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Safeway (NYSE:SWY)

Q1 2011 Earnings Call

April 28, 2011 11:00 am ET

Executives

Melissa Plaisance - Senior Vice President of Finance & Investor Relations

Robert Edwards - Chief Financial Officer and Executive Vice President

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

Analysts

Alex Bisson - Northcoast Research

Edward Kelly - Crédit Suisse AG

Meredith Adler - Barclays Capital

Joseph Agnese - S&P Equity Research

John Heinbockel - Guggenheim Securities, LLC

Scott Mushkin - Jefferies & Company, Inc.

Mark Wiltamuth - Morgan Stanley

Karen Short - BMO Capital Markets U.S.

Deborah Weinswig - Citigroup Inc

Robert Ohmes - BofA Merrill Lynch

Stephen Grambling - Goldman Sachs Group Inc.

Operator

Welcome to the Safeway First Quarter 2011 Conference Call. [Operator Instructions] I will now turn the call over to Ms. Melissa Plaisance, Safeway Senior Vice President of Finance. Please go ahead.

Melissa Plaisance

Good morning, everyone, and thank you for joining us for Safeway's First Quarter Earnings Release Conference Call. With me today is Steve Burd, Safeway's Chairman, President and CEO; and Robert Edwards, Executive Vice President and Chief Financial Officer.

Before I turn the call over to Steve, I'd like to remind you that management will make statements during this call that include forward-looking statements within the meaning of the federal securities laws.

Forward-looking statements contain information about our future operating or financial performance. Forward-looking statements are based on our current expectations and assumptions and involve risks and uncertainties that could cause actual results or events to be materially different from those anticipated. However, we undertake no obligation to update or revise any such statements as a result of new information, future events or otherwise. For a list and description of those risks and uncertainties, please see our filings with the SEC.

And with that, I'll turn the call over to Steve.

Steven Burd

Thank you, Melissa. Let me start with net income. Net income for the quarter was just over $25 million as compared to net income last year for the same quarter of $96 million. Now that $25 million net income number included a tax expense relating to the repatriation of $1.1 billion from Canada, which was reflected in a dividend and announced really at our investor conference. So it was anticipated, I think, by everybody. If you adjust for that to get a real understanding of the operating performance for the quarter, you get an adjusted net income number of $105.3 million compared to last year's $96 million, which is really the basis in which all the first call estimates were done.

Reflected in terms of earnings per share, we earned $0.29 per share as contrasted with $0.25 a share a year ago, which is a nice 16% increase in earnings per share. By way of kind of some summary comments about the quarter, I would say that we're clearly pleased with our results for the quarter as it shows continued progress on behalf of the company. After adjusting for the taxes, as described earlier, we were $0.01 higher than the first call consensus estimate and completely in line with our expectations on the quarter.

We also had positive IDs for the quarter, which we have not had in a while, and we had an improvement in gross margin rate. And we had an expansion in operating margin. You'll recall in our guidance that we said that our operating margin would be flat to maybe up slightly, so good to see the first quarter actually showing an improvement in operating margin.

If you read the press release, you know that we also made an accounting change this quarter and in Blackhawk. It has the effect of increasing Blackhawk's revenue as well as Blackhawk's cost of goods. This has no effect on our ID sales, no effect on gross profit dollars and no effect on net income. But when I talk about gross margin and O&A expense ratios later, you will see that it does have an effect of lowering the company's gross margin rate and also lowering the O&A expense ratio, but more on that in a minute.

Turning first to sales. Total sales increased 4.8% versus last year. This increase in order of magnitude is largely explained by higher fuel sales, which should surprise no one, and increase in the Canadian exchange rate, higher non-fuel-related IDs, and then finally, the Blackhawk accounting change. ID sales, when you exclude fuel, increased 0.4%, and that's the positive number I referenced earlier. This is our fifth consecutive quarter of improvement in ID sales. The non-fuel IDs were 120 basis points higher than last quarter and now stand 450 basis points stronger than the low point of the recession, which for us was the fourth quarter of 2009, so a substantial improvement from that low point.

While the improvement is not uniform, 9 of 10 operating divisions improved in quarter 4. And frankly, were it not for extraordinary snow conditions that occurred in 2010 -- I believe the snowfall difference was sixfold in one of our geographies -- that spiked the 2010 ID numbers. And were it not for that, we would be reporting 10 of 10 operating divisions showing improvement relative to the fourth quarter of 2010.

Transactions were up slightly from last year. Volume, as we talked about in terms of item count, was still a bit negative but stronger than the fourth quarter so showing improvements in volume. And then price per item increased for the quarter, just under 1%, so very close to 1%. And that's consistent with what we had called, in our guidance where we thought we would see, for the year -- obviously, there's some indication that inflation will continue, and that number as we play out the year will probably become higher. Consistent with the last 4 quarters, our sales and volume increases continue to come from our most loyal customers, showing the most improvement from the most loyal of the loyal.

Turning to gross margin. Our gross margin rate declined 87 basis points from last year. When you exclude both fuel sales and the accounting change, if you could pair an apples to apples, our gross margin rate improved 18 basis points over quarter one of 2010. Now this improvement in gross margin was largely the result of very strong improvement in strength. Now those improvements were planned, but nonetheless, very strong compared to last year and quite similar to what we experienced in the fourth quarter, when we initiated that extra effort in strength improvement. So that's been sustained, and we continue to add to it.

Now this was partially offset by a gross margin decline. And really, one of our large categories where we elected to actually make a shift and build sales volume by concentrating more on branded products in this category versus Private Label, we thought we'd gotten a little imbalanced there. And as I think you all know, the margins in Private Label are stronger than they are in national brand. We also had a gross margin rate moderated by experiencing some additional expenses that were associated with the distribution center closure in Vancouver. We first thought that those expenses associated with shutdowns would extend over 2 quarters, meaning quarters 3 and 4. It actually got spread over 3 quarters and now completed. And then, of course, as you saw from our financials, we had an increase in the LIFO charges visibly last year.

Turning to O&A expenses. O&A expenses as a percentage of sales declined 81 basis points from last year's first quarter, helped out a lot by the inflation in fuel prices. So when you exclude fuel sales and the accounting change referenced earlier regarding Blackhawk, the O&A expense ratio increased 2 basis points, which given the level of ID sales, we would consider it to be a very strong result for the quarter.

This small increase was largely the result of an increase in our bonus accruals in the compensation area, which is really a positive sign as it says that the company is making or meeting the plan and accruing more for that category of compensation that is generally at risk, for not just executives of the company, but also a dozen or more people at lower levels. Also, it showed an increase in our legal reserve due to a really unexpected court decision, and these are offset by lower losses in property disposal, lower impairment, lower depreciation and maintenance expenses. So all of those things added together reflect about a 2-basis-point increase in O&A.

Turning to interest expense. It continues to be down quarter after quarter. Somewhat modestly in this quarter, interest expense was down $4 million. Three quarters of that is explained by lower average borrowings, and the balance explained by a slightly lower interest rate on borrowed funds.

Looking at capital expenditures. We spent $185 million on capital projects in the quarter. This reflects 3 new Lifestyle stores and 5 Lifestyle remodels. Of course, that's not the bulk of the expenditure. There's a whole category of infrastructure investments that are made every year and they represent the bulk of the capital in this particular quarter. Now this compares to capital expenditures of just under $193 million from last year.

Turning to free cash flow. Again, a nice positive surprise here. Our first quarter is typically a negative cash flow quarter. That was not true this quarter. This quarter, we had positive free cash flow of $112 million as contrasted with a negative $58 million from last year. That big change is largely due to changes in working capital.

Now, let's shift gears a little bit to talk a little bit about what I'm going to call quality of earnings. As you think back at the investor conference, we discussed how best to assess earnings quality. We talked about an analysis that you could do comparing it to last year and an analysis that you could do to reflect whether or not the earnings performance for the quarter is something that you can expect to be ongoing or doesn't reflect some unusual events. When we did that analysis, it was suggested by someone that it might be beneficial if we actually did some of that on this earnings call. So this is a first-time feature. It's unlikely it will continue in the future, but let me just kind of walk you through some of that analysis that are relatively high-level.

There were several large differences from last year's first quarter, and that's often the case. In the aggregate, the negative differences outweighed the positives. So actually hurting this year's quarter by almost $0.01 per share. Stated differently, the 16% increase in EPS is a more than fair reflection of our earnings improvement in the quarter.

And now let me give you a couple of numbers. Positives for the quarterly comparison total just under $26 million. And I'm going to list these in order of magnitude. So they included a lower property impairment charge as in the previous year, lower property losses than the previous year, a lower tax rate and a more favorable currency change. So those are the positives totaling just under $26 million. The negatives totaled just under $30 million. So there's a $4 million hurt. And they include a quite abnormal legal reserve that I touched on earlier, lower fuel margins -- keep in mind that as fuel prices rises, our margins get squeezed. They become healthy again when fuel stabilizes and then they become very strong when we're in a declining cost to fuel market. Third element would be the non-repeatable severance costs again related to the Vancouver, BC, closure and then LIFO charges. And then rounding out the completion here, higher working comp, driven really by the interest rate and then lower cash-delay earnings. So those are the negatives compared to last year, and they outweigh the positives. So there was a slight difference there.

Another way to do the analysis is just kind of compare it to kind of normal. We described normal at the investor conference as kind of looking at some of these key volatile items that we looked at, at their average performance over the 7-year period. And so when you compare these same volatile categories to the average values over the last 7 years, this quarter's earnings were actually disadvantaged by $0.016. Now I wouldn't make a big deal over that but in summary what I would say is any reasonable adjustment to this quarter's earnings yields the same conclusion. It says that EPS, properly reflected, increased 16% over last year. And secondly, it says that the quarter's earnings are a true reflection of the company's ongoing earnings power. Think of it as a platform of earnings that now we build on as we go forward.

Shifting over to what I'm going to label other notable events for the quarter. We repurchased 7.7 million shares at an average price of $22.47 per share for total expenditure of just under $174 million. We also paid off $500 million worth of debt that was costing us 6.5% per year. And we initially replaced it with commercial paper at an interest rate of less than 0.4%. This commercial paper was later replaced with Canadian debt and some cash. We placed $300 million worth of term debt in Canada at a rate of 3% and then took out some floating rate debts from the banks that would pay -- which cost less than 2.5%. And so if you look at the interest gain from that, our interest gain just from doing this kind of debt financing and retiring at 6.5%, will be worth $15 million of pretax earnings for the balance of 2011, which is a very good result.

Now this was all facilitated, just as a reminder, by declaring a Canadian dividend of $1.1 billion. And just to remind people of how that cash has been used, $95 million will be used to pay cash taxes, and you recall our cash tax rate was 8.6%, so a very small rate. That's why we thought this was such a good idea. $600 million was used to retire U.S. debt, and the balance of $405 million will be used to repurchase Safeway stock.

Kind of an update on the tax rate. Our tax rate in the quarter, excluding the charge for repatriation, was 33%. We expect the full year tax rate, again, excluding the charge for repatriation related to the dividend, will be 33%. And what we experience this quarter, we should experience on the year.

And then finally, I'd like to give at least one data point on the performance of Blackhawk. If you look at the face value of the cards sold, again, another strong quarter for Blackhawk, increasing the face value of cards sold by 20% over last year.

Finally touching on guidance. Our guidance for 2011 remains unchanged. Our EPS after reflecting the negative effect in 2011 on repatriation, which nets out to about $0.15 a share, again, no different from the number discussed at the investor conference. And so when you reflect that $0.15 in the estimates and it's not really reflected in any of the first-call estimates today because it's kind of a one-off event, but when you reflect it, the EPS guidance, again, no change from the investor conference, is $1.45 to $1.65. Maybe differently if you add that $0.15 back, it ends up being $1.60 to $1.80.

ID sales, no change, 1% to 1.5% excluding fuel. Free cash flow, no change. After paying the $80 million, free cash flow will still be $750 million to $850 million. And then our operating margin, again, we would echo being flat to up slightly. Also, within the context of guidance, I just want to comment a little bit on the pattern of earnings, as I did at the investor conference. At the investor conference, I suggested that the consensus estimate that we were seeing at that time for the first call were high in the first half and low in the second half. That's still true as we look at the numbers.

The consensus on first call today kind of fits roughly in the middle of our guidance range of $1.60 to $1.80. If those of you that make these estimates, if you want to be more accurate on a quarterly basis and therefore not be surprised, you would actually lower the first half and the only chance you'll get now is really in the second quarter, then you would increase the back half by an equal amount. So you just sort of be more accurate, you shift the numbers around and you'd probably be better off focusing net add back on the fourth quarter.

There are several reasons for this pattern. First of all, sales will build as we move through the year because that's the kind of plan we built and that's totally consistent with what we've seen over the last 5 quarters. Secondly, cost reduction efforts, just as in the past, will build, and I think we all expect inflation will build as the year progresses.

Third, fuel margin, which are now being squeezed as the cost of fuel rises. They'll stabilize here at some point and then margins will pick it up. And at some point, trust me, fuel cost will go down and margins will expand. You'll recall from a couple of years ago, we showed how volatile our margins for fuel could be from quarter-to-quarter. And -- but we also showed that if you look over the last 7 or 8 years, plus for 1 year, the annual fuel margin has differed by no more than $0.02 a gallon. And so right now, if margins didn't get any better, it would actually cost us $0.03 a share in the second quarter. If margins get better, that will moderate a little bit.

And then the last thing I would say and it has nothing to do with the quarterly pattern, but if you're developing your quarterly pattern off of our performance last year, it would be very helpful to try to do some of that analysis that I described earlier in what I called quality of earnings, but just a comment there that compensation will be higher for no other reason than that we're performing better. And so the element of compensation that is at risk for management, that will be a bigger number this year. And that's a good thing for all of us.

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

Melissa Plaisance

Wendy?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question today is from John Heinbockel. [Guggenheim Securities]

John Heinbockel - Guggenheim Securities, LLC

Guggenheim. So Steve, a couple of things. Where are we comp-wise thus far in the second quarter, or if you don't want to give a specific number, maybe some color on what has happened directionally, particularly as inflation's picked up a little more?

Steven Burd

Sure. For us, given the way our quarter falls, it's kind of an odd quarter. And just to refresh everybody, Easter last year, what we call Easter, which is the topping period before Easter itself, that actually occurred last year in the first week of the second quarter. So that's week 13. This year, that actually occurred in week 16. And so right after Easter, which is now week 17, the week we're in, you always get a dent in your sales that is reflective of the fact that people purchase things for more than just Easter in week 16. So that makes it a little more difficult to assess this number. Secondly, Easter week last year occurred at the first of the month. So right now, what we're experiencing is a week after Easter, is we're experiencing the normal drop in business that occurs in the first, let's say, 3 or 4 days, coupled with the fact that now we're at the end of the month, and the end of the month always has a couple percentage points' difference from the first of the month or even the average of the month. So rather than sort of give you where we are in the quarter, it makes more sense for me, John, to kind of tell you based on what I see and based how we sort of analyze the calendar, how do I think the quarter will look? And I would tell you that we think that we'll continue to make progress in the second quarter, and we think that we could be close to a 1% ID. We'll be close. We'll be very close to 1%. It could be a little less, it could be a little bit more.

And then commenting on a related issue of inflation, we are expecting that inflation in the second quarter would probably be a bit stronger than what we experienced in the first quarter. But again, because of all of the moving parts in the calendar, it's a little difficult to take quarter to date numbers kind of at face value. And so -- and then also, as you come in to this part of the calendar, you have a lot more volatility in your produce area, when certain crops are not available. This year, we are stuck with a very low avocado crop, and that even affects Cinco de Mayo. And then on top of that, because it's a low-volume crop, it's very high priced. But it looks like that's going to be soon replaced with sweet corn coming in earlier. So there are a lot of things moving around. But I think generally, if you ask for direction, sales will be up and I think inflation will be up a bit as well.

John Heinbockel - Guggenheim Securities, LLC

As a follow-up to that, almost with every passing week, you get more manufacture price increases announced, some of them, fairly significant. How do you think about the pass-through? And it seems like retailers are uniformly or almost uniformly passing price through. Volume hasn't gotten hit yet or it doesn't look like it has. Is there -- how concerned are you that volumes take a hit at some point this year, and is that just what you all have to live with?

Steven Burd

Yes. I think your sense of what's going on in the pass-through is correct. And there's really no change in the information that I presented at the investor conference. And I continue to believe that if your inflation is in that 3% or less range, you're generally prevented from having demand depressing effect. Now we're not anywhere near that level. I know that you can look at CPI numbers and CPI include CPI numbers. We've tried to do some analysis on that. I can't give you a full or complete explanation, but there's no question that those numbers overstate what we and other retailers experienced in terms of cost inflation. And then this quarter is a destructive quarter because basically, even though fuel price per gallon retail for us went up a full $0.53, which is pretty significant, we still had increases in transactions. We had an increase in price per item, and we had an improvement in volume. And so a lot of evidence out there that it's not now affecting things. The other thing I would remind folks is that the last time we got to $4 a gallon, we as a nearby, "in the neighborhood" retailer actually benefited. And another data point I might give you, while we don't have fuel stations in all of our stores, I passed 3 stores on the way to work -- I have a short commute, and I passed 2 stations or 2 stores with fuel stations. And our ID gallon in the U.S. are up 20%. I do believe people are consolidating their trips. I do believe that the best consolidation is to take a work trip and consolidate that with a shopping trip. So I can choose 1 of 3 Safeway's to make that consolidation and I may as well get gas while I'm at it. So I think that we have an appropriate complement of fuel, which helps us and inflation is still within reasonable control that I don't see a demand-depressing effect

John Heinbockel - Guggenheim Securities, LLC

Okay, and then one final thing. I know you talked about some of the things that pushed up SG&A for the quarter. Some of that incentive comp will be with us. But if you look at the 1.5% growth rate in SG&A, is that -- how do you think about the right trajectory for that growth given what you tend to do proactively with expenses? It looks like that's probably a high number to be a trajectory going forward?

Steven Burd

Yes. I mean, I think that if you think -- we do everything we can to contain costs, particularly in this time. And I haven't tried to express it in percentage terms. But if you were to -- you have never heard me call out a legal reserve on earnings calls, ever. If that weren't there -- and it was one decision, and we believe they were wrong. And so were it not for that, this would actually have been a positive improvement in O&A in the quarter and sales improved. Again, I'm not going to predict because I don't have all the nuances of last year's quarter in front of me but the higher inflation is, the more likelihood, as we indicated in the investor conference, an operating margin will not be flat but actually be up. And so to come this close on O&A and be up 18 basis points on gross, we feel very good about the quarter.

Operator

Our next question is from Karen Short. [BMO Capital]

Karen Short - BMO Capital Markets U.S.

Karen Short, BMO Capital. I was just wondering, I guess, following on the volume discussions and kind of looking at your income, the demographics of your customer base, are you seeing any differences in how your higher income demographic or higher income customer's able to absorb increased prices versus the middle and slightly lower? Any color on that?

Steven Burd

I think that -- I don't think there's been any material change there. I think I've been talking for a couple quarters about the bifurcated recovery year. And so you find people at the upper end of the income scale that are making a lot more discretionary spend than others. But I don't think anything really changed for us in the quarter that would affect that. Fuel gets a lot of attention. But one of the things to keep in mind about fuel, unlike groceries where some credit cards are used, fuel, they're all credit or debit cards. And in our company, credit would be twice as high on the transaction side in fuel than it would be in grocery. And I think consumers have come to believe that fuel is something that goes up and then comes down. And so it's a lot easier, I think, for consumers to absorb that temporarily. If it becomes permanent, that's much tougher. But I don't really see any falloff in our business from that other 75%. If we can take 25% fully recovered, the other 75% I'll regard that as relatively stable at this time.

Karen Short - BMO Capital Markets U.S.

Okay. And then turning to fuel, I mean, it did see -- I know you just commented on how much your ID gallons were up. But if I look back on prior $3.80 or $4 gas price periods, I show you kind of had negative volumes. So is there anything you're doing with your fuel promotions that's different that's driving traffic to your store?

Steven Burd

Yes. I think 2 things. First of all, we have -- we are doing more promotion on fuel than we did, say, last year. But also keep in mind, one of the reasons why our Fuel business goes up when prices go up is we're the cheapest place to buy fuel. I mean, there isn't anybody cheaper than us. Now there might be some people that are equal to us, but compared to branded folks, we are considerably cheaper, and that's the way we go to market. So you've got the basic street price, which is cheaper than everybody else, then you got the natural discount from being a Safeway customer and then you got the promotional elements in getting cheaper gas if you are a stronger Safeway customer. So all those things work to our advantage at a very time when fuel purchases in the nation are actually down. So that reflects a significant shift in market share say from the branded to us.

Karen Short - BMO Capital Markets U.S.

Okay, and then -- thanks for that tour. And then just looking at your comments on your quarters, 9 out of 10 divisions had sales improvements, and I think it was 7 out of 10 in the last quarter. Can you just talk a little bit about what the contributing factors were?

Steven Burd

I think it's -- the reason for giving that data point is I think whenever you have an improvement that is that broad based, it says that your marketing plans are working, the price investments that you've made and the awareness you're building continues to improve. And that's the reason for providing the data points. And we still have a lot of things that we talked about at the investor conference. They're not fully in place. And that adds to our confidence that sales will build even if inflation did not increase any further. I think it says that -- I'm often asked "How long does it take people to really answer survey questions of price position?" And I think that takes years. I think the foot traffic comes earlier. But I think getting our everyday prices down to a reasonable level and then allowing our shelf-to-shelf prices to be equal to all of our primary competition, and frankly, lower than our secondary competition. I think that's what builds sales kind of across the board, and that's regardless of how strong those economies are.

Karen Short - BMO Capital Markets U.S.

Okay. And then just last question, can you give us an update on what's happening with the Southern California negotiations? There seems to be a lot of noise on strikes.

Steven Burd

,

You probably actually read more stories than I do on Southern California. It's -- I would say that what's happening in Southern California fits a pattern of not only that negotiation but almost other negotiations. It's a relatively slow process. It's very common. In fact, it's more common than not for things to settle well after the official expiration date. And that clearly will be true here because we're expired already. You may have also read that they went for a strike vote among the employees. I can't think -- there might be a circumstance but I can't think of a single time in 19 years where the union asked for a strike vote and didn't get it. So it's pretty common for them to ask for it. It's even more common that they get it. And their strategy is if I have that strike vote, I'm in a stronger position at the bargaining table because I can act. I've got the proxy of the employees. But I don't think you should interpret that in any way that we're near a strike. It's very, very common for them to get a strike vote and be back at the table. So I think discussions are ongoing. And there's really no indication that we won't reach a settlement that's good for both.

Operator

Our next question is from Edward Kelly. [Credit Suisse]

Edward Kelly - Crédit Suisse AG

Credit Suisse. Steve, your ID gallon growth is pretty impressive this quarter. Can you just tell us, the stores that have fuel centers versus stores that don't have fuel centers, do the in-store sales of those stores actually perform better than stores without?

Steven Burd

They do. And that gap grows during times of higher fuel prices. So you would find a measurable difference. But again, what often happens is that people are combining trips. My palette of stores that I personally shop, probably 90% of my business is in 3 stores. And so they just might be shifting their business from one Safeway store to the other. But I do think that we do get some additional business, and that's why we put those fuel stations in to begin with.

Edward Kelly - Crédit Suisse AG

Okay. And I thought your gross margin this quarter was fairly encouraging. At the analyst day, you gave some components of the change in gross margin, price investments, shrink, mix, et cetera. Could you maybe give those details as we're looking at this quarter?

Steven Burd

I commented kind of -- I listed it kind of as an order of magnitude. The thing that most helped on the gross margins this quarter was the shrink effort that you recall we talked about last quarter. And I think I quantified what we were looking for at that time after having a great track record in improving shrink. Last August, we decided that we were going to improve shrink another $300 million, and we wanted to get that run rate by the end of the year. And then we wanted to benefit from that run rate this year. But we had a very strong fourth quarter. We had an equally strong first quarter. And we'll start lapping at some that when we get down to fourth quarter but that's the biggest single explanation for gross margin improvement. And then you have some other bits and pieces. You've got the x in positive mix change; private label continues to outpace national brands; growth in the aggregate; Blackhawk always adds a little something to the equation. And then the takeaways, the -- I'm going to x out the Blackhawk accounting change because if I x that out, that's the 18 basis points of improvement. But as indicated, we had 1 very large category where we thought we had an imbalance in Private Label here versus national brands and we shifted that. And so that had an effect. Energy costs, which affect our distribution area, had an effect. LIFO has an effect. The distribution center closure has an effect. So those are the major elements. And the distribution of the fact -- excuse me, the distribution center closure effect won't be with us next quarter. I suspect we'll still have some energy effect but still have some of that national brand, private labels -- we'll have a very strong shrink performance again in the second quarter. We'll have it at the third quarter. The comparisons will be harder in the fourth quarter but I expect to be better in the fourth quarter than we were last year. So again, I think it all bodes well for having a strong operating margin on the year.

Edward Kelly - Crédit Suisse AG

And as we progress through this year and inflation accelerates, that would then likely become a drag on the gross margin, right?

Steven Burd

No, I don't think it would be a drag on the gross margin. We basically -- if I look at the first quarter, inflation at the gross margin rate neutral for us. In other words, essentially recouping more than pennies of profits but maintaining our gross margin rate x these other factors like shrink. So no, I think you always run some risk determining on the speed of inflation that you could get a little bit of a lag there. But at this juncture, we're not really seeing any real lag out there. It's been tough for retailers over the last couple of years. So when they get cost increases, they pass them along. You might also see if you get higher inflation, you might see vendors providing a little bit more support as they sort of -- that's their way of letting that cost increase string out just a little bit at a time and try to avoid any demand-depressing effect. But of course, we can always shift to private label if those cost increases get too high. So I don't think -- this is really managed very, very closely. It is managed at the minutest level of detail. So we feel pretty good about being able to balance off all those factors on the year.

Operator

Our next question is from Scott Mushkin. [Jefferies & Company]

Scott Mushkin - Jefferies & Company, Inc.

Thanks, it's Jefferies. So I wanted to revisit something you -- I think Karen was talking to you about, Steve, is the high-end bifurcation. I just wanted to make sure I understood what you said. Do you think it's gotten worse as gas prices have gone up? I was just trying to -- or maybe I missed it when you said that. I just wanted to get your view there?

Steven Burd

My comment, Scott, was basically that I don't really see any material change there. You've got -- I would estimate that at 25% that you don't worry about the recession. It's recovered back to a consistent discretionary spend. And then you've got the other 75% that are a lot more cautious. I don't really think that last quarter, we saw any real change in that. And when you look at sales, I mean you'd be surprised how many folks around here, and I know them by first and last name, that I consider to be really students of the calendar. And even though I've been asked this for 19 years, I try to check some of my own logic with people who have been around even longer. And so as I commented earlier, if you were to look particularly at the first few days of this week, you would see a bigger down draft on sales as you would normally see post-Easter week. But that's reflective of the back half of the calendar. And everything that we saw in the quarter, volume up, price per item up, transactions up, indicated that we weren't seeing any really negative effect from rising fuel prices. And again, maybe that's in part because we got a pretty full complement of fuel stations, and we're getting that consolidated shop ourselves. And we're getting the benefits those fuel stations were designed to provide. So others could be, that don't have fuel stations, could have a slightly different view of that.

Scott Mushkin - Jefferies & Company, Inc.

Yes, I mean that's interesting commentary. I guess our data is showing maybe some weakness seen at the low end. I'm just trying to see if it's maybe being offset by even the high-end even getting better. That is kind of my thought process. It sounds like you're not really seeing any change.

Steven Burd

Not seeing any change from previous quarters. We do see, as I commented earlier, this has been going on for 4 quarters now. I'm not talking about income level but talking about level of customer spend. Our more loyal customers are increasingly more loyal. And those that are less loyal, that's where the negative drag is. So if I look at our top 3 volume groups and I show some of that information at the investor conference, they continue to show some very strong numbers.

Scott Mushkin - Jefferies & Company, Inc.

That's a good lead-in to my second round of questions, and I know you guys went into great detail at your Investor Day because I know, the Just for U program, the Open Nature private label program. And so I was just wondering if you could maybe give us an update on Just for U? I think it was in 2 markets at the time of the investor conference. Maybe an update how it's going, is it rolled into more markets, and then maybe some comments on Open Nature and how that's trended for you?

Steven Burd

Sure. Just for U is still consigned to the 2 markets. And we are doing some different things, different features, added to some of those sub-markets and have some very encouraging numbers from those additional features, which caused us to think about putting some of those features in the rollout for the balance of the company. And the one thing I can tell you, we're spending a lot of money on technology. And the conclusion that I've reached is big companies aren't necessarily inherently slower than small companies on software development. The big companies have a lot of legacy systems built over a period of time, and the plug-and-play is not as simple as the startup company. And so the massive technology effort underway to make sure that our plug-and-play works flawlessly as we launch into those other divisions.

On the Open Nature, I look at those numbers every couple of weeks. They continue to build. We will be adding SKUs as we move through the year. No indication that we won't get our expectations for the year. In fact, every indication is that we would beat those. So it's been a very -- I think that Open Nature will end up being a brand of equivalent size as Eating Right and O Organic.

Scott Mushkin - Jefferies & Company, Inc.

That's great. And I hate to do this but I'll sneak one in on the technology challenges. Where is the biggest glitch you find with Just for You? Is it the interface with the consumers? Is it interface with your own systems? Maybe just 30 seconds on where the biggest challenges are?

Steven Burd

Well, I think the -- you've got a combination of things. I mean, you want to make sure that when you go broadly that your systems can scale and you don't run into capacity. So we've been spending some time on that, no capacity constraints at 2 divisions. But what we rolled to the 2 divisions would not have scaled without making some changes in the registration and access. So those represent constraints. Then secondly, some of this work gets done not just inside but gets done with some outsiders. And it might not be their primary business. And so we have to make sure that we have their attention, and they make the appropriate changes for scaling as well. And so it's really that combination of internal and external resources and getting everybody on the same page. And so where we've experienced some difficulties, it has more often than not been the outside resources, it's not the inside resources, that has created those difficulties. They make a change and suddenly maybe the system slows down for a couple of hours. And because, again, we're not their primary customer, and so we're working through those issues. And when we're satisfied that they're behind us, you'll see us rollout at skill speed. But the numbers continue to look very good, very good, and so we're eager to get it rolled out.

Operator

Our next question is from Robbie Ohmes. [BofA Merrill Lynch]

Robert Ohmes - BofA Merrill Lynch

Steve, I think I actually had a couple of questions for you. The first one was I think at the Analyst Day, a couple of other initiatives you guys spoke of was store clustering to support merchandising. I don't know if it's too early to see any update on that, but I was just curious if anything was going on there to comment on. And also, the SimpleNutrition in-store tagging campaign, if you can give us any more detail on what the customer response has been to that as well. And I think the other question was just you mentioned this category shift to branded from private label. Can you give us more detail what the category was and if there might be other categories that you foresee having to do the same thing and as you move through the rest of the year that could pressure your gross margins? Thanks.

Steven Burd

In terms of the clustering, that's an ongoing process. And it's generally done on a category-by-category basis. And so that's ongoing. It's built into the plan and we'll provide benefits as we complete that process. SimpleNutrition, the first step to that was to really provide a bit of a field guide for consumers so they can see the key nutritional aspects of the price they might buying. A category that is very important to us is gluten free. I think in general, if you're looking for gluten-free products at most retailers, that's a very difficult process. This makes that instantly better. And if you're looking to take some other things out of your diet or add some things in, that also make it easier. So I think what you see early on is you see some people being really big fans and others that maybe aren't really making any particular effort with diet, basically ignoring those tags at this juncture. Step 2 is to take our FoodFlex system, which we may have talked about a couple years ago, which we are retooling into a much more user-friendly tool. It will be renamed SimpleNutrition. That will be available in the not-too-distant future. So that will really reinforce and provide a lot more information and provide a greater opportunity to people to really make changes in the items they purchase as they pursue certain goals health and wellness goals. And so I think that, that tool will actually have even greater power than the scientifics to note [ph].

And then on the category, I think I'm going to keep the category. I'm not going to slow the category, but I will say that it really sort of stood by itself. I can't think of another category that we had any plans of doing that with. And the turnaround in sales of the category has been nothing short of dramatic. And we went from a category that was near double-digit declines to a category that now has positive sales. And we'd just taken the category too far in the direction of Private Label. We're also doing some things from a merchandising standpoint in several categories that will further enhance our sales of both national brand and Private Label. So don't think -- I expect private label sales to outgrow national brand sales. I don't know. I see that happening for years to come, quite frankly.

Operator

Our next question is from Adrianne Shapira. [Goldman Sachs]

Stephen Grambling - Goldman Sachs Group Inc.

This is Stephen Grambling on for Adrianne, and I'm with Goldman Sachs. Just earlier on the call, you had mentioned that you had some supply issues with avocados and just the shortage. On the flip side of that, have you had any opportunities to make forward buys?

Steven Burd

Forward buying is -- the opportunities are not what they were a decade ago. And so there is some forward buy that goes on, but it's not a meaningful amount. It's not the way you make your gross margin rate. To the extent that there are opportunities, we capture them. But in the old days, it used to be given a lot of notice on the part of the vendor community in terms of the price increase and ample opportunity to buy in advance of that. But that's not particularly common. And what used to be common is I think you know in the vendor side of the business there used to be a lot of what people used to refer as trade loading. That's quite frowned upon. And so, there really isn't an abundance of forward-buy opportunity out there.

Stephen Grambling - Goldman Sachs Group Inc.

Okay, thanks. And one follow-up. Just earlier on, you had mentioned that your most loyal households were increasing their spend. I'm just wondering in total, have you seen household actually grow during the quarter?

Steven Burd

I didn't look at the household data. Obviously, we kind of jumped up so we did see -- and that's consistent with the last several quarters where households coming to Safeway continues to grow.

Stephen Grambling - Goldman Sachs Group Inc.

Okay. And I guess in the past, you had mentioned your own share, whether you've been gaining or losing share in the supermarket category. Have you seen anything change in terms of that? Are you gaining share within the supermarket category from what you're seeing?

Steven Burd

Yes. We are still running some small negative share numbers. And frankly, you need to see that ID number be north of 1% for that number to turn positive before the end of the year.

Stephen Grambling - Goldman Sachs Group Inc.

I guess one last follow-up on that would be, is there anything to call out geographically?

Steven Burd

No, I think -- we typically don't talk about geographies. And the only data point I gave earlier was that -- but for snow storm events in the past, really improving in all markets.

Operator

Our next question today is from Deborah Weinswig. [Citigroup]

Deborah Weinswig - Citigroup Inc

Citigroup. Steven, the Just for U program in the 2 markets, what are you seeing in terms of your most loyal households?

Steven Burd

I'm going to repeat the question and make sure I got it right. I think you're saying in your Just for U markets, which is 2 markets, what are we seeing from the most loyal households?

Deborah Weinswig - Citigroup Inc

Perfect.

Steven Burd

Is that correct?

Deborah Weinswig - Citigroup Inc

Yes, perfect.

Steven Burd

In the 2 markets where we rolled out the basic Just for U model, we're finding that our more loyal customers are bigger users of Just for U than our less loyal occasional shoppers. We did, however, introduce a feature in the sub-market, which by its design is attractive to the occasional shopper. And in that sub-market, the interest of the occasional shopper is actually stronger than the loyal shopper on that feature. So essentially, what we're trying to do is essentially make adjustments and create features in Just for U that creates a much broader following of all basic loyalty classes. And so we now have something that we will clearly roll out more broadly that will capture people from all elements of the loyalty spectrum.

Deborah Weinswig - Citigroup Inc

And then at the recent analyst meeting, we heard about many of the new initiatives with regards to private label, and it sounds like you experienced a lot of strength in the quarter. Can you just help us gain an understanding in terms of growth in national versus private label during the quarter?

Steven Burd

Yes. I think -- I'm trying to remember last quarter, Robert, where I think we had a difference of, I'm going to say around 400 to 500 basis points. Somebody will look that up while I'm chatting. That narrows because of what I explained of the major category to a couple hundred basis points. But again, half of that narrow was explained by a single category. So I think that, that probably represents, I would bet, a low point and particularly as Open Nature begins to build out more SKUs and grow, that 200 basis-point difference, positive difference, with private brands exceeding national brands, will grow. And, Melissa, just put in front of me, the difference I reported in the fourth quarter, which is about 500 basis points. There was a narrowing there, but I expect that narrowing to represent kind of a low point on a go-forward basis.

Deborah Weinswig - Citigroup Inc

And last question, you mentioned that price per item had increased. How much of that is inflation versus the consumer trading up?

Steven Burd

I think that -- this is more art than it is science, but I think that it is -- it doesn't reflect much consumer trading up. And I think it's a pretty decent reflection of inflation.

Operator

Our next question is from Mark Wiltamuth. [Morgan Stanley]

Mark Wiltamuth - Morgan Stanley

Steve, just to focus a little more on volumes, you said a couple times volumes were up, but aren't they really just less negative than they were before?

Steven Burd

I didn't say they were up. I said they had improved.

Robert Edwards

That was in summing up fuel volumes.

Steven Burd

Well, fuel volumes -- I made a comment about volumes still being negative in my formal remarks, but I said better than the fourth quarter.

Mark Wiltamuth - Morgan Stanley

Okay. Do you have any reference for us the last few quarters what you were doing on volumes so we can see how it's trended?

Steven Burd

We had a quarter or 2 where they had been basically flat. One of the reasons why I'm not so focused on articulating volume is because it is a -- there's lots of ways to measure volume. What we've tended to do is we try to look at items. Well, let me sort of expand on this a little bit. So let's take what I said earlier about avocado. Because of the avocado crop and the cost in retail price points that were created, avocados, which are often sold by the heap, were down 48% in the quarter. And so that has a material effect on items. And it affected the overall produce number, which is our largest single category in the store, by over 250 basis points. So you can't -- and something I learned about avocados, a good year is always followed by the nature of the crop by a bad year. It's like a pattern. And so you actually have a material amount of what we would call item volume that was actually affected by one single item. Now let's move to corn. In the early part of the season, 2 ears of corn is basically an item. In the late part of the season, 10 ears of corn is an item. So you've got so much sort of volatility in what is an item that I don't want to get preoccupied. I think the trend is important, but I think when you're dealing with numbers of 0.2 and 0.4 and 0.5, you can't get lost in this stuff because it could be avocados or corn.

Mark Wiltamuth - Morgan Stanley

But just to stay out of individual categories, and if the overall store price per item is up 0.4 and your inflation is running 1, you should be running like a negative 0.6 on overall volumes. So how has that looked the last couple of quarters?

Steven Burd

Well, price per item I said is up almost 1%, okay? And so IDs for the quarter were 0.4. So if you look purely at item, item count was basically down about 0.5, okay? But again, I'm going to tell you that avocados were 2/10 of that 0.5. It had really nothing to do with the business of the company, but is an artifact of us using item count as a representation of volume.

Mark Wiltamuth - Morgan Stanley

And then lastly, at the analyst meeting, you seem to imply the first and second quarter numbers were too high. Did the first quarter number really come in, in line with what you were expecting or did things get a little better?

Steven Burd

It came in line with what we were expecting. And I don't actually recall whether or not -- I don't recall what the consensus estimates were in the first quarter and whether those came down a little bit or not. But at the investor conference, I was just trying to give guidance on first half versus second half. I got a little more specific on this call with that sort of pattern and just trying to help people with their estimates. But no one -- I did this once before and then there was a press release the next day that said essentially Safeway lowered its estimates. And I guess somebody heard a suggestion that you should lower one and increase the other quarters, but they didn't marry the 2 sound bites, so I'm not lowering estimates. Our guidance is the same. I'm trying to help people pay for their estimates. Let's say they don't pay for their estimates. We'll probably sit here 12 weeks from now and say that we hit our number. But some of you will say, "Well, you didn't hit mine." So I'm just trying to provide a little bit of detail and a little bit of explanation to why that ramped. And this is not new news. It was true last year. It was true the year before. It ramps because when you figure out new ways to control costs or improve profits, they're not instantaneously put in play. There's a lot of execution that takes time. You find something that works. We've got a major sales initiative going on in the Pharmacy business right now. And if I can replicate that, it's material. And I'm confident I can replicate it, but some people replicated it for 4 weeks, and some people will not replicate it for 9 months.

Joseph Agnese - S&P Equity Research

So it sounds like much of it is the cost control building as the year goes. So is the shrink number going to get better as the year goes, or is it SG&A that's going to be more of the effect in the second half?

Steven Burd

So I think I teed up in the fourth quarter earnings release that the shrink number that was very strong in Q4 should look pretty similar in quarters 1, 2 and 3. And then because we started this huge effort in the fourth quarter of last year but didn't complete the whole thing, the shrink number will get softer in the fourth quarter but still should show improvement. But there are other items. I'm kind of banking on fuel margins. If you look at fuel margins, very volatile. I do not expect fuel to go up significantly between now and December 31. And even if it goes up and just stays there, our fuel margins will lighten up. They will become normal. But if this year follows every other year, you get an up-and-down in a cycle. It doesn't always go up in the first half and down in the second. Sometimes it goes down in the first half and up in the second. But fuel margins, we're contemplating, will be stronger if for no other reason fuel will stabilize at some point. Inflation will get, I think, stronger as we move through the year, which will build income. You're correct on cost reductions. So those are the big items that will affect the pattern. And then go back and look at your notes from last year at the description of the quarter and see if there are any odd elements in any of those quarters that you judged won't happen this year or maybe they were beneficial last year that will go away. That's what we do when we develop our quarterly pattern.

Melissa Plaisance

Wendy, we have time for 2 more questions.

Operator

Our next question is from Meredith Adler. [Barclays Capital]

Meredith Adler - Barclays Capital

Meredith Adler from Barclays Capital. Thanks for taking my question. There's been a lot of discussion in the press and I've heard lots of analysts talking about inflation in dry grocery. But another category that is extremely inflationary is meat. And I was wondering if you could talk about kind of what you're seeing in terms of consumer behavior? Is it getting passed along, or are people changing what they buy? And how do you see that sort of playing out for the next year or so because I think meat will stay in short supply for a while?

Steven Burd

I think that on the meat question, if I were to take you back to the third or fourth quarter of last year, as we began to see meat prices rise, we saw much more of a delay in the retail recovery of that than we saw in the first quarter. And so I think as people sort of get geared up for meat prices to maybe continue to rise, they're much quicker to be able to -- to reflect that in retail. So that's what we're experiencing now, and that's a good thing. Is there a trade down to other lower-cost protein? That's always true. And it really depends on -- I mean, there's a lot of shifting back and forth depending on the cost of those different proteins. So again, it's normal, normal course of business. And so I think, if you really think about what goes on in the supermarket business, some of the absolute most challenging categories to manage are those that have volatility in price. Fuel is a single item, so maybe not as challenging. Produce is actually more challenging than meat because it's not about crop. And you're correct, those trends are a lot easier to see because they're basically driven by elements of supply and demand. And whereas in the produce arena, weather can dramatically affect positively or negatively the quality of the crop. So in meat, it's predictable. But right now, things are quite normal on how that gets passed along.

Meredith Adler - Barclays Capital

And do you have any sense about whether we will see the price of meat come down anytime soon?

Steven Burd

I haven't actually pushed any of our folks on that. It's tended to be kind of steady as opposed to shock value. When we get into those dramatic jumps, then I get real curious about what the future holds. But I would say that right now, we're at kind of a normal adjustment period of supply and demand.

Operator

Our final question today is from Alex Bisson. [Northcoast Research]

Alex Bisson - Northcoast Research

Northcoast Research. Thanks for taking my question. One of your competitors said the other day that there are quite a few assets on the market for sale. And I was just curious if you could kind of give us your view of what you see happening in the M&A arena?

Steven Burd

I don't know if I would echo "quite a few assets for sale." I think that the business environment for the supermarket business has been particularly soft over the last couple of years. The lack of inflation has put a lot of pressure on either small retailers or even relatively large retailers that don't have the capacity, or the capability, or the common sense or what have you, in order to look for new inventive ways to control costs. And so I do think that when I think of -- I don't think of this as an abundance of assets on the market. And it tends to be smaller players. We have far greater interest in assets that are kind of in-market or adjacent-to-market because the leverage is much greater against our relatively fixed cost structure. So we're not seeing -- we're not really seeing -- I'm seeing a little extra in terms of assets for sale because of the business downturn, but I wouldn't consider right now to be any different than one year ago.

Melissa Plaisance

Okay. Thank you, everyone. If there are any follow-up questions, Christiane Pelz and I will be available for the balance of the day, and thank you for participating.

Operator

This does conclude today's conference. Thank you for participating. You may now disconnect at this time.

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