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Safeway Inc. (NYSE:SWY)

Q3 2007 Earnings Call

October 11, 200711:00 am ET

Executives

Steven Burd - Chairman, President, CEO

Robert Edwards - CFO

Melissa Plaisance – SVP Finance, IR

Analysts

Mark Husson – HSBC

Bob Summers – Bear Stearns

John Heinbockel – Goldman Sachs

Meredith Adler – Lehman Brothers

Ed Kelly – Credit Suisse

Chuck Cerankosky - FTN Midwest

Mark Wiltamuth - Morgan Stanley

Deborah Weinswig - Citigroup

Jason Whitmer - ClevelandResearch

Andrew Wolf - BB&T CapitalMarkets

Mark Cohodes - Copper River

Todd Dufek - Banc of America

Scott Mushkin - Banc of America

Operator

Good morning and welcome to Safeway's third quarter earningsconference call. (Operator Instructions) At this time I would like to turn the call over to Melissa Plaisance,SVP of Finance and Investor Relations. You may begin.

Melissa Plaisance

Good morning, everyone and thank you for joining us forSafeway's third quarter conference call. This conference call may containforward-looking statements. Such statements may relate to topics such as sales,gross margins, earnings growth, operating improvements, cost reduction, capitalspending, acquisitions, dispositions, debt reduction, labor relations and otherrelated subjects.

These statements are based on Safeway's current plans andexpectations and are subject to risks and uncertainties that could cause actualevents 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 a furtherdiscussion of these risks and uncertainties, including those set out underforward-looking statements in Safeway's annual report, most recent 10-K andsubsequent quarterly reports on the 10-Qs.

Please note that reconciliations appear on Safeway'swebsite, Safeway.com.

With that I would like to turn the call over to Steven Burd,President and Chairman and CEO of Safeway, and mention that Robert Edwards, EVPand CFO, is also joining us on this call.

Steven Burd

Thank you, Melissa. Let me begin with net income. Net incomefor the quarter was $194.6 million, which compares with $173.5 million producedin the same quarter a year ago. Expressed in terms of earnings per share, ourearnings per share were $0.44 in 2007 versus $0.39 in 2006. This represents a13% increase in earnings per share.

Clearly, we're pleased with our results for the quarter andwe believe that we're on track to produce strong performance for the full year.Our EPS growth is largely due to continued growth in ID sales, and what I woulddescribe as a healthy improvement in our operating margin.

Turning first to sales, our total sales increased 3.9%.Excluding fuel, our comparable store sales number increased 3.2%; and againexcluding fuel, the IDs increased 3%. This 3% increase is on top of a verystrong 3.7% increase from last year. This is also the third consecutive quarterin which all ten operating areas of the company have had positive IDs. Notsurprisingly, our market share in the supermarket channel continues to grow andhas now increased for the 11th consecutive quarter.

While the ID sales are softer than last year, theextraordinary growth in generic drugs has had a pronounced effect on scriptsales growth and has impact on our IDs a full 40 basis points when we compare 3Q06to 3Q07. But because generic drugs are generally more profitable than brandeddrugs, the negative effect on IDs really has a positive impact on earnings.

Turning to gross margin, our total gross margin improved 21basis points from last year's third quarter. Fuel sales had a very modestimpact on gross margin. When fuel sales are removed, the gross margin advanceda full 23 basis points. That improvement in gross margin is largely explainedby lower advertising expenses and really, a series of supply chainimprovements. At the same time, we continue making targeted investments inprice and that's just an ongoing process in our company.

Looking at O&A expenses, O&A expenses declined 3basis points from last year's third quarter. When you exclude the fuel effects,the O&A expenses actually declined even further, which has not been thenorm, and so O&A expenses excluding fuel give us a 5 basis pointimprovement versus last year.

The 5 basis points decline is explained by a host offactors, but just talking about the larger elements, we had significantreductions in workers' compensation, utility expenses -- which was a good thingto see -- and store labor costs. Now, those improvements were partially offsetby increases in depreciation, which result, as you know, from our heavy capitalprogram, reductions in property gains which on a quarter-to-quarter basis isalways going to vary. Then we do a fair amount of debit and credit business,and those fees just continue to go up, so that would be my third largeexplanation for the negative offsets to some of the positive things thathappened on O&A in the quarter.

Looking at interest expense, our interest expense declinedever so slightly, just under a $1 million, due largely to lower levels of debtcoupled with a modest increase in average interest rates. Our averageborrowings actually declined by $211 million from last year. Last year we had$6.1 billion in outstanding debt. This year third quarter we had $5.9 billion.At the same time our average borrowing rate increased, again modestly, 17 basispoints from 635 to 652.

During the quarter we issued $500 million worth of tenureddebt right in the middle of that whole credit squeeze, with a coupon rate of6.35%. This essentially replaced commercial paper that had been used short termto repay some of our maturing debt.

We also had a change in outlook on our debt ratings, forthose of you that follow that, from two agencies during the quarter, reflectingimproved credit metrics as well as improvements in business prospects. Moody'snow has Safeway rated BAA2 with a stable outlook, replacing what had been for acouple years really a negative outlook; and S&P now has Safeway rated BBB minuswith a positive outlook.

Turning to capital expenditures, keep in mind that our newstore program, which I would describe as modest at this point, is heavilyback-end loaded. That has always been the case. So in the quarter we completedonly one new store, but more importantly we completed 76 remodels during thequarter. Year-to-date we've completed six new stores and 158 remodels. As aresult, we now have 53%, or 915 stores, in the lifestyle format. By year end,we'll have 1,026 lifestyle stores or 59% of our store base lifestyle, whichreally represents no change from what we anticipated almost three years ago.We're just right on track. We've invested a total of a $1.2 billion two on ayear-to-date basis and believe that we will in fact spend a $1.7 billion byyear end.

Turning to free cash flow, free cash flow for Q3 was $139million. This enabled us to reduce debt by just under $119 million. We alsorepurchased 395,000 shares of stock during the quarter, at a total cost of$12.5 million. This brings our year-to-date purchases to 3.8 million shares ata cost of $132.5 million. At this point we still have remaining authorizationfrom our board of some $615 million to continue to do repurchases of our ownstock.

I want to provide a couple of updates on Black Hawk Network.As expected, Black Hawk's business just continues to grow at what you couldonly describe as an extraordinary rate. Card sales increased 100% over thethird quarter of 2006.

Unique brands, which are the products we get from our cardpartners, increased 98% over last year's third quarter, meaning the contentthat we provide in our stores and in the distribution network. In the thirdquarter alone we added 18 card partners, and maybe some of the more notablebrands worth mentioning would be Nike and eBay.

We also continue to sign distribution outlets. Relative tothe third quarter a year ago, we've had a 53% increase in signed outlets. Themost significant new outlets for us would be Kroger and Myers in the Michiganarea. Active outlets, I would just remind you that active outlets which wouldbe store fronts that are actually selling card content grew by 36%. There isalways a time lag between getting a commitment to sign up outlets and thenactually getting their POS systems on board to sell cards.

I think the great news for the growth of Black Hawk is thatstill less than half of the outlets that we've signed are in fact up andrunning and selling product, which says that if we didn't add any more outletswe would continue to have extraordinary growth for some time yet to come.

The international effort, we're selling product in both Mexicoand the U.K.We've been selling product in Canada,as you know, for a long time and will be selling product in Australiabefore year end.

Let me just finish up with some comments about guidance. Ourannual guidance from the second quarter remains unchanged. Free cash flow,which we described at that time as excluding the cash flow implications ofBlack Hawk and its seasonal business, should be in the $400 million to $600million range. ID sales for 2007 are expected to be in that same range that wedescribed in the second quarter, 3.6 to 3.8.

You recall in Q2 we provided an update to our earnings pershare guidance and said that for 2007 we would be with in a range of $1.95 to $2,so we essentially narrowed our range, but at the same time I commented that wewould be at the top end of that range. That's true today. We have virtually nochange to guidance over the second quarter, should be at the top end of thatrange.

If we achieve the top end of our EPS range, we will exceedthe upper end of our long-term guidance which as you recall was 12% to 15% EPSgrowth, really for the third year in a row. In 2005 our EPS growth was 22%. In2006 it was 23%. At the upper end or $2 a share, that equate to a 16% growth inEPS, all well above the top end of our long-term guidance.

Now, we've not personally provided any guidance for 2008. Itis interesting to note that the First Call consensus, as they try to put togethertheir estimates for us, are at $2.27 suggesting that at the top end of therange that we would be a 13% growth story next year, and at the bottom end ofthe range we would be a 16%.

Now, we will provide guidance at our investor conference inDecember, but essentially we have reemerged, as I said last December, as agrowth company that's demonstrated not only by our long-term history but it'sdemonstrated by the short-term history. Stated a bit differently, we'veconsistently been a growth company by any measure you can imagine, havingconsistently outperformed the S&P 500 and we expect to continue to be agrowth story.

The lifestyle conversions are only half complete. You've allseen the evidence on the second and third and fourth year of those lifestylestores and how they perform. They remain very strong performers. Then when youconsider Black Hawk, Black Hawk should continue producing extraordinary growth.

So we're pleased with the quarter. We're on track for theyear. We're please about our growth story and look forward to not only '07 butfrankly '08, as we begin to piece together our plans for '08.

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

Question-and-AnswerSession

Operator

Our first question comes from Mark Husson - HSBC.

Mark Husson – HSBC

I just wanted to ask a little bit on Black Hawk. In theguidance you had originally offered, I think the expectation was if you did $45million of EBIT last year, it is going to be, I think you said $100 millionthis year, or double last year -- I forget what you actually said. Is thatstill the guidance for Black Hawk, first of all?

Steven Burd

Yes. The guidancethat we gave at the investor conference was predominantly in earnings guidancefor the year. We also commented that we thought that Black Hawk would have acompound growth rate over the next five years of about 80%, and then of coursewe gave the long-term guidance I alluded to in the call.

Additionally, we had commented that when you consider allthat Black Hawk contributes to the company -- it has its own P&L plus thereis the income it generates on the Safeway side plus some of the peripheralstuff that they were originally all about, which Safeway has now absorbed intoits own enterprise -- that we did talk about achieving about $100 million in2007.

As I look at the year-to-date, we're essentially on trackwith that. The fourth quarter, this is a fourth quarter business. It reminds mea little bit of the NBA. I now don't watch the NBA but for the fourth quarter,because that's where it all happens. There really shouldn't be any reason givenhow the business has performed so far for us not to have an outstanding yearfor Black Hawk.

Mark Husson – HSBC

I just watch the lasttwo minutes actually. As far as the corebusiness is concerned, the comparable store sales in this quarter, I appreciateyou're up against big comparisons, but there was a significant amount ofinflation in the quarter. Can you talk about that?

Also this was slightly below your guidance for the year interms of range for comp store sales, so maybe you could just talk about how itpanned out during the quarter, how you absorbed inflation and what part thatplayed?

Steven Burd

I think in terms of the ID sales guidance for the year,which is 3.6 to 3.8, the third quarter and the two previous quarters andreasonable numbers for 04 would still put us in that range; admittedly on thelower end of that range, but we still think the range is a good number for2007.

With respect to inflation, you heard me speak on the secondquarter earnings call that the second quarter and frankly the year hadgenerated more inflation than I've seen in the 15 years I have been with thecompany. I would describe the inflation in the third quarter as essentially thesame as we experienced in the second quarter. So again, it was a quarter of afair amount of inflation. Most of that is occurring on the perishable,high-turn merchandise side which really has very little effect on the LIFOcharges that we take on a quarterly basis and will ultimately take for theyear. So I don't think the inflation necessarily has any negative implicationsfor the LIFO expenses that we report.

I think that what you will see is third quarter a fairamount of inflation, fourth quarter probably about the same, maybe we arestarting to see some things moderate in produce, for example. I think thingswill continue to be high inflation in the dairy and egg category a bit forawhile. We see inflation in beef and chicken, but not as dramatic as what youwould see in dairy. Dairy is the one outstanding area.

With respect to, were we able to pass this along toconsumers? The answer is yes. Last quarter I indicated that we had maybeabsorbed about a $0.02 per share hit in the quarter as a result of not beingable to exactly keep pace. It was not a problem in the third quarter, don'texpect it to be a problem in the fourth quarter.

One of the things that we've done, Mark, throughout ouroperations is with this kind of inflation we're just a lot closer to it thanwhat we had to be when inflation was at a slower rate. Again, I don't thinkthat we're going into a hyper-inflation environment. I think things will beginto settle down in '08, and I think that consumer packaged goods companies --and we -- are both very in tune with the demand dampening effects that passingthese things along can have. At the same time, when you push the numbers, as aretailer you would absolutely pass them along; it is better for you.

Mark Husson – HSBC

Just finally, I knowcomparisons are odious, but when you look at Kroger's gross margin and your ownin the quarter, both were very respectable. Theirs was very surprisinglybetter. Can you think of any reason why the two were different?

Steven Burd

I think the only explanationI can give you was if you go back at their historical pattern, I don't want toput a value judgment on this, but our pattern in gross margin is moreconsistently up whereas I believe they were actually down in their firstquarter or flat, and therefore maybe they had a bit to catch up on.

Operator

Your next question comes from Bob Summers – Bear Stearns.

Bob Summers – BearStearns

Digging in a little more to the inflation discussion andagain, the idea that when you updated us on the second quarter that you werecontemplating that same level of margin pressure through the reminder of theyear, it seems like that's not happened. If that's the case, why aren't we seeing the slack in terms ofthe guidance?

Regarding the competitive environment and the consumer, anydramatic changes there? I think there is a lot being talked about in terms ofincremental Wal-Mart competitive activities in terms of rollback pricing. Anychange in consumer behavior, particularly in California?

Steven Burd

Let me try to take these in reverse order. I think as wetried to ascertain whether or not consumers were trading down, there is reallyno clear evidence that consumers are trading down. Again, it is a difficultthing to measure because sometimes subtle changes in your mix are the result ofsome different promotions that you might have had this quarter versus lastquarter. What we're really trying to separate here is, is it driven byconsumers or is it really driven by their response to price? I would say I amnot seeing, as a result of consumer uncertainty, any particular trading down.

With respect to your question on competitive activity, Ihave a very similar answer to what I have had for a long time. Things tend toget heated up in one market or another, but when I look at the aggregate acrossall of our operations, I don't really see any dramatic shifts in competitiveactivities. I think it is pretty much business as normal.

Now, in your first question I wasn't really sure of thequestion. Was your question, why aren't earnings softening? I am not sure whatyour question was.

Bob Summers – BearStearns

Back in the second quarter I think I asked you this questionabout what was baked in the guidance? Ithink the answer was a similar inflation environment, and it sounds like that'schanged.

Steven Burd

So the question is,why not take the guidance up?

Bob Summers – BearStearns

Yes. Absolutely.

Steven Burd

I will give you a couple reasons. First of all, we startedwith a very strong earnings growth number to begin with. Others may havestarted with lower growth numbers, so it is a lot easier to take those numbersup.

Secondly, as we look at the economy going back to the secondquarter, we felt that there were two things that were causing us to be carefulon our guidance. One was this consumer uncertainty could lead to some softeningin demand. And then additionally -- and maybe they're related -- as you seemore pronounced price inflation, while you can recoup it in your pricestructure, you can have a dampening effect on demand.

So it was really those two factors, the uncertainty and thepotential dampening effect on demand. We felt very confident that costincreases could be easily passed along so that wasn't causing us to not raiseguidance. We think it is prudent and as I look at a host of companies that aresurprising people in guiding down, I am not embarrassed to turn in potentiallya 16% earnings increase after a 22% and a 23%.

I think you have to look at it in context of how we performvis-a-vis how other food retailers have performed. Earnings growth amongconventional players has been at the top of the heap for three years. If I pushthe numbers, I think they expect to be there again this year. That's anotherexplanation.

Operator

Our next question comes from John Heinbockel – GoldmanSachs.

John Heinbockel –Goldman Sachs

Steve, a couple of things. The inflation, negative impact onmargin which was $0.02 in the last quarter was basically zero or a push thisquarter, is that right?

Steven Burd

Correct.

John Heinbockel –Goldman Sachs

Secondly on Black Hawk, is that a Kroger division or thereare plans in place for the whole company to be rolled out?

Steven Burd

It is it is all Kroger.

John Heinbockel –Goldman Sachs

The whole thing, okay. Historically, did anything change inthat relationship? Because you had not sold them before, which was a littlesurprising. Did they come to you or are you willing to sell to them now? Whathas changed?

Steven Burd

I think that when we started the Black Hawk business severalyears ago, we initially started it by selling to non-competing retailers. Wechanged that more than two years ago, because we thought it was a betterbusiness model. Obviously, we have a really extraordinary group of cardpartners which gives us just great content, so it makes sense for us and itmakes sense for them and other retailers. We would have most of theconventional supermarket industry as distribution partners for Black Hawk.

Given the penetration that gift cards have in a typicalretail store, it just increases the opportunity to sell cards, and we havenever been able to measure any negative effect on our own Safeway card salesand don't expect there will be any.

John Heinbockel –Goldman Sachs

The two remaininglarge retailers you don't sell to are Wal-Mart and Walgreen’s, is that right?

Steven Burd

Those would be two of the largest that we don't sell to,correct.

John Heinbockel –Goldman Sachs

Just on the expense side for a second, I think you probablyagree on a 3% comp there is certainly the potential to get more than maybe 5basis points of leverage. I understand D&A is impeding that. Are there somesteps to be taken or do you think should be taken? I think you referred to this in the past alittle bit about getting even more aggressive on the expense side, in light ofmaybe a slowing top line to get more leverage out of a 3% comp or somethingalong those lines.

Steven Burd

It is a good question, John. Every fall we pull together asenior management team and talk about both short and long-term plans. One ofthe areas that we're committed to putting a renewed focus in is something thatfor a long time has been a core strength of the company which is really beingthoughtful about how we spend our money.

So while I would say we're very good at that, the thingsthat we've had to do over the last three or four years -- completely changingour strategy, choosing to differentiate ourselves, building all of these stores-- has occupied some of the same management and I think that we have greatopportunities to drive down costs in virtually all areas, whether they be onthe gross margin side or the O&A side. I don't think you will see mucheffect of that in the balance of '07, but it will begin to pay dividends in '08and beyond.

Essentially we're returning to elements of that culture ofthrift and as we look at the large expenditures we make, we think we have lotsof opportunity.

John Heinbockel –Goldman Sachs

That would beinclusive of the healthcare initiatives or those would be additional?

Steven Burd

Healthcare is a pieceof that, but I would say that healthcare is quite a small piece of that.

Operator

Our next question comes from Meredith Adler – LehmanBrothers.

Meredith Adler –Lehman Brothers

There wasn't any mention today about shrink, and I was justwondering if you would give us an update?

Steven Burd

In terms of our shrink effort, you recall last year we hadset a $50 million target and we actually just blew the doors off that numberand reduced our overall shrink $116 million, which brought our shrink effort todate to about a $400 million reduction in costs over a multi-year period.

We set a very similar goal this year. We were behind thatgoal through the second quarter and we continue to run behind that goal throughthe first couple of periods of the third quarter; began making some progressagainst that in really the last period of the quarter which for us is periodnine and feel quite optimistic that we'll make good progress in the fourthquarter on shrink, which should have an enhancing effect on gross margin.

Will we make our $50 million this year? No. Will we giveanything back to last year? No. Do we have more opportunity for shrinkreduction as we go forward? The answer is we have a lot. So again, when youmiss a target like that, obviously we made up for it in other areas. It justhappens because some of the same people have to do multiple things, so we don'tfeel badly that we're behind on a shrink target. It just puts more opportunityfor us for next year and beyond.

Meredith Adler –Lehman Brothers

Then you specifically mentioned on the opposite side thatutilities and workers comp were a benefit to O&A. Could you talk about whether there were specificinitiatives in terms of utilities? In workers comp is it mostly the changes in Californialaw or other things?

Steven Burd

I think in terms of workers comp, it is a combination of thechanges in the law that happen a couple years ago, and it is a concerted efforton the part of our operating management to really reduce the incidents. Interms of claims management, to aggressively manage those claims, the longer aclaim is open, in the end, the more it can cost you.

The second area was on utilities. In utilities, we'reprobably benefiting more from a softening in costs out there on the energy sidethan necessarily some things that we have done in Q3. At the same time I wouldremind you that we've done a lot in terms of energy management for the lastthree or four years. We are pretty unique in our ability to access energysources outside of California forthe California market, and we'vebeen a big fan of open access, so if we don't like the prices in California,we reach outside the state and capture our utility and energy from that source.

I think it is not anything particularly unique in the thirdquarter except the softening in prices, but it is reflective of a long-termeffort to do a great job managing energy costs.

Meredith Adler –Lehman Brothers

My memory for numbers is not the best, but I think you saidyou would remodel 260 stores this year, and I had 300 in my head. Did I have the numberwrong or is some stuff slipping into next year?

Steven Burd

The 300 that you have in your head is not a bad workingnumber, but it was always intended to include both new stores and remodels.Then we separate what we call completion from openings. Sometimes we'llcomplete some stores in the fourth quarter that we will choose not to grandopen until the first quarter. But I think when you look at the numbers in termsof openings, that number this year will be in the 288-290 range and thatincludes the new stores. The completions will be about 270 or so, when youinclude the new stores, maybe a tad more than that. You never know exactly howthat will fall out, but that's very consistent with the 276 remodels wecompleted last year.

Operator

Your next question comes from Ed Kelly – Credit Suisse.

Ed Kelly – CreditSuisse

Your free cash flow year-to-date seems like it is only upmodestly; it looked like it was up about $300 million last year, year-to-date,and is doesn't look like your fourth quarter is seasonally your strongest. Canyou help us understand you ho you get to the $400 million to $600 million? I guess Black Hawk has something to do withall of this. Can you just walk us through that?

Steven Burd

I am going to askRobert to tackle that one.

Robert Edwards

The summary is we still feel confident in the range of $400million to $600 million. The two key differences this year versus last year iswe spent this year, year-to-date, about $125 million more of CapEx than we didlast year. We made more progress in terms through the first three quarters interms of getting the full year's program done in the first three quarterscompared to last year, so we've got more of the annual work done at this pointin time.

Having said that, right now we're projecting to do 30 fewerremodels in the fourth quarter this year compared to last year so CapEx will bedown this quarter compared to the year ago quarter.

The second major driver of cash has been the amount of cashtaxes we paid. If you look at the amount of taxes we paid so far, it is about$100 million more this year than last year. That will change in the fourthquarter. We're anticipating significantly less cash taxes in Q4 this yearcompared to last year, so based on those two factors and a few other items, westill feel confident that we'll be in the $400 to $600 million range.

Steven Burd

Keep in mind that Black Hawk is not included in that number,so the benefits of their cash flow, which a big piece of it tends to betemporary cash flow, we hold it to the last week of the quarter, and then wepay that out early in January.

Robert Edwards

Okay, and then Steve, you’ve seen your sales deceleratesequentially now the last couple of quarters and I know you have toughercomparisons. There’s generics in there, although generics seem like they wereprobably equally impactful in the last couple of quarters. Are we starting tosee the slowdown in the consumer and the dampening effect of inflation that youwere talking about in these numbers?

Steven Burd

First of all, on the generic issue, the generic issue hasnot been uniform for the last couple of quarters. While I didn’t call it out inprevious quarters, quarter one it was worth about 20 basis points and quartertwo, it was 30 basis points and in quarter three, it was 40 basis points. AndQ4 will be closer to the 40 and could be a nudge higher but I think 40 isprobably a respectable, working number.

When I consider that and the 3.7 that we went against lastyear, 3.4 is trimmed back a little bit from 3.7, I think that I would probably -- there is nogreat science in this but given the fact that we’ve had a much moreinflationary environment, that we pass those cost increases on to consumers,very easy to see a dampening effect in demand on something like milk. It ishard to separate the dampening effect of price inflation from whatever uncertaintythere might be in the consumer’s mind but I think given that uncertainty, giventhe extraordinary amount of price inflation, and then throw I this genericthing, we’re quite pleased with the 3% number that we produced for the quarter.

I think that we are not disappointed in the numbers. Youalways want them to be higher and we are doing all kinds of things to make thatthe case. And you know, keep in mind that we continue to gain share in thesupermarket channel and that’s also another metric that we watch very closely.

Operator

Thank you. Our next question comes from Chuck Cerankosky.Please state your affiliation.

Chuck Cerankosky -FTN Midwest

Good morning, everyone. Back to Blackhawk a bit, Steve, andmaybe this is a question for Robert, if we are looking at the reduction inpayables year over year related to third party gift cards in your cash flowstatement, is that any indication of how the business is going at the top line?

Robert Edwards

It is, Chuck. I think you should view the change in payablesthere as a positive. That reflects that the business is growing and most of thechanges you are seeing that we broke out on the cash flow statement actuallyoccurred in the first quarter, and it is based on strong sales, particularly inthe quarter. We collect a lot of cash right before the end of the year. Aswe’ve talked before, the majority of that cash then we disperse back out to thecontent providers, but it is a reflection of how the business is growing. It’sa good thing.

Chuck Cerankosky -FTN Midwest

I understand that, great. If you are talking about 100%growth in Blackhawk year-to-date, is there anything, Steve, that one should bewary of in projecting that growth into the seasonally important fourth quarter?

Steven Burd

I think nothing. I mean, the fourth quarter -- in fact,we’ve done some things operationally that should say the fourth quarter oughtto be quite strong. Just to mention a couple, within the Safeway store system,which is still a very important piece of this business, we’ve taken a thousandof our stores and put in double end-cap in the front of the stores. And we’vedevoted the front section of that second end-cap to open loop cards, which arefrankly outselling over the last probably 16 weeks or more, the closed loopcards.

So if you get a chance to get in any of our stores in thelast eight weeks of the year, it is very difficult to get around these fixturesso we basically took 1,000 high volume stores, put a double fixture.

Also, within the distribution network, non-Safeway stores,we are adding several thousand end-caps, whereas they used to operate withspinner racks. This makes it more of a location, there is more capacity forthose stores, and becomes much more of a destination.

I think there are physical things going on in themerchandising side that would suggest that we ought to be able to hold theseincreases, if not do better.

Chuck Cerankosky -FTN Midwest

Excellent. It looks like Constellation, are they paying adividend?

Robert Edwards

Yes, we did. There was a dividendfrom Casa Ley in the quarter.

Chuck Cerankosky -FTN Midwest

Is that -- are we going to see that every quarter now inthat amount or is that one-time?

Robert Edwards

No, I would not view that as a quarterly amount. From time totime, the board of Casa Ley, as we do at Safeway, looks at what an appropriatedividend might be and so there is no projection as to what those might be inthe future but we felt it was appropriate, along with the other directors ofCasa Ley, that they pay a dividend?

Chuck Cerankosky -FTN Midwest

Steve, back to the economy and looking at it at a differentimpact, sub-prime mortgages, they are all over the place, a lot of them in California.Any thoughts on what that might be doing to the marketplace?

Steven Burd

Well, you know, I think there’s been a lot written, as youknow, about the Californiamarket. We do see in Californiaprobably more of a pronounced reduction in housing prices than you see in otherparts of the country. It is really difficult to detect whether or not the Californiaeconomy has got any more softening to it than the rest of the country.

Although when we look at our market shares in California,we are experiencing among our best growth, so if the economy is softening, thenwe are taking advantage of that and taking share.

Chuck Cerankosky -FTN Midwest

All right. Thank you very much. Good quarter.

Operator

Thank you. Our next question comes from Mark Wiltamuth.Please state your affiliation.

Mark Wiltamuth -Morgan Stanley

I wanted to ask a little bit about Tesco’s entry. Iunderstand earlier in the quarter, you had some comments at a conference sayingthat you thought you could do a good job with small format stores also. Are youcontemplating small format stores or have you looked at this at all? I justwanted to get your thoughts there.

Steven Burd

Well, let me clarify. There was a conference I attended andI did speak about this in reaction to a question, so first I will clarify maybewhat I said at that conference. We’ve gotten a lot of questions about the Tescoentry into the California market and obviously they are coming in with a fairlybold strategy of taking down over 100 locations, will be opening I think theirfirst six stores here shortly.

What I said at that conference is that I believe that thatformat is a challenging format, because it is a very small format and it ischallenging to make money with all the fixed costs in our business in thatformat.

At the same time, we look at new formats all the time and soyou could expect that that is something that we too have been looking at, notnecessarily prompted by their entry.

All I said was that if you are looking for 10,000 or 15,000 square feet, and intheir case they are looking for 10,000 square feet, thatis very easy real estate to get your hands on. And so what I commented was thatif we conclude that that is a good format for us, we could be very fast atbuilding out locations.

But for right now, we’ll watch the entry of Tesco closelyand I reminded investors at that conference, I can’t recall how many times inthe last 15 years someone was going to materially affect the fortunes of ourcompany. You’ll remember -- well, maybe you don’t remember, Webvan’s was goingto destroy the conventional supermarket business and they imploded, and thenCostco was going to affect us, and then Wal-Mart was going to affect us andTrader Joe’s and Whole Foods.

We just have another competitor coming in to see if they cantake advantage of a niche and as someone who -- we think we run an innovativebusiness. We think we’ve done innovative things with our costs and with ourmarketing and merchandising over the years, and so we’ll just respond. Will oneof those responses be a small store vehicle? I don’t think we really know yetbut we are comfortable that we have a business to protect, that we have astrategy that will protect it, and we stand by the notion that we are along-term growth story.

Mark Wiltamuth -Morgan Stanley

I guess just to switch gears a little bit and look forward alittle bit, what is the date where you think you run out of lifestyle remodelsand I think you’ve hinted that you might head back to acquisitions at somepoint. Are you thinking fill-in acquisitions or something larger?

Steven Burd

Well, 2009 is the year in which I think we’ll be about 92%complete. While you could say well, gosh, can you get the other 8% in 2010? Asa practical matter, you can’t because some of that 8% of the stores will havetwo years remaining on the lease and we won’t lifestyle those.

So I think you can say in large part the program getscompleted in ’09, although we’ll continue to do lifestyle stores in the form ofremodels for probably a couple of years after that, but not at the level thatwe have been producing.

I would just remind investors that when that happens, therewill be a pronounced increase in cash flow and there will be a pronouncedincrease in earnings per share, which should add materially to the growth ofthe company in terms of EPS in both 2010 and 2011.

Also, most of my comments about acquisitions tend to be inresponse to questions, just like your question here. I actually like the ideathat while we’ve been so busy on lifestyle stores and it takes the commitmentof thousands of people, that we have not been presented with so manyopportunities that we “couldn’t pass up”, so I like the fact that things havebeen a little bit quiet.

I do think that acquisitions are a logical thing for us todo in the future. I think we have done a lot of fill-in stuff, you know, storeshere and there. Fill-ins can be very attractive from a return-on-investmentstandpoint. Adjacent markets can be second best and third best would beout-of-market acquisitions.

We are not really confined in terms of being this growth storyto doing acquisitions. We have Blackhawk now, which is a high growth entity. Icommitted I think a year ago at the investor conference that we would createother high growth vehicles, and so the beauty of Blackhawk is it requireslittle or no capital. And so part of our effort to find new growth engines isto look for things that don’t have the capital intensity of the supermarketbusiness. It’s a much better balancing act. Why go into multiple capitalintensive businesses?

So while acquisitions could be a part of our downstreamfuture, they don’t necessarily have to be a big part. I think we have otherways to grow shareholder value.

Mark Wiltamuth -Morgan Stanley

And just to dig in on the source of the EPS boost you’ll getin 2010 and 2011, is that just from reduced D&A drag from less capitalspending? And would you consider a bigger share buy-back rather thanacquisition?

Steven Burd

You know, it’s a combination of -- you are not laying outthe same sort of D&A expenses. You are not laying out the kind of grossmargin investments that it takes to launch a new store. You are notexperiencing all the operating expenses, and I think I will try to quantifythat more specifically at the upcoming investor conference so that investorscan more clearly look forward to what the earnings implications are ofcompleting a 10-year remodel program over a six-year time period. Because thathas actually, you know, despite the fact that the numbers have been great, thathas had a depressing effect on near-term earnings.

We’ll provide some clarity at the investor conference inDecember.

Mark Wiltamuth -Morgan Stanley

Thank you.

Operator

Thank you. Our next question comes from Deborah Weinswig.Please state your affiliation.

Deborah Weinswig -Citigroup

A few quick ones; one, can you basically -- Steve, I thinkyou alluded to the fact that you had seen lower advertising expense in thequarter. Is there any technology that is importing that or is there a differentapproach? Maybe if you can just elaborate a little bit more.

Steven Burd

Robert, do you want to comment on that?

Robert Edwards

We review advertising each quarter and we adjust thespending based on competitive conditions. What really changed in the quarterthis year versus last year is that last year, a lot of the spending wasfocusing on the ingredients for life brand campaign that included a heavier mixof TV spending versus what we are doing this year.

If you look at the whole year, we expect to be essentiallyflat in ’07 versus ’06, so a little more efficient spending this year. Andagain, we look at it on a quarterly basis.

Deborah Weinswig -Citigroup

Can you also elaborate -- some retailers have talked aboutthe utilization of advertising optimization to basically gain a betterunderstanding of the identical source sales boost, if you will, as a result ofcertain ad campaigns. Would you say that you are also heading down that path oris that something that we could see in the future?

Robert Edwards

I think we do a lot of work trying to measure theeffectiveness of our advertising and I think over the course of the ingredientsfor life campaign, we’ve been very pleased with what we perceive to be the rateof return on investment on that campaign, and so I think we’ve done well. Andwe monitor that from time to time to make sure that our spend is as effectiveas it can be, and I think we’ve done a very good job in that regard.

Deborah Weinswig -Citigroup

And then Steve, can you also just kind of -- I think it wastable five in what was sent out to investors from today with the same-storesales increases, but can you dig in a little bit deeper in terms of fuel salesbeing a little bit light in the quarter?

Steven Burd

With respect to fuel sales, our volume in fuel sales hasbeen remarkably consistent over the last three years. At the same time, withprices being where they are, that has a demand depressing effect, so gallonsper station were down slightly, although not in a material way because we had avery consistent pricing strategy. So it is just how the numbers worked out inthe quarter.

Deborah Weinswig -Citigroup

And then last question -- actually, a few questions we’vegotten today with regard to trends that you guys saw throughout the quarterwith regard to and did you see any noticeable differences as you progressedthrough in terms of sales, I think obviously also alluding to the macroenvironment as well?

Steven Burd

The quarter actually came together in a bit of an unusualpattern. We started the quarter with some traditional goods strength. Weactually hit a three-week window in there that I referred to as a speed bump,and when we first looked at that, we wondered whether there was some shift ineconomic activity that was going to affect us.

And then, as we finished out the quarter, we actually in thelast four weeks of the quarter, they were among the four strongest weeks for usin the entire year. And then as you look into really the early beginnings ofthe fourth quarter, it sort of kind of more normalized.

I think your quarterly pattern can be quite varied but Ithink what is most interesting about the quarter is that we actuallystrengthened over the last four weeks. Now, that strengthening didn’tnecessarily continue because it was pretty impressive, but I would stick withour guidance on the year. We believe we’ll be in the 3.6 to 3.8 range and onecan easily do the math on that and try to figure out what that implies aboutthe fourth quarter.

Again, with the degree of uncertainty and with the priceinflation continuing, we just don’t think it’s prudent to try to push thosenumbers any higher in terms of a forecast.

Deborah Weinswig -Citigroup

Great. As always, thanks so much for your insight.

Operator

Thank you. Our next question comes from Jason Whitmer. Please state your affiliation.

Jason Whitmer - Cleveland Research

Good morning. Steve, could you go back to something you saidearlier in terms of a number of things that drive sales? Obviously you arestill focused with the core on lifestyle, but maybe some ancillary catalysts orinitiatives around lifestyle, or something within the core of your business tolook at, not just to finish off this year but 2008 as your kind of top salesdrivers?

Steven Burd

I think that one of the things that we really launched earlierthis year was a much more collaborative effort with our key vendor partners. Ithink it was a year ago, it could have even been two years ago, that we showed-- people thought that the lifestyle store was focused on perishables and thatwe were going to ignore the center of the store, so we showed a slide in ourinvestor conference that showed the kind of sales increases that we weregetting from our top 10 vendors.

If I were to reproduce that slide for 2008, that salesgrowth among the top ten vendors would be even more pronounced than it was --I’m sorry, 2007 than it was in 2006, which I think is indicative of the kind ofthe collaborative relationship that we’ve built with initially our key vendors,but then that’s going to trickle down to the second and third level of vendors.Obviously you focus on the ones first that you do the most business with and Ithink if you had conversations with them, the top 10 would be very pleased withtheir business with Safeway.

Some of the segmentation that we’ve done in marketing thatallows us to look at the behavioral characteristics of why people buy what theydo, the penetration they have in various categories, the ability to make veryspecific, customer-specific offers to people, and the big challenge there ishow you communicate that offer.

We do it a number of ways. Others I think do similar thingsbut we think the kind of segmentation we’ve done is pretty unique and I thinkit will continue to pay dividends as we roll that out collaboratively with abroader set of vendors.

Jason Whitmer - Cleveland Research

Are you prepared to offer us any post lifestyle comments ordirection over the next couple of years?

Steven Burd

You mean when the lifestyle stores are completed?

Jason Whitmer - Cleveland Research

Yeah, it sounds like you have your eye on a post lifestylestrategy or initiative, or is --

Steven Burd

I think that for us, it’s all about finding new ways toinnovate that grab the attention of our customers, and so while the lifestylestore has been a big boost, we are doing a lot of innovation in products.

Last year we talked about the introduction of O-organics,which is a great product with again some exceptional growth. This year,O-organics will generate about $300 million in sales and for the second year ofa brand, that’s a pretty good result. And then we created Eating Right, whichwith fewer SKUs, is mimicking the performance of O-organics.

We are doing a lot of work in the deli food service area totake business from other channels, and so I don’t think innovation for us endswith the lifestyle store. We’ve been very innovative on the product side. Imean, the quality of our perishables, as demonstrated by consumer research, issecond to none, whether you are talking about the beef category or whether youare talking about produce, or even in the bakery and in parts of the deli.

I would remind people that are thinking about productinnovation that if you consider our beef product, signature soup, Eating Right,and O-organics, that is a whole lot of innovation, which is very important toattracting the loyalty and keeping that loyalty to customers.

Jason Whitmer - Cleveland Research

Thank you.

Operator

Thank you. Our next question comes from Andrew Wolf. Pleasestate your affiliation.

AndrewWolf - BB&T Capital Markets

Back to the pasture of inflation,would you think -- at this point, is it fairly market wide or are there any ormany major competitors not necessarily passing it through and trying to makemaybe a price statement with consumers?

RobertEdwards

I think in the main, Andrew, peoplepass this along because the financial implicationsare just too great not to. And so what you do find is people do it atdifferential rates, and one of the things that I think has occurred with thelevel of inflation that we are experiencing, we are not seeing anybody say wellI’ll look at it at the end of the quarter and see if I need to make someadjustments, so I think what we’re seeing is virtually all of retail, certainlyin the conventional food business, is much more on top of the inflation intheir core products and is doing a much better job of passing that along as itoccurs.

AndrewWolf - BB&T Capital Markets

And then just a question on the -- you talked about -- Ithink you talked about less gains from real estate sales, but just using yourcash flow statement, it looks -- the way I was able to figure out, at least,more like the property impairment charges were up. I think you might havespoken about that as a net number and obviously net, it would have penalizedthe quarter, but just the way you look at it, did I parse that correctly? Itlooks like you had a pretty big swing against you this quarter in the propertyimpairment charges and it was a pretty big number. Maybe you could just sort oftalk to what got impaired.

Robert Edwards

You are right. In the quarter, we actually had, in terms ofgains and losses, less this quarter than we did last year, so it actually wentagainst us. Year-to-date, we are a bit better than we were last year and it wasboth in terms of we had lower gains in real estate this time was the primarydriver.

So as Steven mentioned earlier, the timing of real estatetransactions can vary year over year, but in this specific quarter, we did havelower gains and losses, which hurt us on the O&A line.

AndrewWolf - BB&T Capital Markets

Okay, I can perhaps catch up with you offline to get moreclarity. Thank you.

Operator

Thank you. Our next question comes from Mark Cohodes. Pleasestate your affiliation.

Mark Cohodes - Copper River

Thanks for taking my call. You know, Steve, it’s amazing thestuff that you’ve internally developed and have accomplished and the tailsyou’ve kicked over the years and the lack of respect you get from the peoplewho follow your stock. It’s truly amazing.

That being said, what steps are you going to take tomaximize the value of A, the company and B, Blackhawk marketing?

Steven Burd

I think one of the things that -- you are correct to thinkthat you don’t always believe that the market is reflecting the true value ofyour stock and that causes you to think about how you get people to appreciatenot only the current value of your stock but how you might perform over a moreextended period of time.

I think that as we look at the upcoming investor conference,we are going to give a lot of thought to how we -- we try to describe thisthing so many ways, how we provide the ultimate in investor clarity. One of thethings that I will focus on in that investor conference is doing perhaps a morecomprehensive job of highlighting the intrinsic value of Blackhawk which, whenyou do that, regardless of what kind of value you put on it, it would suggestthat the underlying value investors place on the supermarket business, whichhas essentially outperformed all other conventional supermarkets for the last15 years and certainly over the last three years, that the supermarket asset isgrossly undervalued, regardless of what sort of reasonable value you place onBlackhawk.

So one of the things that we’ll do is we will try to drawthat crisply for investors and provide even more insight into the growthprospects of Blackhawk.

That being said, I think that right now, we clearly havedone some stock repurchases and at the end of the day, if you feel your stockprice is being grossly undervalued, you can always take advantage and buy moreof that stock.

I think as that occurs, we think more about that but I dothink that come December, and it is so much easier to do in a four hourinvestor conference than it is on a sound byte earnings call, to really getpeople to appreciate the value of the supermarket business and the value of theBlackhawk business.

Mark Cohodes - Copper River

Thank you.

Operator

Thank you. Our next question comes from Todd Dufek. Pleasestate your affiliation.

Todd Dufek - Banc of America

Two quick questions; first of all, I think you mentionedthat this quarter was the first quarter in which you had positive ID sales inall of your areas. Can you tell us what areas you’ve seen the strongestimprovement in and really what is behind that improvement?

Steven Burd

Let me just clarify something you said. What I said in myopening remarks, it wasn’t the first quarter. It was in fact the thirdconsecutive quarter, and the only reason for mentioning that, when I firstmentioned in the first quarter of ’07 that all 10 operating areas had positiveIds, I also commented that in the near 15 years I’ve been with the company,that was a rare occurrence in the early and mid-90s. So I think it wasbeneficial for those that have long thought that we struggled with some of ouracquisitions to appreciate that we’ve got several markets now that arecompletely penetrated by super centers and yet we continue to produce strongnumbers in those markets.

So again, we don’t comment on the specifics of geographiesand therefore, I thought it was a good thing to be able to say there’s reallynot a single market that is left out.

Now, our ID performance, like everybody else’s that operatesmore by regionally, is not uniform and it really changes over time, largely asthe result of competitive circumstances. But no, we are in our thirdconsecutive of everything being positive.

Todd Dufek - Banc of America

Okay, that’s helpful. And then just finally, with respect tothe credit rating, definitely you do have some positive credit rating momentum,as you indicated in your comments earlier. I am just wanting to know, withrespect to the credit rating, if you do get an upgrade from S&P and aretriple B by all three agencies, then is it primarily financial flexibility thatgains for you? If you can just tell us a little bit about what the value ofthat credit rating, the triple B will be.

Melissa Plaisance

We are committed to a stable triple B credit rating becauseit does give us financial flexibility, primarily giving us access, ample accessto the commercial paper market. We enjoy that today. We can more than meet ourneeds through the commercial paper market but at a stable triple B creditrating, we feel that’s the sweet spot and want to operate at that level.

Todd Dufek - Banc of America

Okay, that’s great. Thank you.

Operator

Thank you. Our final question comes from Scott Mushkin.Please state your affiliation.

ScottMushkin - Banc of America

I just wanted to -- I know you guyswere behind a little bit in Texasand Chicago on the lifestyle remodels and you kind of kicked them intogear. I was wondering if you could give us an update on maybe particularly Chicago,where that stands.

StevenBurd

In Chicago,I think we will end the year. We got a late start there but we’ve come out ofthe blocks pretty fast. Chicago I think will be around -- I think around 40% complete, maybea tad more than that, by the end of this year. And so we are moving as aggressivelyas we can in Chicago and then Texas, we’ve really followed a kind of a morenormal -- I think probably in our, the top market, we might be in the low 70sin terms of completions. And then Dominic’s would probably be the lowest,because you’ll recall we held -- we held capital -- gosh, I hate to use thisword -- we held capital back, let’s put it this way, waiting for a laboragreement that made sense and so that gave us a slow start.

In Chicago, you’ll recall we investedin one store there to show the labor unions what we were prepared to do and sothat was really instrumental in helping us get the agreement that we did. Butthat explains the slow start. But if I were to look at the speed of thingshappening in Dominic, it probably exceeds the speed of things happening in allother markets.

ScottMushkin - Banc of America

We’ve heard some noise from thatmarket that maybe you would slow it down again. Is that just 100% not true?

StevenBurd

No, they -- you know, I think theyhave something like six completions in the fourth quarter or something, sosomebody might have thought well, gee, if we didn’t complete many in the thirdquarter or something, it is just the way it falls. There has been nodeceleration in Chicago at all.

ScottMushkin - Banc of America

Great. Thanks.

Operator

Thank you. And at this time, we areshowing no further questions.

Melissa Plaisance

Thank you, everyone, forparticipating in the call. Julie Hong and I will be available if you haveadditional follow-up questions. Thank you very much.

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Source: Safeway Q3 2007 Earnings Call Transcript
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