Safeway Q2 2007 Earnings Call Transcript

Jul.19.07 | About: Safeway Inc. (SWY)
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Safeway Inc. (NYSE:SWY)

Q2 2007 Earnings Call

July 19, 2007 11:00 am ET

Executives

Steven Burd - Chairman, President, CEO

Robert Edwards - CFO

Melissa Plaisance - IR

Analysts

Mark Husson - HSBC

Perry Caicco - CIBC World Markets

Chuck Cerankosky - FTN Midwest Research

Meredith Adler - Lehman Brothers

Jason Whitmer - FTN Midwest Research

Mark Wiltamuth - Morgan Stanley

Todd Duvick – Banc of America

Scott Mushkin - Banc of America Securities

John Heinbockel - Goldman Sachs

Ed Kelly - Credit Suisse

Deborah Weinswig – Citigroup

Steve Chick – JP Morgan

Bob Summers - Bear Stearns

Presentation

Operator

Welcome to the Safeway, Inc. second quarter 2007 earnings conference call. (Operator instructions) Now, I will turn the meeting over to Melissa Plaisance, Senior Vice President of Finance and Investor Relations.

Melissa Plaisance

Good morning, everyone, and thank you for joining us for the second quarter conference call. With me this morning is Steve Burd, our Chairman, President and CEO; and Robert Edwards, our Executive Vice President and Chief Financial Officer.

Let me remind you that this conference call may contain forward-looking statements. Such statements may relate to topics such as sales, gross margins, earnings growth, operating improvements, cost reductions, capital spending, acquisitions and dispositions, debt reduction, labor relations 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 in Safeway's annual report to stockholders, included in Safeway's most recent Form 10-K and subsequent quarterly reports on Forms 10-Q.

With that, I would like to turn the call over to Steve Burd.

Steve Burd

Thank you, Melissa. We reported $218.2 million in the second quarter. This compares with a reported $246.2 million from one year ago. When you express that in terms of earnings per share, this quarter we made $0.49, as contrasted with $0.55 one year ago. I'm sure most of you recall that a year ago we had a very large tax refund from the federal government, some $318 million. A piece of that refund was accrued interest, which was in excess of $58 million.

So last year when we reported our second quarter, we isolated that $0.13 a share because we didn't think it was appropriate to associate it with that quarter. When you make the same adjustments this year, you see that this quarter's $0.49 a share compares very favorably with the tax adjusted number from last year, which would be $0.42 a share, which is equivalent to a 17% increase in earnings per share.

We're clearly pleased with our results for the quarter. That $0.49 per share puts us at $0.01 cent ahead of the consensus estimate and is the result of both strong sales growth and an expansion in our operating margin.

Turning first to sales, total sales increased on the quarter 4.9% over last year. Comparable store sales increased, also 4.9% when you include fuel, and then when you exclude fuel, comparables advanced some 4%.

The more conservative definition, which is the one that we follow more closely, is the identical store sales, which increased 4.5% when you include fuel and increase 3.7% when fuel is excluded. This represents the fifth consecutive quarter that non-fuel related IDs have equaled or exceeded 3.5%.

Sales increases continue to be well balanced, with perishable and nonperishable both generating IDs in excess of 3% and our market share, as we measure it, which is confined to the supermarket channel, has now grown for the tenth consecutive quarter.

Turning to gross margin, while our gross margin rate as reported declined 15 basis points, higher fuel sales explains 14 basis points of that decline. Maybe stated a bit differently, our non-fuel gross margin rate was essentially flat for the quarter.

Looking at O&A expenses, O&A expenses declined 37 basis points from last year's second quarter. Again, 15 basis points of this decline is the result of higher fuel sales. The remaining 22 basis points of non fuel-related declines is largely the result of sales growth, which is leveraging some of our fixed costs; employee-related expense reductions, with a very strong contribution coming from reductions in workers' comp; and then lastly, net property gains, which were partially offset by higher store occupancy costs, reflecting our aggressive capital program and a smaller increase in energy costs.

While we had a large gain in non-operating properties, we also had a large offsetting loss related to the lease exit costs associated with the closure of 14 stores at Dominic’s which you recall we announced in the first quarter, but those closures took place really in the second quarter.

Turning to interest expense, our interest expense declined almost $2 million due to lower outstanding debt levels, partially offset by a slightly higher average interest rate. The average borrowing declined by $228 million on the quarter from last year, and at the same time, our borrowing rate increased some 10 basis points; still at an attractive level, 626 versus 636 this year.

Turning to capital expenditures, we completed four new stores and 59 remodels during the quarter, so if you look on a year-to-date basis, through two quarters we have completed five new stores. Again, our new store program, as well as the remodel program tends to be back half loaded and we have completed a total of 82 remodels. Those numbers are very consistent with our experience from last year.

As a result, we now have 48% of our 838 stores in the lifestyle format. We of course expect to have 60% of those stores in that format by the end of this year. We've invested a total of $753 million year-to-date and then we believe we're on track to spend $1.7 billion by year end.

Looking at income taxes, our income tax rate in the second quarter was 35.5%. For a long time we believed a normal tax rate for us was essentially 38%, but you recall historically we've always managed to do things in the quarter. We manage taxes like any other cost and we oftentimes beat that 38% number.

Going forward, to give you some longer-term guidance, we believe that a more normal rate is now much closer to 37%. The tax rate for the first half of this year was 36.3%, which suggests that we think that the tax rate in the back half will be around 37%. Keep in mind we still have a lot of tax issues outstanding. We are chasing after some of the state refunds that relate to the same thing that gave as the federal refund, so those numbers will of course change from quarter to quarter.

This quarter's reduced rate is largely the result of a new FASB ruling, famously referred to as FIN 48. I'll let Robert explain that should anybody have a deep interest. The quarter was impacted moderately in addition to FIN 48 by some favorable resolution of some prior year tax issues.

Turning to cash flow, this was a very solid quarter for free cash flow at $297 million. This free cash flow performance enabled us to reduce debt by $149 million during the quarter, while at the same time purchasing 3.4 million shares of our own stock. The 3.4 million shares were purchased for an average price of $35.52 per share for a total expenditure of $120 million. This leaves us with the remaining authorization to purchase an additional $627 million worth of stock.

Turning to guidance, really for the balance of the year we feel very good about our performance here in the first half. We feel equally good about our performance in the second half. In response to that, we're narrowing our EPS guidance from a range that has been $1.90 to $2.00 a share to a range of $1.95 to $2.00 per share.

I'm sure some of you, maybe all of you, would prefer that we increase our guidance but as good as we feel about the back half and we're off to a good start, we think it's more prudent to simply narrow that range.

Let me give you a couple of reasons for that. You may recall that last year we set what we thought was a pretty aggressive target for reducing shrink in our stores, and we beat that target by more than 100%. In fact, what would normally be a target for us we turned in almost two-and-a-half year’s worth of progress on shrink last year.

We set an equally aggressive target this year, and we're not tracking on that target, which means that when you look at our performance on the year through the first half, we come up short against our shrink target. We have lost no ground to what we gained last year, but we just haven't hit those numbers. We believe we'll be on track with our back half goals, could possibly beat that, but we're just trying to be a little cautious here. While on the first half we're ahead of the consensus estimate, we are essentially right on our number. Our plan number is essentially what we produced in the first half.

We are also experiencing more product inflation than we have experienced in a long time. While the conventional wisdom is that product inflation is good for retail companies, we've had very little experience with that, but I can share what that experience is.

We remain confident and we've had enough experience to know that we can pass along the vast majority of cost increases. When you have cost increases in the commodity areas like fuel and milk and eggs and butter, you typically are passing on cost increases and protecting your pennies of profit. When you have cost increases in the center of the store, you typically are protecting your gross margin, and so those increases actually tend to be more beneficial from a profit standpoint than the commodity areas.

At the same time, in the commodity areas there tends to sometimes be a lag now and then. Any time you raise prices you have the potential for a dampening of demand. So again, as good as we feel about the back half, I think there's enough inflation and worry out there that we just want to be a little cautious about what happens relative to inflation in the back half of the year.

By narrowing the EPS range, we are targeting a 13% to 16% EPS improvement. Couple that with our dividend yield and you get a very respectable result relative to how the S&P typically performs. That comes on top of generating two successive years with earnings per share growth in excess of 20%.

We still expect ID sales excluding fuel to be in the range of 3.6 to 3.8. We continue to believe that our free cash flow will be in the range of $400 million to $600 million and that excludes the free cash flow that may flow from Blackhawk, which as you know is a very seasonal business.

Finally, we no longer provide quarterly guidance but from time to time, comment a little bit on at least the half years. We believe the consensus estimates in the back half are reasonable, but we also believe that they're a bit high in Q3 and frankly they're a bit low in Q4. So if someone wanted to be more accurate, they would move a bit from Q3 and put it in Q4.

This earnings pattern is driven predominantly by the timing of property sales. Property sales for us are very important, have always been important. They are not highly predictable. We're not going to sell a property for less than its intrinsic value, just to put it in one quarter or the other. So as you get closer to those prospects, you have a much better feel for where they will fall and so property sales that we anticipate, which always offset some of the losses and impairment charges we might incur, cause us to think that those movements will take place between Q3 and Q4.

Just a comment on Blackhawk, Blackhawk continues to perform well. Card sales, what we refer to as the face value of card sales at our investor conference, as well as net commissions, which are the commissions that Blackhawk receives from those sales, continue to increase relative to last year in excess of 100%. We continue to add both content, with that content being exclusive content to Blackhawk, and continue to add points of distribution, which should cause that business to continue to grow at a very attractive rate.

So with that, Melissa, I'm prepared to open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mark Husson – HSBC.

Mark Husson – HSBC

First on the Southern California strike resolution. When you had that last strike, you had to correct up some accruals for the pension fund or healthcare costs for the old employees. Is there anything in this agreement which you're alluding to in the second half of this year that we may need to take into account in terms of forecasting?

Steve Burd

I'm sure you can appreciate it. I didn't mention the Southern California settlement, just because it had been such big news. I'm sure it is on people's minds. I don't want to discuss any of the details of that and the unions have not been discussing the details of that until we get it ratified. But no, there's nothing in that agreement that is causing me to suggest putting a bit of this from Q3 into Q4.

Mark Husson – HSBC

The second thing is, maybe I missed it, but I can't remember a quarter when your actual store count was down year over year. It's down now. I know you've got a back half weighted store opening program. Can you talk about in general your attitude towards opening stores and the capacity that's out there in the market? Obviously we've got Tesco coming in, San Diego has kicked out its big box resolution and you've also got all those other stores still kicking around out there. Can you give us a sense of ebbs and flows?

Steve Burd

You're talking about new stores?

Mark Husson – HSBC

Yes.

Steve Burd

Our new store program continues to be pretty moderate. We still think that's the right course of action, given that we've got another 50% of our stores to lifestyle. The lifestyle stores continue to perform famously. I think it could have been in the last call I mentioned that we've got some lifestyle stores that are four years old. While the data set on the last call was quite small, as we look at the fourth year of the lifestyle stores, they're performing just as well as the stores did in the second year and in the third year, which is actually pretty remarkable.

So again, from a pure return on investment standpoint, plus the fact that we consider the lifestyle stores to be every bit as good a defense as they are an offense, we're going to continue to focus on remodels. We're very alert to good real estate that comes up and sometimes we'll buy that real estate and secure it for future store sites.

I don't think you will see us be aggressive with conventional store growth until we get much further along in the remodel effort, because it just makes so much sense to do that. That's also a good strategy relative to any new entrants that comes against us. We would typically lifestyle the store in advance of a new entrant coming into any of our markets and that seems to be a very good strategy for us.

Mark Husson – HSBC

But do you think you are losing your share of total market space a little bit, as other people open up at a faster rate? You say it's quality, not quantity that matters, but is there a danger there?

Steve Burd

You are correct that in some high growth markets where if we take our market share and we look at the stores that we're building, there are a couple of markets that I can think of where we're not building. Let's say if we have a 20% share, we're not building 20% of the stores. So from that standpoint, you can lose share in that market.

But if you have good, strong ID sales growth that will compensate for that, and when you look at our market share in the supermarket channel, it's an all-in share. It's a combination of what we're doing with our IDs, together with our new store building program. So despite a very modest store building program, we are gaining market share.

When we tune that thing back up to a more normalized program, our market share gains ought to be stronger than what they are now. At the end of the day, as you can appreciate, the profitability of driving those sales through existing boxes is so much greater than putting new capital to work in a new box.

We know it's important, but it's not overpowering. It hasn't hurt us. It hasn't hurt our ability to grow earnings in the last couple years north of 20, and this year at a very respectable number. We're quite comfortable with what we're doing and , someday we'll change it, but not for a couple of years.

Operator

Our next question comes from Perry Caicco – CIBC World Markets.

Perry Caicco – CIBC World Markets

You talked a little bit about inflation, but I wonder if you could give us a little more detail about the impact of food cost inflation on your business in this reported quarter? How you managed through it? Also, could you talk a little bit about the potential impact of inflation on your private label programs?

Steve Burd

In terms of inflation on the quarter, the areas that had the most inflation -- and again, we never give precise numbers on inflation because it's a very difficult thing to measure with mix changes and everything. The category probably with the strongest inflation was refrigerated dairy products, followed by items in the meat and produce area.

Those are very high turn categories, and those categories either don't have much of an effect on the LIFO charges, or are not in the LIFO layers in the main. What would typically happen, let's use milk as an example. There's been a lot of cost inflation in milk and when we get that cost inflation, if it's a couple of pennies we just sit on it. If it becomes $0.30, we move but it's a very competitive item and if we can't sustain that pass through, then we might change our attitude about that. So sometimes you do what you have to do to recoup costs and to remain competitive in those items.

I think the produce inflation is a pure supply and demand issue. On the dairy side, we're seeing some of the ethanol influence here. We're seeing an ethanol influence on poultry. We're seeing an ethanol influence on meat, and it's kind of an unfortunate thing because it's not the driving factor in all of our inflation, but it is a factor and most people that have looked at ethanol, it's not the best thing to do from a pure energy standpoint. let me just say that. But it's driving these numbers. Corn prices at one point had doubled. Now they have come back a little bit, but they are still up 50% from a year ago, and they're an important input into a lot of our products.

So the inflation that we've experienced is predominantly, although not exclusively, it's predominantly in the commodity side where there's probably much better pass-through. On the other hand, sometimes it's not perfect. There's a little bit of a lag in there. There's more of a lag in meat than there would be in dairy, for example. So the fact that dairy was a leading category helps it.

At the same time, if I look at our ability to pass along, the lag probably cost us about $0.02 a share in the quarter. But again, if that inflation were to moderate, that gives us an opportunity to catch that up, because invariably it does get passed through.

What you get concerned about is that at some level it has a dampening effect on demand. It's still not self defeating, the pass-through cost increase, but it does have a dampening effect on demand and that is affecting our guidance really in the fourth quarter because we don't know. Today's Wall Street Journal, now the Fed's saying they are just a little worried about inflation. We're just being a little bit cautious here.

Perry Caicco – CIBC World Markets

Is there any unusual impact in your private label programs?

Steve Burd

I didn't answer that. It's actually positive to the private label program because on a relative basis it puts our private label, particularly on the process side, puts us in better shape. With milk, it's a non-issue because basically most milk is private label. I think if you're looking at the center of the store, the center of the store benefits when we experience inflation in national brand, center of the store items. We're seeing that in the second quarter.

Operator

Our next question comes from Chuck Cerankosky – FTN Midwest.

Chuck Cerankosky - FTN Midwest

Steve, going back to inflation, can you talk about what you see it doing, both food inflation and fuel cost inflation, and what it's doing to the demand for food at home versus food away from home?

Steve Burd

I do think that when you look at the high cost of energy, which is not going up by leaps and bounds, but is staying at a sustained high level, I think that clearly has benefited supermarkets, as people make an effort to consolidate trips.

I don't know if we've seen a shift from restaurants to grocery stores, but we've clearly seen a reduction in that trend. So I think grocery stores are benefiting at the expense of restaurants and are benefiting as a result of high energy costs.

Chuck Cerankosky - FTN Midwest

If you look at your competitive environment right now versus a year ago, how do you feel about the ability to take market share as the industry consolidates? You've got some competitors that have made acquisitions, there's still pieces of Albertson's not doing as well, and just comment on the environment.

Steve Burd

I think the environment is probably a little different from what it was a year ago in that a year ago, a lot of the poor-performing assets from the Albertson's transaction stopped becoming grocery stores or began the conversions to some other use; or in some cases, some other owner. I think relative to a year ago, there's probably a little bit less of that going on. I think you'll continue to see bits and pieces of that happening. I still think that the assets that SuperValu chose not to take, I still think that a lot of those assets are marginal assets and I think will ultimately trade hands. I see us to be a beneficiary of that, probably less from acquiring some of those assets than from benefiting from the activity in the market and a change in ownership.

Chuck Cerankosky - FTN Midwest

Can you give us a look at real estate gains in the first half of this year versus last year and what the comparison might be in the second half?

Robert Edwards

Steve had commented that we had had some non-op gains in the quarter. Those were offset by the lease exit cost of Dominic’s, so they were up a bit this year versus last year. In preparation for the call, I looked back at the average dispositions over the last five years, and where we're at right now is pretty much on trend with the average over the last five years, although we're up just a bit from last year.

So as Steve said, real estate sales, particularly for non-operating properties, are a key part of our cash flow every year. We have a very good real estate group that focuses on this, so it's a continuing activity. The timing of the sales can vary from quarter to quarter because we can't always predict those with accuracy, but it's a key part of cash flow, has been for a number of years and will be going forward.

Steve Burd

We're very good at predicting how those numbers will behave on the year and are very seldom wrong. What's really hard is the quarter to quarter. We benefited both from a negative lump this quarter and a positive lump, but on the year, you're going to see that we'll basically deliver the numbers that we expect.

Robert Edwards

The transactions that occurred in the second quarter, those have always been in the plan for the year. The timing, whether it was Q1 or Q2 was a bit uncertain because of when we put the plan together.

Chuck Cerankosky - FTN Midwest

If you look at the second half of this year, do you expect it to be above or below the second half of last year?

Robert Edwards

I would say it would be relatively consistent with last year. The timing between Q3 and Q4 may be a bit different.

Chuck Cerankosky - FTN Midwest

That's what I'm more concerned about, the second half. Thank you very much.

Operator

Our next question comes from Meredith Adler – Lehman Brothers.

Meredith Adler - Lehman Brothers

I have a question about some news that we read about, Save Mart converting the stores in Northern California to Lucky? I don't know if you have any comment. The brand is kind of old. It hasn't been in the market for about seven years, but just wondering whether you have any thoughts about that.

Steve Burd

I think my thoughts are parallel to yours. The brand has been out of this market for six or seven years, and we're not at all concerned about somebody bringing that brand back.

Meredith Adler - Lehman Brothers

I wasn't exactly clear about your comments about the labor negotiation. Were you just talking about a one-time true-up of a healthcare fund when you talked about the second half and the impact of the contract? Or were you talking more generally?

Steve Burd

The way I interpreted the question, the question was you just suggested that maybe the consensus was high in Q3 and low in Q4 and is that driven by the Southern California settlement? My answer was no. That was the question I was answering.

I think once the contract is ratified and I believe the voting is this weekend we'll be a lot more forthcoming about it. My basic view is that it's a thing that you've seen expressed by others. This is a good result. It's a good result for us. It's a good result for the employees, and it was a long negotiation. In any good negotiation, both parties have to feel like they did well. We're comfortable that our competitive position will be sustained and you'll read more about the settlement, but I think it's a good result for everybody involved.

Meredith Adler - Lehman Brothers

Obviously you folks have made a lot of changes to your offering. You have more prepared food, so you probably are seeing sales in that area go up. But if you look at the stores that have been lifestyled for the longest, are you seeing consumers purchase more prepared meals out of the supermarket? Do you ever see any tie-in to what's happening with gas prices?

Steve Burd

Clearly in lifestyle stores, which are a much better merchandising vehicle have better meals performance than the conventional stores. I do think that they benefit more than the average store. That's why we're doing all the remodels. I think the most remarkable thing about the lifestyle store is that it continues to be a magnet for customers first, second, third, and now fourth year. I won't predict the fifth year because we need a little experience in that, but we think we've built a very good mousetrap here.

Operator

Our next question comes from Jason Whitmer – FTN Midwest.

Jason Whitmer - FTN Midwest Research

Steve, you've seen a pretty meaningful improvement in your sales productivity, sales per square foot over the last couple years. Would you say this is driven by a rationalization of stores, lifestyle stores, perishables and nonperishables, and do you have a goal within that? How do you approach your overall sales productivity?

Steve Burd

We don't use it as a basic metric that necessarily we track and we're not trying to move that. Basically what we're trying to do is grow long-term earnings. The secret to that is growing ID sales and having good control of your cost structure, always making great returns on your investments. That by it's very nature is going to drive sales per square foot.

The fact that is helped a little bit by the closure of some stores that might not be as productive, I think that's a minor piece of the equation. I think the dominant piece is what we're doing on the top line and as you make a store more comfortable and more attractive and you increase trips to that store and you increase items per transaction, you start building your sales per square foot. So I would expect that our sales per square foot would just continue to grow.

Jason Whitmer - FTN Midwest Research

What do you think you've been doing differently this year with lifestyle stores, either customization in certain markets or different variances by market? Is that something you're always tweaking?

Steve Burd

I would say that it would be an exaggeration to say we learn from every store, because it takes it a while to sort of crystallize that thinking, but we have learned so much from the initial lifestyle stores that I think had we not put that learning to work, we probably would have seen a moderation in the sales performance per store.

We just finished the store here in Livermore, it will have its grand opening on Friday, and it is very different from the first stores that we did in this market. So it is predominantly about tailoring, not just for the demographics, but tailoring to the competitive environment as well.

I think we've talked about it, maybe on these previous calls, but we laid out at the investor conference, we have variations from the low to the high that might double the cost of the lifestyle store and the low one is probably maybe a 40% reduction in cost to what we would have normally done. Those tend to apply in rural areas and we've actually had rural area lifestyle stores with 100% increases in sales, because it is such an extraordinary vehicle in that environment.

So that's what we're trying to put to work. It's not simply the content in the store, but how that store fits into a particular locale. Of course we've got the experience now of having opened almost 900 of these and I can't, overemphasize how valuable it is to have done this 900 times.

We have a couple thousand people in this company. This is all they do. I mean people have been skeptical for years about how you can continue to see good results in the lifestyle store and it's fun for me to ask my store managers, tell me how many stores have you opened, were you better with the fifth one than the first one? Of course the answer is always yes.

So it's a combination of content. It's a combination of doing the right thing for the geography and competitive circumstances and then having all of this experience.

Jason Whitmer - FTN Midwest Research

Lastly, can you give us an update on some of your proprietary products, specifically within the health and wellness arena, Eating Right comes to mind as a launch in the second quarter, as well as Natural and Organic?

Steve Burd

Sure. Organics, as you recall, was a huge win last year. Last year we did $164 million the first year. We will threaten $300 million this year on Organics. We launched the Eating Right brand. It has roughly half the SKUs of O-Organics at the same stage of its life and we're probably in Week 18 or 20 there and we're outpacing O-Organics.

So right now, our feeling is that eating right will be equally as good as O-Organics; to say it was a grand slam is an understatement. I think we just broke Hank Aaron's home run record with O-Organics and maybe we are on our way to doing that again with Eating Right. I'm a baseball fan.

Operator

Our next question comes from Mark Wiltamuth – Morgan Stanley.

Mark Wiltamuth - Morgan Stanley

Question is on the Blackhawk network. Your valuation has been running at a slight discount to Kroger. You don't seem to be getting a lot of valuation credit for the higher growth Blackhawk business. Could you talk about the balance of sitting on that business while it's in rapid growth versus looking at a sub-IPO or maybe selling a minority stake to show that value to the marketplace?

Steve Burd

Well, here's what I would tell you. When you look at the growth rate of Blackhawk and you recall from the investor conference as we laid out the next five years, we felt that that business would grow at an 80% compound rate.

That being said, if you were to sell a piece of that to the public to try to put a public value out there which would imply some value of our remaining holdings, with that kind of growth, it's a little hard to think about doing that in the near term because we would just leave way too much on the table.

The idea in creating Blackhawk, as well as some other vehicles that we want to create, was to supplement the growth of the supermarket business with some newly created growth engines. So the last thing you would think about is an outright spin, just to impress the world that you could do a start-up and create great value. It was really designed to generate earnings growth for the company. That isn't to say that someday you might not share some of that, but I would just tell you it's way too early because you would give away too much.

Operator

Our next question comes from Todd Duvick – Banc of America.

Todd Duvick – Banc of America

I wanted to ask a capital structure question, if I could. You've been paying down debt over the last several years and your leverage is now at the lowest point in recent history, and we had Kroger just this past quarter basically say that they no longer have debt reduction as a free cash flow priority. We have seen in this environment where sometimes if companies get too lowly levered, they are either subject to shareholder activism or a potential LBO. Obviously yesterday it was speculated that Sears may be interested in buying Safeway.

I don't expect you to comment on that, but with respect to your debt, you've got some debt maturing. Can you just talk about how you're thinking about capital structure, free cash flow priorities and if you plan to pay down debt further?

Robert Edwards

As we've said in the past, the priorities for use of cash remain paying down debt, even though as you're well aware, we paid off a substantial amount of debt over the last two or three years. Our objective is to achieve a stable BBB rating from the agencies. We think we're a long way toward that. As you know, we spent $318 million on stock buyback. We spent in the quarter we just completed, another $120 million, so we're mindful of returning cash to shareholders. We increased the dividend by 20%, so we're at a run rate on the dividend, well north of $100 million a year.

We had some debt coming due just a few days ago. We initially retired that with commercial paper. We've got another traunch coming due in September. We expect to finance some of the combined amount of those two traunchs with either long-term debt or commercial paper depending on how rates do over the near term and then we'll finalize those plans. We expect to continue to pay some debt down.

Operator

Our next question comes from Scott Mushkin – Banc of America.

Scott Mushkin - Banc of America

Getting back to the economy, it seems like, Steve, you're a little cautious going into the back half of the year. I know the unemployment rate has ticked up in California. Have you noticed any consumer, consumer changes, behavior changes, trading down with pricing going up?

Steve Burd

No. We haven't noticed any real change in consumer behavior. It's a gradual thing. I mean you see maybe trading down some items, but it's not easy to get a handle on the subtle shifts in that. You have to see something a bit more dramatic, I think.

My primary caution about the quarter was I wanted to get back on track with our shrink performance and I've just been introduced with more inflation than I've seen in the 15 years I've been here and so I don't know what the second half is going to bring and we just want to be careful about it.

Scott Mushkin - Banc of America

That's understandable. My second question, I know you touched on this on the last conference call, but as you look out, you know, as you have mentioned, you have a lot of lifestyle stores still to go through, but as investors, we look out over the next couple years and think about how we're going to get some growth.

Acquisition strategy, would you ever think of a not necessarily a typical supermarket, would you ever think outside of that arena when you look at acquisitions? What are your thoughts again on that?

Steve Burd

We expect to be a perpetual growth company. We think our market cap of just north of $15 billion gives us the opportunity to do that. That's a combination of being innovative in our supermarket business. It's creating growth engines like Blackhawk and we do think at some point it involves doing acquisitions.

We would look predominantly in the supermarket channel because that's where our operating strength is, and that's where lifestyle stores would really boost their performance. I wouldn't rule out that there could be something that's so related that you might feel comfortable doing it. The most likely kind of acquisition for us to do down the road would probably be a supermarket acquisition.

Scott Mushkin - Banc of America

Do you ever give us the Blackhawk influence on gross margins? Do you guys ever tell us that?

Steve Burd

I think we've commented directionally that the margin influence in the first three quarters of the year is relatively modest just because the business is so seasonal. In the fourth quarter, we'll do more than 50% of the year.

I think when we announce our fourth quarter, we'll probably give you some insight into that gross margin because in the fourth quarter this year, at the pace the business is growing, it's going to have a very measurable effect on gross margin and the only way for you to understand what's going on in the supermarket business is for us to isolate the Blackhawk effect on gross margin. But in the fourth quarter it's going to be quite large.

Scott Mushkin - Banc of America

That's actually really good insight. Following up on that, that $107.5 million negative in your operating cash flow, but then you flip it back for free cash flow, can you just remind me why that happens? Maybe a little silly question, but why does that happen?

Robert Edwards

What line item are you looking at?

Scott Mushkin - Banc of America

The $107.5 million, the decrease in payables related to the third party gifts.

Robert Edwards

When we announced our guidance for the year, Scott, you might recall that we said we were going to exclude the working capital component of the Blackhawk cash flow. If you recall the rationale for that is that the way the business works and Steve just commented on it, it's such a seasonal business that we'll collect a lot of cash right at the end of the year. Most of that cash gets paid out to the content providers, say for example Nordstrom’s or Home Depot or Best Buy, after the first of the year and so it's more of a temporary nature. Based on how fast Blackhawk is growing, we felt it would be more appropriate to exclude that. So the line item you'll see on the cash flow statement is the attempt to remove that temporary working capital that Blackhawk generates and it's consistent with the guidance we gave on free cash flow for $400 million to $600 million which excludes Blackhawk. That's what we're doing there, Scott.

Steve Burd

The other comment I would make to that, we think that's the best way to give investors a clear view of our free cash flow today. There is so much of that that is transitional, but as that business grows and as we introduce products that are generating even more cash, we’ll eventually bring Blackhawk back in to the free cash flow equation, but isolate the transitional components.

Operator

Our next question comes from John Heinbockel – Goldman Sachs.

John Heinbockel - Goldman Sachs

Last quarter you guys talked about the investments you made in labor at the stores at about 24 basis points. What would the similar number be this quarter and what have you budgeted for the back half of the year?

Steve Burd

You know, I don't really have a number. I haven't quantified that, John, this quarter. We have worked very hard this quarter and thankfully the entire first half of the year, of improving our in-stock condition, which has meant more daytime stockers. We have had a pretty dramatic increase in our front end performance, the flows at check stand. That's probably less about added labor than it is about how that labor gets managed on the front end. There is some investment in labor in the quarter, but not worth really calling out.

John Heinbockel - Goldman Sachs

So it would have been substantially lower than what you had invested in the first quarter, is that fair?

Steve Burd

That's fair.

John Heinbockel - Goldman Sachs

Secondly, when you look at supermarket gross, you were flat this quarter, up 20 bips last quarter. The bulk of that, in your mind, is mostly inflation timing and then pass-through timing as opposed to anything else?

Steve Burd

We did make investments in price in the quarter, but we continue to reduce a lot of our operating costs, cost of goods, and other supply chain elements, but we did get hurt. You're absolutely correct. To the extent that we had a lag in passing through some of the commodity increases equivalent to $0.02 a share, all of that would have gone into gross margin.

Perhaps another way of saying it is that had we not experienced the kind of inflation we did in the second quarter, particularly on the commodity side, we would have had a higher gross margin.

John Heinbockel - Goldman Sachs

Do you also get a benefit, that $0.02, is that net of any top line benefit and what that would do to expense leverage? Or there really wasn't much top line benefit in the quarter?

Steve Burd

No, there would have been some top line benefit in the quarter and there would have been some expense leverage. I was just really trying to put it in the context that while we're very confident we can pass these cost increases along and protect our pennies and profit, there invariably is some kind of a lag.

I wanted to quantify that for people; you know, some people are going to not want to give us credit for our reduction in tax rate. The reality is there's a lot that goes on in an income statement and it's unfair to give credit for this and not credit for that. So I wanted people to just understand how that lag in inflation and why we're just being a little bit tentative on how inflation could impact us in the second half.

If inflation moderates and we don't see inflation in the back half, we'll get the catch-up and that will be favorable to gross margin and it will be great for earnings and we'll be happy campers.

John Heinbockel - Goldman Sachs

I know it's very early, but any type of response to Tesco, or given the box they are building, your response will be pretty negligible?

Steve Burd

I think you can appreciate anytime anyone has ambitions to come into your market that you anticipate what they are going to do and you make adjustments in your marketing plan to accommodate that. There's a lot we know and there is a lot that we're guessing about. But my general attitude about Tesco, they are a highly respected retailer, but if I had a bunch of money every time we were going to be killed by Wal-Mart and Costco and Whole Foods, I would have a higher net worth.

So we just view this as one more player, and the fact that we think our lifestyle format in combination with what we're doing with the content of our stores, and what we always delivered on service. I expect them to take somebody's business. We just don't expect it to be ours.

John Heinbockel - Goldman Sachs

What's the timing for Blackhawk to roll out their next large business?

Steve Burd

You're implying Blackhawk would create another start-up?

John Heinbockel - Goldman Sachs

Yes. You guys have sort of implied that, right?

Steve Burd

I didn't mean to imply that Blackhawk would do it. Although when you have a world class entrepreneur over there running Blackhawk, to the extent that we would create another growth engine, I think it's appropriate to think that you would involve a guy like Don Kingsborough, but it doesn't necessarily mean that it's Blackhawk, too.

John Heinbockel - Goldman Sachs

Is that this year or next year, beyond that?

Steve Burd

Our tendency is to really talk about it once we create it and have some good results, but we are working very hard on some other growth engines and feel very good about what we might be able to produce and so let me just leave it there. But absolutely confident we're going to create another growth engine and it's going to be a serious growth engine.

Operator

Our next question comes from Ed Kelly – Credit Suisse.

Ed Kelly - Credit Suisse

I just have a quick question for you on the $400 million to $600 million of free cash flow guidance. It looks like you're starting the year first half in the hole modestly, which is not generally typical, I guess. But you've also got $1 billion of spending for CapEx in the second half, a little bit more than what it's been historically.

Can you just help us understand how you get to $400 million to $600 million, and does this mean that we are potentially at the lower end of that range?

Robert Edwards

Well, with Blackhawk primarily affecting Q1, Q1 now is generally a negative cash flow quarter. It was last year. It was this year by a similar amount. As Steve mentioned, we had a very good cash flow quarter in Q2, about approximately $300 million. Traditionally, Q2 and Q3 are our strongest quarters, as well as some in Q4. So we're following the pattern that we established last year.

But primarily the negative cash flow in Q1 is all the cash that we're collecting for Blackhawk on the cards and then paying the majority of that out to the content providers. Then also, one of the reasons Q1 is negative is we traditionally have a large amount of construction on our lifestyle stores done in the fourth quarter, a significant amount of that cash has paid out in Q1. So that's really the second key reason why Q1's a negative cash flow quarter. So we're still expecting to be in that range and feel good about cash flow. So we're following our historical pattern here. Had a very good cash flow quarter.

Operator

Our next question comes from Deborah Weinswig – Citigroup.

Deborah Weinswig – Citigroup

With regards to consumer behavior, can you talk a little bit about traffic and ticket trends you're seeing? Obviously with the kind of food at home trend and also lifestyle conversions, what kind of impact do you think that those have has as well?

Steve Burd

We don't give details about how the sales are generated, but I would just give you directional, that it's coming more from baskets than necessarily transactions. Again, I think that's attributable to the lifestyle store being such a comfortable, comfortable shopping environment.

If I look at the Lifestyle stores isolated, you have a very healthy mix of transactions and baskets, but when you look in the aggregate, you know, it's predominantly baskets, which means people are buying more when they are coming in.

Deborah Weinswig – Citigroup

Steve, you and Safeway have been very big proponents of consumer-driven healthcare. Can you talk about some of the early impacts on the business and also just in terms of kind of what you're seeing from an employee perspective as well?

Steve Burd

Well, one of the things that we did was we basically took destiny into our own hands. We're a self-insured employer. So we took the non-union workforce, which numbers about 30,000 and we designed a new healthcare plan for that group. We did it so that we could essentially reduce the inflation going forward, which was around 10% or 12%. We surprised ourselves and had a 15% reduction on a per capita basis, while fundamentally improving the quality of care for the employees in that plan, which numbers over 20,000.

In the second year, we added some additional benefits, believing that conventional wellness would lower our cost even further. We pay for 100% of some of the standard prevention and screening stuff. That kept our costs flat, while the rest of industry went up another 10% in 2007, and now as we have about 18 or more changes planned for that plan for next year and believe that our costs on a per capita basis will decline another 10% to potentially 15%.

Now, the next step is to actually apply that in all of our union contracts. Now, it doesn't necessarily mean that you have to renegotiate those contracts. There's a lot that we can do inside the trust, where we sit as a member of that trust, and what we found in conversations with union leaders, that they very much want to see healthcare costs on a per capita basis decline, particularly if you can elevate the level of care that you give people, and we have proven that we can do that.

It's caused me to kind of advocate national reform, because we actually believe that we can probably reduce our healthcare bill in total over the course of time here as much as 30%, maybe more. For us, that's $300 million. So it's no small piece of change.

We're having a very good experience internally that now needs to get applied to our union contracts. That's not going to be new news to the unions that we negotiate with. We've met several months ago with 28 union presidents to talk about how collectively we could make changes in the healthcare plans. I would say there's a very strong interest, and frankly, even in the Southern California agreement, you're going to see elements of behavior changes creating ultimately cost reductions.

Operator

Our next question comes from Steve Chick – JP Morgan.

Steve Chick - JP Morgan

Steve, just to clarify, with your earnings guidance I think at the beginning of the year or at your investor conference, I think you targeted gross profit margin expansion for the year by 15 to 25 basis points. Looks like it's up year-to-date 2 basis points. With your narrow guidance in earnings, are you implying and factoring in that you're still going to have gross profit margin expansion in this second half?

Steve Burd

The answer is yes, and keep in mind comments I made earlier on the call. There will be a pronounced impact of Blackhawk in the fourth quarter, because they are so strong. Also bear in mind that our gross margin guidance was really excluding fuel. So if you exclude fuel, we were up 20 in the first quarter, essentially flat in the second quarter. Bottom line is the guidance we gave you on gross margin, we're quite confident that we'll have those kinds of numbers.

Steve Chick - JP Morgan

Implicitly the down 1 basis point ex-fuel for this quarter, that's probably the worst it's going to get. It gets better from that trend in the second half?

Steve Burd

That's correct.

Steve Chick - JP Morgan

With the inflation that you saw, was that smooth during the quarter, or did it accelerate as the quarter went on?

Steve Burd

No, it comes in bits and pieces and it affects different areas differently. So it certainly wasn't smooth, nor would I say it was necessarily erratic. I mean it just happened.

Steve Chick - JP Morgan

Your pre-paid expense balance on your balance sheet, looks to be $365 million or so. That's a little higher than I think what it's been and I know there was a funky thing going on with last year. You had an income tax receivable I think in the number, but can you speak to that at all? Is there something in that account that we should look at?

Robert Edwards

It really has to do, Steve, with some tax payments that we made, that basically we made to stop some interest payments being accrued on one of the tax positions that we've taken with the IRS. It also is a function of some payments; we have what we call a variable benefit trust that we make payments to. So the timing of those vary during the year and so it's really some tax payments we made relative to some of the positions that we're working with the IRS on, as well as the timing of some benefit payments. The timing of those will change during the year, but those are the two main drivers of that change right now.

Operator

Our final question comes from Bob Summers – Bear Stearns.

Bob Summers - Bear Stearns

Hi. Just real quick, on the departure of Brian Cornell, can you talk about what will happen with the branding, lifestyle, organic effort? Do you plan on filling his shoes, what's the bench strength look like? Just some granularity there.

Steve Burd

For right now, what I've chosen to do is take those folks that directly reported to Brian, consolidate those reporting relationships a little bit, and personally get a lot closer to the marketing effort. So when you think about it, I have taken four direct reports from marketing; I used to have one and that was Brian. I've added three direct reports. I have three VPs that report to me and then I have Blackhawk. So I probably have the fewest direct reports in the executive management team. That's good, because I spend a lot of time just thinking about the business strategically.

The thing that I think investors need to understand is that the strategy that we've been tracking on was developed in 2003. Brian wasn't here. The lifestyle store was developed in late 2003. Brian wasn't here. The people that developed O-Organics and Eating Right are still here. The guy that designed the Ingredients For Life campaign has been here for 11 years. The strength in marketing exists in the player set that's in marketing.

Brian did a great job. I think his greatest legacy is he helped us make centralization work, but I think Brian himself would tell you that he didn't do all these things personally. He was a good leader and we were happy to have him, but we don't believe we've skipped a beat and frankly I'm enjoying doing a little bit of marketing right now as we try to figure out what we want to do longer-term, because I will not run the marketing department forever.

But it's a really good idea. In fact, I recommend this with all of my executives. If you have a senior departure, there's your opportunity to get closer to the function, evaluate the players, see what you might want to strengthen in terms of player set relative to strategy going forward, and invariably you find you can give some of the existing people you have broader responsibility, which is exactly what we did.

I'm always pleasantly surprised in the main about what people can additionally take on and how eager they are to do it and how successfully they execute. So we're very comfortable with the marketing efforts and no one should be confused that our success was driven by a single person.

Brian came along at a very good time and helped us do some things, but the infrastructure is in place and again, his legacy is making centralization work and building the team that we have, many of whom were here.

It's just like when I came in 1992, we had this fabulous turnaround in the company and we had a 30-fold increase in the share price over an eight-year period. I brought five people with me. What I did was I found, inside the organization, the talent to do that 30-fold increase in market cap. I think it's just a replay of that, only it's inside the walls of marketing.

Bob Summers - Bear Stearns

Then with respect to the earnings guidance, what kind of inflationary/pass-through environment are you embedding in that?

Steve Burd

What we're contemplating in the back half, just being cautious, is a little bit more of what you saw in the first half. If in fact inflation moderates -- and there is good reason to think produce inflation will -- if inflation moderates, whatever we lagged on our pass-through -- and let's take milk for example. The lag is no longer there. We've recouped it. So the question is are we going to experience more inflation there, are you going to experience another bit of a lag? If inflation moderates, we have an opportunity to do better than we're currently contemplating.

Melissa Plaisance

Thank you, everyone. We appreciate your participating in the call. If there are any follow-up calls, Julie Hong and I will be available through the balance of the day. Thanks a lot.

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