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Safeway Inc. (NYSE:SWY)

Q3 2007 Earnings Call

October 11, 2007 11:00 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 - Cleveland Research

Andrew Wolf - BB&T Capital Markets

Mark Cohodes - Copper River

Todd Dufek - Banc of America

Scott Mushkin - Banc of America

Operator

Good morning and welcome to Safeway's third quarter earnings conference 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 for Safeway's third quarter conference call. This conference call may contain forward-looking statements. Such statements may relate to topics such as sales, gross margins, earnings growth, operating improvements, cost reduction, capital spending, acquisitions, 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 a further discussion of these risks and uncertainties, including those set out under forward-looking statements in Safeway's annual report, most recent 10-K and subsequent quarterly reports on the 10-Qs.

Please note that reconciliations appear on Safeway's website, 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, EVP and CFO, is also joining us on this call.

Steven Burd

Thank you, Melissa. Let me begin with net income. Net income for the quarter was $194.6 million, which compares with $173.5 million produced in the same quarter a year ago. Expressed in terms of earnings per share, our earnings per share were $0.44 in 2007 versus $0.39 in 2006. This represents a 13% increase in earnings per share.

Clearly, we're pleased with our results for the quarter and we 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 would describe 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 again excluding fuel, the IDs increased 3%. This 3% increase is on top of a very strong 3.7% increase from last year. This is also the third consecutive quarter in which all ten operating areas of the company have had positive IDs. Not surprisingly, our market share in the supermarket channel continues to grow and has now increased for the 11th consecutive quarter.

While the ID sales are softer than last year, the extraordinary growth in generic drugs has had a pronounced effect on script sales growth and has impact on our IDs a full 40 basis points when we compare 3Q06 to 3Q07. But because generic drugs are generally more profitable than branded drugs, the negative effect on IDs really has a positive impact on earnings.

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

Looking at O&A expenses, O&A expenses declined 3 basis 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 the norm, and so O&A expenses excluding fuel give us a 5 basis point improvement versus last year.

The 5 basis points decline is explained by a host of factors, but just talking about the larger elements, we had significant reductions in workers' compensation, utility expenses -- which was a good thing to see -- and store labor costs. Now, those improvements were partially offset by increases in depreciation, which result, as you know, from our heavy capital program, reductions in property gains which on a quarter-to-quarter basis is always 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 large explanation for the negative offsets to some of the positive things that happened on O&A in the quarter.

Looking at interest expense, our interest expense declined ever so slightly, just under a $1 million, due largely to lower levels of debt coupled with a modest increase in average interest rates. Our average borrowings 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 basis points from 635 to 652.

During the quarter we issued $500 million worth of tenured debt right in the middle of that whole credit squeeze, with a coupon rate of 6.35%. This essentially replaced commercial paper that had been used short term to repay some of our maturing debt.

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

Turning to capital expenditures, keep in mind that our new store program, which I would describe as modest at this point, is heavily back-end loaded. That has always been the case. So in the quarter we completed only one new store, but more importantly we completed 76 remodels during the quarter. Year-to-date we've completed six new stores and 158 remodels. As a result, 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, which really 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 a year-to-date basis and believe that we will in fact spend a $1.7 billion by year end.

Turning to free cash flow, free cash flow for Q3 was $139 million. This enabled us to reduce debt by just under $119 million. We also repurchased 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 at a cost of $132.5 million. At this point we still have remaining authorization from our board of some $615 million to continue to do repurchases of our own stock.

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 could only describe as an extraordinary rate. Card sales increased 100% over the third quarter of 2006.

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

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

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

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

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

You recall in Q2 we provided an update to our earnings per share 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 we would be at the top end of that range. That's true today. We have virtually no change to guidance over the second quarter, should be at the top end of that range.

If we achieve the top end of our EPS range, we will exceed the upper end of our long-term guidance which as you recall was 12% to 15% EPS growth, really for the third year in a row. In 2005 our EPS growth was 22%. In 2006 it was 23%. At the upper end or $2 a share, that equate to a 16% growth in EPS, all well above the top end of our long-term guidance.

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

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

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

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

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

Question-and-Answer Session

Operator

Our first question comes from Mark Husson - HSBC.

Mark Husson – HSBC

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

Steven Burd

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

Additionally, we had commented that when you consider all that Black Hawk contributes to the company -- it has its own P&L plus there is the income it generates on the Safeway side plus some of the peripheral stuff that they were originally all about, which Safeway has now absorbed into its own enterprise -- that we did talk about achieving about $100 million in 2007.

As I look at the year-to-date, we're essentially on track with that. The fourth quarter, this is a fourth quarter business. It reminds me a 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 given how the business has performed so far for us not to have an outstanding year for Black Hawk.

Mark Husson – HSBC

I just watch the last two minutes actually. As far as the core business is concerned, the comparable store sales in this quarter, I appreciate you're up against big comparisons, but there was a significant amount of inflation in the quarter. Can you talk about that?

Also this was slightly below your guidance for the year in terms of range for comp store sales, so maybe you could just talk about how it panned out during the quarter, how you absorbed inflation and what part that played?

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 and reasonable numbers for 04 would still put us in that range; admittedly on the lower end of that range, but we still think the range is a good number for 2007.

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

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

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

One of the things that we've done, Mark, throughout our operations is with this kind of inflation we're just a lot closer to it than what we had to be when inflation was at a slower rate. Again, I don't think that we're going into a hyper-inflation environment. I think things will begin to 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 passing these things along can have. At the same time, when you push the numbers, as a retailer you would absolutely pass them along; it is better for you.

Mark Husson – HSBC

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

Steven Burd

I think the only explanation I can give you was if you go back at their historical pattern, I don't want to put a value judgment on this, but our pattern in gross margin is more consistently up whereas I believe they were actually down in their first quarter 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 – Bear Stearns

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

Regarding the competitive environment and the consumer, any dramatic changes there? I think there is a lot being talked about in terms of incremental Wal-Mart competitive activities in terms of rollback pricing. Any change in consumer behavior, particularly in California?

Steven Burd

Let me try to take these in reverse order. I think as we tried to ascertain whether or not consumers were trading down, there is really no clear evidence that consumers are trading down. Again, it is a difficult thing to measure because sometimes subtle changes in your mix are the result of some different promotions that you might have had this quarter versus last quarter. What we're really trying to separate here is, is it driven by consumers or is it really driven by their response to price? I would say I am not seeing, as a result of consumer uncertainty, any particular trading down.

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

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

Bob Summers – Bear Stearns

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

Steven Burd

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

Bob Summers – Bear Stearns

Yes. Absolutely.

Steven Burd

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

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

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

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

Operator

Our next question comes from John Heinbockel – Goldman Sachs.

John Heinbockel – Goldman Sachs

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

Steven Burd

Correct.

John Heinbockel – Goldman Sachs

Secondly on Black Hawk, is that a Kroger division or there are 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 in that relationship? Because you had not sold them before, which was a little surprising. Did they come to you or are you willing to sell to them now? What has changed?

Steven Burd

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

Given the penetration that gift cards have in a typical retail store, it just increases the opportunity to sell cards, and we have never been able to measure any negative effect on our own Safeway card sales and don't expect there will be any.

John Heinbockel – Goldman Sachs

The two remaining large 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 probably agree on a 3% comp there is certainly the potential to get more than maybe 5 basis points of leverage. I understand D&A is impeding that. Are there some steps to be taken or do you think should be taken? I think you referred to this in the past a little bit about getting even more aggressive on the expense side, in light of maybe a slowing top line to get more leverage out of a 3% comp or something along those lines.

Steven Burd

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

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

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

John Heinbockel – Goldman Sachs

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

Steven Burd

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

Operator

Our next question comes from Meredith Adler – Lehman Brothers.

Meredith Adler – Lehman Brothers

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

Steven Burd

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

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

Will we make our $50 million this year? No. Will we give anything back to last year? No. Do we have more opportunity for shrink reduction as we go forward? The answer is we have a lot. So again, when you miss a target like that, obviously we made up for it in other areas. It just happens because some of the same people have to do multiple things, so we don't feel badly that we're behind on a shrink target. It just puts more opportunity for us for next year and beyond.

Meredith Adler – Lehman Brothers

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

Steven Burd

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

The second area was on utilities. In utilities, we're probably benefiting more from a softening in costs out there on the energy side than necessarily some things that we have done in Q3. At the same time I would remind you that we've done a lot in terms of energy management for the last three or four years. We are pretty unique in our ability to access energy sources outside of California for the California market, and we've been 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 third quarter except the softening in prices, but it is reflective of a long-term effort to do a great job managing energy costs.

Meredith Adler – Lehman Brothers

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

Steven Burd

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

Operator

Your next question comes from Ed Kelly – Credit Suisse.

Ed Kelly – Credit Suisse

Your free cash flow year-to-date seems like it is only up modestly; 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. Can you help us understand you ho you get to the $400 million to $600 million? I guess Black Hawk has something to do with all of this. Can you just walk us through that?

Steven Burd

I am going to ask Robert to tackle that one.

Robert Edwards

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

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

The second major driver of cash has been the amount of cash taxes 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 fourth quarter. We're anticipating significantly less cash taxes in Q4 this year compared to last year, so based on those two factors and a few other items, we still 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 be temporary cash flow, we hold it to the last week of the quarter, and then we pay that out early in January.

Robert Edwards

Okay, and then Steve, you’ve seen your sales decelerate sequentially now the last couple of quarters and I know you have tougher comparisons. There’s generics in there, although generics seem like they were probably equally impactful in the last couple of quarters. Are we starting to see the slowdown in the consumer and the dampening effect of inflation that you were talking about in these numbers?

Steven Burd

First of all, on the generic issue, the generic issue has not been uniform for the last couple of quarters. While I didn’t call it out in previous quarters, quarter one it was worth about 20 basis points and quarter two, it was 30 basis points and in quarter three, it was 40 basis points. And Q4 will be closer to the 40 and could be a nudge higher but I think 40 is probably a respectable, working number.

When I consider that and the 3.7 that we went against last year, 3.4 is trimmed back a little bit from 3.7, I think that I would probably -- there is no great science in this but given the fact that we’ve had a much more inflationary environment, that we pass those cost increases on to consumers, very easy to see a dampening effect in demand on something like milk. It is hard to separate the dampening effect of price inflation from whatever uncertainty there might be in the consumer’s mind but I think given that uncertainty, given the extraordinary amount of price inflation, and then throw I this generic thing, we’re quite pleased with the 3% number that we produced for the quarter.

I think that we are not disappointed in the numbers. You always want them to be higher and we are doing all kinds of things to make that the case. And you know, keep in mind that we continue to gain share in the supermarket 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, and maybe this is a question for Robert, if we are looking at the reduction in payables year over year related to third party gift cards in your cash flow statement, 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 payables there as a positive. That reflects that the business is growing and most of the changes you are seeing that we broke out on the cash flow statement actually occurred in the first quarter, and it is based on strong sales, particularly in the quarter. We collect a lot of cash right before the end of the year. As we’ve talked before, the majority of that cash then we disperse back out to the content providers, but it is a reflection of how the business is growing. It’s a 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 be wary 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 ought to 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 thousand of our stores and put in double end-cap in the front of the stores. And we’ve devoted the front section of that second end-cap to open loop cards, which are frankly outselling over the last probably 16 weeks or more, the closed loop cards.

So if you get a chance to get in any of our stores in the last eight weeks of the year, it is very difficult to get around these fixtures so 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 with spinner racks. This makes it more of a location, there is more capacity for those stores, and becomes much more of a destination.

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

Chuck Cerankosky - FTN Midwest

Excellent. It looks like Constellation, are they paying a dividend?

Robert Edwards

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

Chuck Cerankosky - FTN Midwest

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

Robert Edwards

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

Chuck Cerankosky - FTN Midwest

Steve, back to the economy and looking at it at a different impact, 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 you know, about the California market. We do see in California probably more of a pronounced reduction in housing prices than you see in other parts of the country. It is really difficult to detect whether or not the California economy 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, then we 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. I understand earlier in the quarter, you had some comments at a conference saying that you thought you could do a good job with small format stores also. Are you contemplating small format stores or have you looked at this at all? I just wanted to get your thoughts there.

Steven Burd

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

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

At the same time, we look at new formats all the time and so you could expect that that is something that we too have been looking at, not necessarily prompted by their entry.

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

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

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

Mark Wiltamuth - Morgan Stanley

I guess just to switch gears a little bit and look forward a little bit, what is the date where you think you run out of lifestyle remodels and I think you’ve hinted that you might head back to acquisitions at some point. 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? As a practical matter, you can’t because some of that 8% of the stores will have two years remaining on the lease and we won’t lifestyle those.

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

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

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

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

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

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

Mark Wiltamuth - Morgan Stanley

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

Steven Burd

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

We’ll provide some clarity at the investor conference in December.

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 think you alluded to the fact that you had seen lower advertising expense in the quarter. Is there any technology that is importing that or is there a different approach? 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 the spending based on competitive conditions. What really changed in the quarter this year versus last year is that last year, a lot of the spending was focusing on the ingredients for life brand campaign that included a heavier mix of TV spending versus what we are doing this year.

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

Deborah Weinswig - Citigroup

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

Robert Edwards

I think we do a lot of work trying to measure the effectiveness of our advertising and I think over the course of the ingredients for life campaign, we’ve been very pleased with what we perceive to be the rate of return on investment on that campaign, and so I think we’ve done well. And we monitor that from time to time to make sure that our spend is as effective as 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 was table five in what was sent out to investors from today with the same-store sales increases, but can you dig in a little bit deeper in terms of fuel sales being a little bit light in the quarter?

Steven Burd

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

Deborah Weinswig - Citigroup

And then last question -- actually, a few questions we’ve gotten today with regard to trends that you guys saw throughout the quarter with regard to and did you see any noticeable differences as you progressed through in terms of sales, I think obviously also alluding to the macro environment as well?

Steven Burd

The quarter actually came together in a bit of an unusual pattern. We started the quarter with some traditional goods strength. We actually 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 in economic activity that was going to affect us.

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

I think your quarterly pattern can be quite varied but I think what is most interesting about the quarter is that we actually strengthened over the last four weeks. Now, that strengthening didn’t necessarily continue because it was pretty impressive, but I would stick with our guidance on the year. We believe we’ll be in the 3.6 to 3.8 range and one can easily do the math on that and try to figure out what that implies about the fourth quarter.

Again, with the degree of uncertainty and with the price inflation continuing, we just don’t think it’s prudent to try to push those numbers 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 said earlier in terms of a number of things that drive sales? Obviously you are still focused with the core on lifestyle, but maybe some ancillary catalysts or initiatives around lifestyle, or something within the core of your business to look at, not just to finish off this year but 2008 as your kind of top sales drivers?

Steven Burd

I think that one of the things that we really launched earlier this year was a much more collaborative effort with our key vendor partners. I think 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 that we were going to ignore the center of the store, so we showed a slide in our investor conference that showed the kind of sales increases that we were getting from our top 10 vendors.

If I were to reproduce that slide for 2008, that sales growth 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 of the 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 I think if you had conversations with them, the top 10 would be very pleased with their business with Safeway.

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

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

Jason Whitmer - Cleveland Research

Are you prepared to offer us any post lifestyle comments or direction 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 lifestyle strategy or initiative, or is --

Steven Burd

I think that for us, it’s all about finding new ways to innovate that grab the attention of our customers, and so while the lifestyle store 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 of a brand, that’s a pretty good result. And then we created Eating Right, which with fewer SKUs, is mimicking the performance of O-organics.

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

I would remind people that are thinking about product innovation 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 to attracting the loyalty and keeping that loyalty to customers.

Jason Whitmer - Cleveland Research

Thank you.

Operator

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

Andrew Wolf - 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 or many major competitors not necessarily passing it through and trying to make maybe a price statement with consumers?

Robert Edwards

I think in the main, Andrew, people pass this along because the financial implications are just too great not to. And so what you do find is people do it at differential rates, and one of the things that I think has occurred with the level of inflation that we are experiencing, we are not seeing anybody say well I’ll look at it at the end of the quarter and see if I need to make some adjustments, so I think what we’re seeing is virtually all of retail, certainly in the conventional food business, is much more on top of the inflation in their core products and is doing a much better job of passing that along as it occurs.

Andrew Wolf - BB&T Capital Markets

And then just a question on the -- you talked about -- I think you talked about less gains from real estate sales, but just using your cash 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 have spoken about that as a net number and obviously net, it would have penalized the quarter, but just the way you look at it, did I parse that correctly? It looks like you had a pretty big swing against you this quarter in the property impairment charges and it was a pretty big number. Maybe you could just sort of talk to what got impaired.

Robert Edwards

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

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

Andrew Wolf - BB&T Capital Markets

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

Operator

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

Mark Cohodes - Copper River

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

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

Steven Burd

I think one of the things that -- you are correct to think that you don’t always believe that the market is reflecting the true value of your stock and that causes you to think about how you get people to appreciate not only the current value of your stock but how you might perform over a more extended 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 this thing so many ways, how we provide the ultimate in investor clarity. One of the things that I will focus on in that investor conference is doing perhaps a more comprehensive job of highlighting the intrinsic value of Blackhawk which, when you do that, regardless of what kind of value you put on it, it would suggest that the underlying value investors place on the supermarket business, which has essentially outperformed all other conventional supermarkets for the last 15 years and certainly over the last three years, that the supermarket asset is grossly undervalued, regardless of what sort of reasonable value you place on Blackhawk.

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

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

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

Mark Cohodes - Copper River

Thank you.

Operator

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

Todd Dufek - Banc of America

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

Steven Burd

Let me just clarify something you said. What I said in my opening remarks, it wasn’t the first quarter. It was in fact the third consecutive quarter, and the only reason for mentioning that, when I first mentioned in the first quarter of ’07 that all 10 operating areas had positive Ids, 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 was beneficial for those that have long thought that we struggled with some of our acquisitions to appreciate that we’ve got several markets now that are completely penetrated by super centers and yet we continue to produce strong numbers in those markets.

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

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

Todd Dufek - Banc of America

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

Melissa Plaisance

We are committed to a stable triple B credit rating because it does give us financial flexibility, primarily giving us access, ample access to the commercial paper market. We enjoy that today. We can more than meet our needs through the commercial paper market but at a stable triple B credit rating, 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.

Scott Mushkin - Banc of America

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

Steven Burd

In Chicago, I think we will end the year. We got a late start there but we’ve come out of the blocks pretty fast. Chicago I think will be around -- I think around 40% complete, maybe a tad more than that, by the end of this year. And so we are moving as aggressively as we can in Chicago and then Texas, we’ve really followed a kind of a more normal -- I think probably in our, the top market, we might be in the low 70s in 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 this word -- we held capital back, let’s put it this way, waiting for a labor agreement that made sense and so that gave us a slow start.

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

Scott Mushkin - Banc of America

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

Steven Burd

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

Scott Mushkin - Banc of America

Great. Thanks.

Operator

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

Melissa Plaisance

Thank you, everyone, for participating in the call. Julie Hong and I will be available if you have additional follow-up questions. Thank you very much.

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Source: Safeway Q3 2007 Earnings Call Transcript
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