private label and brands? Or do you think private label growth is a little bit stronger still?

Steven Burd

Private label growth is stronger.

Neil Currie - UBS Investment Bank

And how are you seeing the brand promotion environment? We've noticed Wal-Mart cutting back in SKUs and some suppliers talking about looking for different channels to support them under promotional money. Are you seeing some of that?

Steven Burd

I would say that what we're seeing in the center of the store is there's no big change. I think it's a decent environment. We're not having people hold back on promotional money, it's a decent environment. Everybody's looking to grow sales. Going back to private label, I think because of our strategy, I think you'll see in all likelihood our private label sales will outpace the growth of national brand even post-recovery because of our strategy. But I don't think that anybody in the Consumer Packaged Goods business is holding back on promotional money as they try to drive business.

Neil Currie - UBS Investment Bank

And finally, gas prices are creeping up again, and that seems to be above $3. What sort of level does this start to become a bit of a worry, both in terms of other inflation and consumer indigestion of price increases? And also, just generally people pulling back on other things as gas prices go up and balancing that, of course, the fact that you sell cheap gas.

Steven Burd

Right now, I don't think the price of gas is a big issue. It's sort of like Roger Bannister's four-minute mile. If you're below $3, you're probably okay. When we got to $4, it was really crazy. So probably you don't get much of an issue until that gets over $3.40, $3.50 a gallon would be my judgment.

Operator

Our next question comes from Susan Anderson [Citigroup].

Susan Anderson - Citigroup

Can you give us some update on your statement initiative in terms of shrink and then consumer response? And also it seems like the restaurants have seen some improvements recently. Do you think that consumers are starting to trade back into the restaurants, or how should we think about that impact when it happens?

Steven Burd

You're correct that it was a long-term trend away from food retail and restaurants. And that trend has broken a couple of years ago. Our particular Home Meal Replacement program is going very strong. It has growth rate in excess of 20%. The shrink problem we saw as we reformulated and repackaged the product, and so I don't really expect any change in trend there. I expect that we'll continue to build and grow that business.

Susan Anderson - Citigroup

And then just really quick on advertising expenses. I think maybe you'll start to see to lapping increase in the third quarter, is that correct? As we think about it in terms of flat beginning then year-over-year?

Steven Burd

I think it was the third quarter when we started picking up the pace there, so you're correct.

Susan Anderson - Citigroup

If you could give us an update on union contract negotiations and any expectations for increases in wages or benefits?

Steven Burd

Yes. I think the -- we settled Phoenix and we settled Denver. We have a couple of contracts in negotiation right now. I'll just talk about the large ones. We've got Alberta, which is around 10,000 employees and then we've got a piece of Seattle which is around 7,000 employees. The Alberta contract itself actually expired in March. That's not unusual. I think I want to calculate the average settlement is close to one year after the expiration of the contract. And if anything, there's been a longer time after expiration in Canada than even in the U.S. And then in Seattle, that contract expires in May. And then, we have -- those are the big contracts. And then usually, we'll have a Teamster contract regarding a distribution center that is up for renewal in one market or another.

Operator

Our next question comes from Alex Bisson [Northcoast Research].

Alex Bisson - Northcoast Research

You touched on this a little bit, but, Steve, are you seeing any signs of a trading up?

Steven Burd

The answer is yes, we are seeing signs of trading up. I think it's a bit of a slow process driven by the fact that unemployment numbers haven't really improved materially in this country. But yes, we are seeing signs of trading up. I mean, I would tell you that I think that you're seeing a slow recovery. And then I think things don't really return to normal until probably 2011.

Alex Bisson - Northcoast Research

And then one other question. You suggested for this year that cost reductions would be more heavily weighted to the second half. I think you said that's the typical seasonal pattern, is that right?

Steven Burd

Correct.

Alex Bisson - Northcoast Research

I know in the past you've talked about cost reductions as being kind of a core competency to Safeway. Why would there be seasonality to when you recognized kind of the fruits of that effort? I understand lumpiness, but seasonality?

Steven Burd

Well, because what we do is, as we planned for each budget cycle, we put a lot of effort into how and where can we control the costs. And once you identify the cost reduction effort, you still have to execute on it. And often times, that requires a slight change in the information flow, it requires some training, it sometimes requires piloting in a division or geography, tuning it up and then rolling it out more aggressively. And so it's just the way it's always been. And then keep in mind that the back half of the year always has one more week as well.

Operator

Our next question comes from Alton Stump [Longbow Research].

Alton Stump - Longbow Research LLC

I just want to get an idea of how successful do you think some of the discounting and/or lack of full pricing pass through a milk, eggs and meat actually did in terms of driving into traffic or basket size? Has it been so far a good lever for you?

Steven Burd

For some reason your transition was sort of breaking up. I didn't quite understand the question. Give me another shot at this.

Alton Stump - Longbow Research LLC

Just asking if the lack of full cost pass through and what I'm guessing was in some cases some pretty aggressive pricing behavior in milk, eggs and meat, whether that drove either higher traffic or higher basket size for you in the first quarter?

Steven Burd

I don't think so. I don't think there was any magic to that. I think that our overall price program getting competitive on everyday values and still being a bit more promotional than most of our competition, I think it's what's driving our results.

Alton Stump - Longbow Research LLC

What I'm getting at is, could there be an opportunity here to potentially pull back a little bit, get a bit more rational in those particular categories with your price points?

Steven Burd

Well, that's kind of what we're forecasting that, that will happen. But again it's a competitive environment, and so we think that's the natural. We don't think the marketplace is irrational. We think the marketplace was pretty rational.

Operator

Our next question comes from Joe Feldman [Telsey Advisory Group].

Joseph Feldman - Telsey Advisory Group

I wanted to ask, you made a comment, I think, when you're talking about some of the market share data, that you're seeing transactions per basket up. And I guess sort of just kind of curious as to what you think might be driving that? And especially in light of that fact that it seems that we're hearing more about consumers eating away from home a little more frequently as the restaurant operators have been having better results lately. So maybe you can reconcile that?

Steven Burd

Yes, what I said was that transactions per household are up and items per basket, think about items per transaction is up. And when you look behind those numbers, we often categorize our customers as being anywhere from, I'll call it, occasional to quite loyal. And so when you look at the data, again, I would attribute this to our price position, our change in price position is that you're getting a much greater response from the occasional as you move your way up. In other words, for someone who didn't shop with us that often, when they come in and see the prices, they are building their basket. And they are now coming in more often. And that is most pronounced with the latest shopper. But basically, we've improved across every category of shopper. But it's most pronounced, the lighter the shopper you were, because we were occasional choice for you, and now we're a much more reliable choice for the consumer.

Alton Stump - Longbow Research LLC

Just about the pricing as to -- with the increase in some of the commodity costs that you've seen on milk and dairy or produce, have you attempted to pass on some of the price and it was met with resistance? Or are you guys just strategically not passing on at the moment? And then at what point in a normal cycle would you be able to pass on that price?

Steven Burd

Price is something that you -- price changes for us across thousands of items on a weekly basis. And so you're always trying to attract business, and you're always trying to build basket and you're always trying to make money. And so it varies a lot by item. But your ultimate goal is to build volume, to build sales and to make money. And so you make price changes sometimes to recoup costs, you make price changes sometimes to build a business and sometimes you make price changes and you roll them back. Sometimes you make price changes and then you make changes again, and you roll them forward. So it's really -- we have an objective, so we pursue the objective. And we're very thoughtful about how we do that. And it's a competitive world.

Melissa Plaisance

Thank you, everyone. We appreciate you spending the time to participate in the call. If you have any further questions or clarifications, Christiane Pelz and myself will be available for the balance of the day.

Operator

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

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Source: Safeway Q1 2010 Earnings Call Transcript
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