Safeway's Collateral Damage

| About: Safeway Inc. (SWY)

Shares of Safeway (NYSE:SWY) have taken a strong hit the past two days, down 12% at the close on Thursday, June 12, but regaining some value Friday. The drop in value comes due to comparable competitor Supervalu's (NYSE:SVU) earnings meltdown, shedding about half of its share price. I recently covered SWY and noted that it may present some upside given its nearly 25% short float and low P/E ratios. The company also boasts a strong dividend, with an annualized yield of 3.92% and a payout ratio of 32.77%. Given SWY's similar nature to SVU, investors may be interested in the following points as they may offer some insight to SWY's upcoming earnings report next week (July 19).

SVU reported net sales of $10.6 billion and net earnings of $41 million, or $0.19/ share, down 46% quarter over quarter. SVU notes that "the decrease in net sales reflects the disposition of a majority of our fuel centers, and a decline in identical-store sales attributable to intense price sensitivity on the part of consumers and aggressive promotion and price actions by competitors." Here, SVU has posted consistently declining same-store sales in recent quarters. SWY, on the other hand, has retained and slightly increased same store-sales in Q1, though not nearly as much as prior quarters. Wal-Mart (NYSE:WMT) and Kroger (NYSE:KR) have been strong in retaining same-store sales, and while this paints a bleak picture as time goes on, SWY has at least done better at insulating itself from this competition compared to SVU.

Meanwhile, the company also said that "the decrease in gross margin as a percent of net sales reflects the rate benefit from lower fuel sales (approximately 30 basis points) and a lower LIFO charge, which were more than offset by the negative rate impact of higher shrink, marketing costs and a change in business mix." Overall, extremely high competition combined with consumers trading down given shaky economic footing has negatively affected SVU. The decline in gross margins may have affected SWY as well due to trade downs, though I don't believe it will have negatively affected SWY merely as much due to SVU's poor historical performance (it has had to "change its business mix" considerably) and only recent move toward drastic price cuts.

In light of the earnings, SVU has suspended its quarterly dividend, which was previously at an 8% dividend yield. This is undoubtedly also driving its share price down. I do not believe that SWY's dividend is in danger, with the 32.77% payout ratio giving SWY some "wiggle room" to defend its dividend at least.

In conclusion, I believe that most of the above problems at least more strongly negatively affect SVU compared to SWY, given that SVU's turnaround plan has floundered and the company has continually lost market share. With this sell-off, SWY now trades at a 52-week low (and, I believe, an all-time low). The market is now pricing in perceived less-than-stellar results this quarter from SWY due to SVU's disastrous results. In short, SWY is "collateral damage" to SVU's earnings miss. I don't believe that the amount of damage is justified unless SWY managed to perform as poorly as SVU, which is unlikely given that SVU has been plagued by problems for some time. It is my view that further downside should be minimal, barring a similar earnings miss from SWY.

I believe that my original investment thesis still holds true, but until an obvious level of support is established, I will not be initiating a position. I will be waiting until early next week to let the market sort itself out a bit before deciding on whether or not to enter a position ahead of earnings. Given that the previous 52-week low has been broken and the stock closed below it, investors must be very mindful of the chart.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.