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Safeway Inc. (NYSE:SWY)

Q2 2008 Earnings Call

July 17, 2008 11:00 am ET

Executives

Melissa Plaisance - Senior Vice President, Finance

Steve Burd - Chairman, President and CEO

Analysts

John Heinbockel - Goldman-Sachs

Charles Cerankosky - FTN Midwest

Scott Mushkin - Jefferies

Deborah Weinswig - Citigroup

Karen Short - Friedman, Billings, Ramsey & Co

Mark Wiltamuth - Morgan Stanley

Meredith Adler - Lehman Brothers

Ed Kelly - Credit Suisse

Operator

Welcome to the Safeway second quarter earnings call. At this time all participants are in a listen-only mode. During the question-and-answer session, you may press star-one to ask a question.

I will now like to turn the call over to Melissa Plaisance, Safeway's Senior Vice President of Finance. Please go ahead.

Melissa Plaisance

Good morning, everyone and thank you for joining us for our second quarter conference call. With me this morning is Steve Burd, our Chairman, President and CEO, and Robert Edwards our executive vice-president and Chief Financial Officer. Also with me this morning is Christiane Pelz, our new Vice President of Investor Relations.

Before I hand the call over to Steve, let me remind you that this conference call may contain forward-looking statements. Such statements may relate to topics such as sales, gross margins, earnings growth, operating improvements, cost reduction, capital spending, acquisition, disposition, 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 including those set out under forward-looking statements in Safeway's annual report to stockholders, included in Safeway's most recent 10-K and 10-Q.

And with that, let me turn the call over to Steve.

Steve Burd

Thank you, Melissa. I'm sure many of you saw the press release this morning. But let me, if I can cover the highlights for you. Reported earnings for the quarter came in at $234 million, as contrasted with $218 million reported the same quarter a year ago.

Expressed in items of earnings per share, we earned $0.53 in this 2008 quarter as contrasted with $0.49 in the same quarter in 2007. That represents an 8.2% increase in earnings per share.

From an earnings perspective, it was a very strong quarter. The 8% increase in year-over-year EPS was achieved despite several negative earnings effects, which by our estimation totaled about $0.11 a share. And just to highlight those sort of in order of importance, we absorbed a higher energy costs in the quarter, higher than last year by about $0.04 a share.

As everybody knows energy costs are at all-time highs, and our expectation in the back half is things won't get any better there. So we'll have that head wind to contend with for the balance of the year.

Also property gains, which you know, we talked about often in these earnings calls, they come, not in a smooth fashion, not always predictable, on the year usually predictable not by quarter. And last year we had a very large property gain and this year much more normal.

That difference between last year and this year is $0.03 a share. And then the Easter holiday shift, as many of you know, I think we're probably the only pure food retailer that has a fiscal year, and therefore a quarterly split that causes the Easter holiday and sometimes other holidays to shift from one quarter to the other.

So you'll hear us talk on this call about adjusting for the Easter shift. This year Easter, the shopping that received Easter actually fell in the last week of the first quarter, and it was not true last year it fell on the second quarter. So that Easter shift was worth $0.03 a share.

And then finally, some of you finally noticed, we had a higher tax rate. This quarter last year, we were 35.5, which is lower than normal. And this year much more normal number. So, we feel very good about the earnings given the fact that we absorbed this $0.11 increased earnings $0.04 a share. And so from a pure earnings perspective, you can't describe it as anything, but a very strong quarter.

The earnings improvement, as expected, was driven by very strong cost control, which positively affected both operating and admin expenses, what we often abbreviate as O&A, and also gross margin. I'll talk more about that later.

ID sales performance, on the other hand, there is no getting around it, was soft. And obviously that's something that we're focused on improving. If I turn first to sales, and it's been our practice to talk about total sales, higher fuel sales and ID sales. I will do that on this call as I've done for the last couple of years, but I'm thinking about converting in the future to just an ID number, because it is pretty complicated to keep track of all these numbers.

The reason that we do it is that in the food retail business, most people use an ID, but there are lot of folks out there that are not in the pure food business, and they use a comparable number, and so we'll always publish that number for you. But this could be the last time you hear me talk about comparables on the call, unless there is a huge demand to have me talk about that each quarter.

So, let's first of all start with total sales. Total sales increased 3% over last year. Comparable store sales increased 1%, but that 1% includes fuel, which as you know is a very different business, and very low margin business and subject to huge commodity inflation.

So when you adjust out fuel and you look at the comparables, but don't adjust for Easter, you end up with a 0.2 increase in sales. ID sales, first looked at exactly the same way including fuel were slightly lower at 0.9. And then when you removed fuel, but don't yet adjust for Easter, you end up with a negative 0.3 in IDs for the quarter.

Now, again, if we didn't have this phenomenon and our primary competitors do not, we wouldn't be talking about adjusting for Easter. But when you adjust for Easter, and you appropriately exclude fuel sales, which I think everybody likes to have us do, our ID sales for the quarter were 1%.

Now, the ID sales continue to be affected negatively by two kind of phenomenon that we've been talking about in the case of generic drugs for probably five or six quarters, in the case of corporate brands for at least four quarters. And so, the shift from branded drugs to generic drugs probably cost us about 40 basis points in the quarter.

And the growth of corporate brands probably cost us about 29 basis points in the quarter. So I'm not saying that, gosh, we really had a 1.7% increase in IDs. It was very important to understand how those mix shifts are affecting top line IDs, because both of those mix shifts are basically attractive, bottom line things to do.

In fact, when you look at Safeway today, and you look at really the strength of our corporate brands portfolio, a major way we bring value to consumers is to focus on corporate brands. And so we continue to see growth in corporate brands relative to national brands, and while I haven't looked at that metric consistently every quarter for 16 years, it wouldn't surprise me if it is at an all-time high.

So whether there is just an extraordinary shift in our business to corporate brands, and I'm excluding those items that are always corporate brands like milk and let's say, eggs. So it is a genuine shift, predominantly, in the center of the store, and the shift, frankly, that we've been encouraging.

We have been encouraging that shift even though we know it hurts IDs, we are encouraging it because that's what consumers want to stick with. And we'll continue to focus on that as we simultaneously build national brand sales. That said, you know, we're not happy with our ID sales, and, you know, clearly have plans to improve our momentum as we move through the balance of 2008. So I'm sure we'll get some questions on that.

Turning next to gross margins, our total gross margin rate declined 20 basis points. But, again, that's a decline that reflects a large dose of fuel sales increases. When you exclude fuel sales, the gross margin on our non-fuel-related business, actually increased 26 basis points. When you take apart the 26 basis points, the biggest factor by some distance was the improve at shrink. I think we teed up, probably at the investor conference in December. But despite the fact that we've been very good at shrink removal, by my recollection, taking out almost $116 million in 2006, taking out something like $53 million, $54 million in 2007, we taxed ourselves with taking out another $50 million in 2008. And the retail execution has been so strong on this that we've actually, exceeded, marginally our entire year's goal in the first half.

Now, some of the comparisons to last year are going to get a little tougher into the back half but it's our belief that we will continue to make progress on this and it is our belief we will put up another goal up for next year that we will also achieve. So that's a significant piece of the gross margin improvement. Also, I touched on the corporate brand mix being an extraordinary shift from national brands to corporate brands, with all of the gross margin implications that entails. And then third, our advertising expense, as a percentage of sales, was also down as we continue to look for efficiencies in how we spend our advertising dollars. Now, these were heavily offset by a commitment to investment price, but all of that still yielded, when you exclude fuel, a 26 basis-point improvement in gross margin on the quarter.

Turning to operating and admin expenses, as a percentage, they declined by 36 basis points from last year's second quarter but again 26 basis points of that decline was really the result of higher fuel. So when we gave guidance at the beginning of the year about how margin might expand, again we didn't separate gross from O&A, but essentially, when we gave that guidance, that was absent fuel. Okay. So that's why we encourage you to focus on to the 10, not the 36.

The big pieces of that where we had large reductions in employee-related expenses, and that's labor, that's benefit s, that's some indirect costs that, comp is always thrown in there, again it's percentage of sales. And then there were a bunch of offsets. The offsets were the lower property gains which is booked in the O&A column, which I talked about earlier. Obviously higher occupancy costs, particularly depreciation, because of the heavy capital program. Remember, we're putting six years, or excuse me 10 years of capital spend in a six year time frame. And then higher utility expense, which I called out on the front part of this call and there is a catch-all category we would describe as other. So again, from an operating and admin expense ratio standpoint, a very strong quarter.

Interest expense declined more than it has been. It declined $8 million and that was a combination of lower debt outstanding and the reduction in the average borrowing rate. Looking first at the debt outstanding relative to last year, it declined $161 million, and the average borrowing rate declined some 41 basis points going from 6.36% to 5.95%. So if you tried to parcel that out and do the math, about 70% of the $8 million decline is the result of the interest rate and the remaining 30% is the result of debt. Long and short of it is, as we continue to benefit from our debt rating upgrade with increased access to commercial paper which yields, lower borrowing rates.

Turning to capital expenditures, as you know from following the company, we tend to spend more capital dollars in the back half than in the front half, but just to give you the numbers in the front half here, or at least this quarter, we completed three new stores in the quarter and 46 Lifestyle remodels during this same quarter.

Year-to-date, that means we have done four new stores and a total of 68 remodels. And that puts us at about 63% of our stores or just under 1,100, 1,096, to be specific, that are now in the Lifestyle format. We have invested a total of $676.8 million on a year-to-date business, and believe that we are on track to spend what we said at the outset, roughly $1.07 billion to $1.075 billion, and that should cover about 20 new stores by year-end and 250 Lifestyle remodels.

Touching just briefly on income tax rates, our tax rate in the quarter was 37%. This compares to last year's second quarter of 35.5%. As you know, tax rates can move around a bit, from quarter-to-quarter, and while they are difficult to predict, we would describe a 37% that we experienced this quarter to be more of a normal sort of tax rate.

Turning to cash flow, another great data point on the quarter, our free cash flow for the quarter was $442 million compared to last year's second quarter of $297.5 million, or an improvement of almost $145 million. Free cash flow for the first half was $238 million compared to $66.8 million, or a difference of $171 million, so quite an improvement. And while $76 million of this $171 million is explained by lower capital expenditures in the first half, the balance is explained by just fundamental improvements at managing free cash flow.

Just a brief update on Blackhawk. We've been providing some metrics over the last several quarters. One of the key metrics for Blackhawk is the face value of card sales, and if you put all of the cards in there, face value of sales increased 56% for quarter two which is a strong performance. That compares with 63% for the first half, I would remind you in the first half we've had Easter in it and that creates a spike in sales.

Retail partner cards, I thought there might be some interest in that, so I'm excluding telecom, open look, sports and entertainment, experienced a 58% increase in the second quarter, and it was 68% in the first half, again reflecting that holiday behavior. And I think the reason that's an important number is that when you look at partner card sales, and that kind of an increase, you should find that very encouraging given that the overall ID sales performance of the card partners that I'm talking about is much more impacted.

I mean, they are impacted heavily by the current economic circumstances, and fundamentally Blackhawk's business is not, indicating a real shift I think towards the gift cards as a fundamental vehicle for gift-giving, and that's why those sales are not affected the same way. I'm not saying they aren't somewhat affected but those are extraordinary numbers in view of what's happening to the ID sales of the retail partners.

I want to shift to some other notable events and I want to call out what occurred in the quarter. I'm going to start with what I think is the most significant event. We hired Diane Dietz who will serve as Executive Vice-President and Chief Marketing Officer. The term of the Chief Marketing Officer is probably a little bit of misnomer to apply the narrower responsibility that this job really has. Diane will be responsible for the Company's marketing, merchandising, manufacturing and distribution functions and there is a lot tied to that.

She is joining Safeway after a 19-year career with one of the best marketing companies in the CPC world, Procter & Gamble, where she ran one of Procter & Gamble's largest business units and quite successfully. Diane comes with a strong track record of building sales and growing market share, and she arrives on Monday, okay? So we are all looking forward to that.

Our dividend payout was increased at 20% in the quarter at our annual shareholders' meeting. That is the second year in a row that we've increased the dividend 20%, so the quarter dividend now stands at $8.28 per share. The Board of Directors also increased our authorization for buying back stock to $1 billion. And in the quarter we purchased 3.2 million shares bringing our first half purchases to 5.7 million shares, totaling $174.7 million, leaving us with a remaining authorization right now of $1.3 billion.

Finally turning to guidance, we're confirming our earnings guidance for 2008 which you recall was 2.25 to 2.35 per share. I would remind everybody that covers a 53-week year. Our free cash flow guidance had a great start, remains at 500 million to 700 million and that's 500 million to 700 million excluding the year-end pop if we get from Blackhawk, because the seasonality of that business.

We're revising our ID sales guidance, the current guidance stands at 2 to 2.3. Given the numbers in the second quarter, and given what we think it takes to build that momentum back in this kind of environment, we are changing the sales guidance on IDs from 1% to 2%.

Our confidence in our ability to achieve our earnings guidance rests largely on three factors. Our retail execution has been nothing short of outstanding in every respect. From store standards, in-stock condition, cost control, shrink improvement, merchandising, you go into our stores, we are ready for business. And we think, we stand out relative to the competition, So that, we see no changes in that.

Our cost reduction efforts launched in October and November of last year, which we described in previous calls, was added into guidance, it was intended to give us money to more aggressively invest in price. It was intended to be some insurance against anything that can happen economically in the environment and it's serving that purpose.

Our cost reduction efforts through the both, the first quarter and the second quarter, every time you do the cost reduction, you put some targets on the table and you assign people responsibility, and you expect them to deliver those numbers. We over-delivered in the first quarter, we over-delivered in the second quarter. And the plan calls for a ramp-up, and the vast majority of that plan are things that we've already done.

So now it is simply reaping the rewards of things that have been executed in the first and second quarter. And so the plan on that cost saving, it is bigger in quarter three than in quarters two and one. And it's even bigger in quarter four than in it is in quarter three. So that ramps up to clearly help on the earnings side of the equation.

And then, finally, we expect sales momentum from initiatives that have been put in place, and others that we will still put in place, to build sales as we move through the back half, particularly as we move through the fourth quarter.

One comment, consensus estimates, we said we are comfortable with the guidance, we provide annual guidance, but then of course everybody does quarterly estimates, and we think that if you want to be more accurate on the quarter, or those of you that make estimates, you probably would be well served to shift $0.02 out of quarter three, and put it in quarter four.

And so it's just my way of summary. My definition of summary is a bit redundant. But my way of summary, as we expected, we produced solid earnings. Beating the consensus estimates by a penny a share, on what is admittedly soft sales.

Our cost reduction effort, as I indicated earlier, led by great retail execution, is ahead of plan, and it is expected to continue to build as we move through the back half. We have efforts in place to build sales, and we'll add to these efforts. This should allow us to deliver the expected 13% to 18% EPS growth for 2008, a 53-week year.

And, finally, our cash flow remains very strong, giving it the kind of flexibility we need to manage through I think what everybody now recognizes is a tough economic environment. I remember when I first said in the fourth quarter that, yes, we saw evidence of people trading down. People were shocked, okay? I don't know anybody is shocked today. And probably the strongest evidence I can provide you for trading down exists, is the rush to corporate brands that we and, frankly, the entire industry has experienced. As we look at the numbers, our shift to corporate brands is much stronger than the industry numbers that we see.

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

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). So looks like our first question comes from John Heinbockel. You may ask your question. Please state your company name.

John Heinbockel - Goldman Sachs

Yes, Goldman Sachs. So, Steve, two things I wanted to drill down on. First, the dynamics of the sales slowdown. Secondly, how you address that? If you look at over the last six months, how broad-based is the slowdown when you look at it by division, or any other way you want to look at it?

Is it more California-centric, or the divisions are the bulk of them down from where they were six months ago?

Steve Burd

I will give you a couple data points. If you were to look at a geographic map of the United States and look at loans, foreclosures and that stuff, not unexpectedly, even though those might not be the total reason, those areas are down more generally. Okay?

Second data point, would be I would tell you that that fact aside, it is generally it is generally broad-based. So that the best performing divisions over the last four quarters, eight quarters are still the best performing divisions. So I think it is relatively broad-based.

As I try to parcel it out, I have detailed for you the amount of the ID sales that is the result of generic and corporate brands. If I were to try to just judgmentally tell you how much is driven by the economy and how well we are positioned to deal in that softness today, you would probably put a 1% number on that.

John Heinbockel - Goldman Sachs

Do we’ve any divisions that are yet, I think you have said in the past all the divisions are positive. Given where we are now, have any dipped into any negative territory yet or no?

Steve Burd

The answer is yes, some are negative, when you do a 1% ID, you have got to have some that are negative.

John Heinbockel - Goldman Sachs

Right. If you look at where we sit today, you talked about the 1%, do we know now, or it is always tough to say, but is there a good sense if we’ve hit bottom or things have decelerated still further the last month or two?

Steve Burd

I think that, reflected in our sales guidance, is essentially the notion that you will not see a lot of improvement in the third quarter and you should see improvement in the fourth quarter. It is not because we think the economy is going to get any better. I do not think anybody would, just forecasting the economy will get better. We think we will get better, because of the actions that we’ve taken and of the actions that we plan to take. So I think bottom is a little bit of a hard term because I listened to the news this morning and the sky is falling. If you look at it, the consumers' psychology is not good. The consumer confidence index is at an all-time low. Could it drop lower? Yes. Do I think sales for us is going to get worse? I do not really think so.

I think that, and that is more on the basis of actions that we’ve taken as opposed to how I feel about the economy. I do not think any of us feel the economy is going to improve any time soon, at least not consumer confidence. It might gradually improve. However, we are responsible for our own destiny here. So we do not take the current level of consumer confidence as an indication that we should be doing poorly.

John Heinbockel - Goldman Sachs

All right. Then finally, you talked of the balance between sales and earnings because it looks like maybe there is a little bit of an imbalance and earnings have some very good sales and not so much. Whether there is opportunity to reinvest, food gross was up 26, I suppose it could have been greater reinvestment in the quarter. Talking about that balance, and then also in the environment we are in today, do you get a better bang for the buck with shelf pricing, or promotional activity?

Steve Burd

Yes, it is a good question. I think that you know our story well, John. I mean, since about 2003, we’ve been selling quality to our consumers. For a couple of years now we’ve said we needed to add to that a stronger value proposition. Frankly, a stronger every day value proposition. You can invest promotionally, which is the DNA of this company, and you can get a relatively quick response to that. However, we are trying to be a lot more surgical and thoughtful in trying to get a much better value impression to go along with the quality impression we’ve today. So we are making surgical investments, we think significant investments. We think they have a longer gestation period. However, we are confident they will work.

John Heinbockel - Goldman Sachs

Okay. Thanks.

Operator

Thank you. Our next question comes from Chuck Cerankosky. You may ask your question. Please state your company name.

Charles Cerankosky - FTN Midwest

Good morning, FTN Midwest. Steve, could you comment on how you are looking at market share, not only within the conventional supermarket channel, but against some other food marketing companies?

Steve Burd

Well, the easiest way for us to measure market share is in the supermarket channel because you are not relying on estimates. Everybody provides their data to IRI. You can get accurate data and you can get it by business units, you can get it cut any way that you want. So that is the basis in which we typically talk about it. When you look at the ID sales of what I will call non-supermarket companies, people that they sell a significant amount of food, I have seen stronger numbers than what he we’ve just reported. So you got to believe that there is generally a shift, out of most supermarket players and that is probably, a one or two-quarter phenomenon. Okay?

It was not there in 2007. In general, if you want to maintain your market share broadly, you have got to, in a modestly inflationary environment, have to generate sales, increases that you see, population growth. Population growth is about 1.2. So we did not do that this quarter. So I would say that for the first time in probably 13 quarters, we had a slight tick-down in market share and we are not happy about it.

Charles Cerankosky - FTN Midwest

Out of curiosity, why do you feel the non-supermarket comps surge, if you want to call that, is just a phenomenon for a couple quarters?

Steve Burd

Well, I am just saying that if you look at our IDs, we haven't lost to those players, but in recent times. Then I am going to tell you that their numbers, particularly in the super center format, those numbers only recently got better. You would have to parcel out and try to figure out how much of that is food and how much of that is non-food. However, it is just in a soft economic environment, people that have been selling price for value, and that is their message, and they have sold people on that, they are going to do better. You can look in the department store industry for that, you can look in specialty retail for that. This is not a food industry phenomenon. It is that, I think I would describe it as an economic fact for life.

Charles Cerankosky - FTN Midwest

When you look at what departments are doing well and what consumers are doing Steve, can you give us some additional thoughts on trading down? You talked about private label, but how about within some of the protein categories or some of the other fresh departments? What do you see, and especially things like prepared foods?

Steve Burd

Yes, I think I do not want to go into great detail but I will call out one category that frankly we are making great progress on. You can appreciate that a floral department, we are one of the largest, if not the largest floral players in the country, much stronger floral presentation of presence than anybody else in our channel or even outside of our channel. Those are largely discretionary items, and it is not that people are not buying floral, they are buying different floral. So that area is an obvious area where you see trading down but we’ve employed some strategies and we are building that business back, and that is a good example.

In the past, I have mentioned latte sales going through as well as pure coffee sales and things of that nature. So I do not want to provide a lot of detail on that for competitive reasons, but it is really clear. Even though we’ve been selling quality now for several years, we are not going to stop selling quality, but we are getting more aggressive on the value side of the equation, which has always been our ambition. So you will see more of that coming from us and if you walk into our stores today, you will see an overpowering presentation on corporate brands because right now that is one of our absolute best weapons, which unfortunately lowers ID sales, but it has good profit implications and that is what consumers want.

Charles Cerankosky - FTN Midwest

Final thought, when we look at our past this period with the increased popularity and demand for corporate brands Steve, how much of it do you think sticks? Because the quality is there, that is the underlying.

Steve Burd

Well, I think that because we’ve a pretty unique corporate brands portfolio. I think we will get more stickiness than others that do not have the quality and brands that we’ve. I mean, if I take a look at something like O Organics, I mean O Organics is going to experience a 50% increase in sales.

We’ve gone from $150 million to over $300 million, to this year over $400 million, okay? Eating Right tracking with that, just about to do a major brand launch on Eating Right to expand that line. So, you do not know until it is overweight but we think that when people experience quality and they really like it, they get attracted to that, you will keep a good deal of that. So this is an opportunity for people like us to build shares in corporate brands. At the same time national brands are very important to consumers, and you have got to provide good value on the ones that they buy most often, which is our strategy.

Charles Cerankosky - FTN Midwest

Thank you.

Operator

Thank you. Our next question comes from Scott Mushkin. You may ask your question, please state your company name.

Scott Mushkin - Jefferies

Jeffries. Hey, just wanted to get back to the price investments you were talking about earlier Steve. Just trying to get a feel for where you think you are as far as price investment goes? Where it needs to be to try to get those sales going the other way? Do you have any concerns that it could spark more competition between you and your competitors?

Steve Burd

It is difficult to describe, I was thinking about a baseball analogy here to try to give you the inning we are in, but little hesitant to that, because we are not all baseball fans on this call. I would say that we are not halfway through, okay? So, we’ve got more work to do there. You had a second part to your question.

Scott Mushkin - Jefferies

Yes. Just whether it will spark, maybe increased competition in the markets where you are doing this.

Steve Burd

Here's the thing. If we look at our everyday value proposition, overall price proposition, we do not find ourselves on the high-end; we find ourselves in the middle. A lot of the work that we are doing is to get ourselves, at the level of the conventional guy that is low.

So it is not like we are trying to get below somebody, we are already below somebody. We are just making investments in a surgical fashion in our market, the way we think consumers will respond to our merchandising, and I do not think it triggers the same response as if you want to be a dollar lower than somebody.

However, again you do not just compete with one player, you compete with several players. So as you improve your consumer proposition relative to all the people that you compete with, that is how you gain.

Scott Mushkin - Jefferies

Do you anticipate once you are done, I mean, how do you feel the image of the company is price-wise? I know Stop’N Shop here in the Northeast has fought against a high-price image now, even though their prices are down. Where do you think you fall in that?

Steve Burd

Here is what I think happens, and I have always believed this. I believe that when you make these investments, particularly in everyday price, you get foot traffic before you win the survey contest.

So I think it takes years to win, when I say the survey contest, I am talking the impression of consumers, because people feed on that impression and so people have that in their mind. However, when you are effectively priced on everyday value items, people respond with their feet and shop your stores before they give you credit in a survey.

So I am not worried about winning the survey. I just want to win the foot traffic. So we’ve no illusions about changing those impressions, but we do believe we can change foot traffic in the near-term.

Scott Mushkin - Jefferies

Can I have just one more follow-up? What was the inflation? I do not know if I heard that, maybe I missed. There was the inflation in the quarter. Did you say?

Steve Burd

We never give inflation numbers simply because it is a really difficult thing to measure, but I think you get an indicator of that by just looking at our LIFO charge. In the second quarter, we put a LIFO charge in there that is probably the highest quarterly LIFO charge that I can remember.

But if you say, in overall inflation, remember LIFO just measures, predominantly non-perishables. Okay? Obviously there is commodity inflation in perishable. I think my gut would tell you that inflation in the second quarter was about the way it was in the first quarter.

In the first quarter, I described it as the highest inflation that I had personally seen in sixteen years. You people have to understand that when the prices go up, whether its fuel I mean, just this week they reported that fuel consumption in this country is down 3%, prices are up quite a bit more than that.

However, when prices go up, sales go down. I do not care what the item is. So there is a little bit of that going on, and I do not think that is going to change any time soon.

Scott Mushkin - Jefferies

All right, that is good. Thank you very much.

Operator

Thank you. Our next question comes from Deborah Weinswig. You may ask your question and please state your company name.

Deborah Weinswig - Citigroup

Citigroup. Back to Chuck's question earlier, Steve, you said that you thought that the private label brands would be sticky. However you trade down if you will the non-food retailers, Wal-Marts, Costco, etcetera, might not be as sticky. Philosophically speaking, what will be the difference between those two changes in consumer behavior?

Steve Burd

Okay. I think it is pretty simple. I have sixteen personal years to rely on when I make those statements, and I think people in this room have 30 years of experience. I mean, you just go study, look at consumer confidence, correlate it to, price value guys versus quality players, pick even markets, pick anybody you want, pick any industry you want, and there is a shift during soft economic times, the value price guys and there is a shift back to regular players when that ends. Always happens.

I do not see any reason why that would not happen again. Do some people stick and use those value players as a piece of their shopping experience on a go-forward basis? Yes. All right?

Now, on the corporate brand side, keep in mind that if someone is that has 31 manufacturing plants as an extraordinary corporate brand portfolio, the portfolio that is now being sold outside of Safeway, both domestically and internationally, that we’ve brands that have more sticking power than many of our competitors and so I am not suggesting to you that it all sticks.

I am just suggesting to you that it is a very important piece of our value equation to consumers that we are exploiting and there is going to be more stickiness I believe with our brands than typical corporate brands out there. So it is a relative thing. It is not an absolute thing.

Deborah Weinswig - Citigroup

So almost in some ways it would be an aspirational customer who maybe is not feeling as wealthy at this point in time, who is trading down. However, let's say if they are trading town to the Safeway box and try and more corporate brands there, impressive to quality, etcetera and so it is just a different change in terms of consumer behavior.

Steve Burd

Yes. I mean, if you have a real quality brand and they find either no difference or they think its better, there is no reason to change because it is equal or better and it is cheaper. So why change unless you are, you ever heard of the Veblen effect?

Deborah Weinswig - Citigroup

Yes.

Steve Burd

Okay. Unless there is the Veblen effect, which is the conspicuous consumer who thinks that higher prices are always better and that is not a large segment of the population.

Deborah Weinswig - Citigroup

Okay. That is helpful and then in terms of where we started at the beginning of '08 with regards to your ID sales guidance and where we are now. Has the biggest difference been traffic or ticket? If you can just help us think through what has happened.

Steve Burd

It is predominantly traffic. However, you have got customer accounts that are soft, but then again trying to consolidate trips you have got baskets going up. So it is that combination that yields the 1% ID.

Deborah Weinswig - Citigroup

Okay. Then, last question, obviously it is at a minority of your stores but in terms of fuel stations, what types of initiatives do you have in place in terms of driving traffic to your fuel stations and hopefully driving traffic into the stores? Has anything changed over the past 12 months with the rise in fuel?

Steve Burd

Well, I think that we embarked upon a strategy. Gosh, I would have to go back. It could be four it could be five years ago to begin to compliment our stores with fuel stations. Then we’ve experimented and migrated over time to some fuel promotion existing in most, if not all markets. Then those things change from time to time and if you were to go back a year, I am confident I can tell you that those things have changed.

So, we’ve a different fuel promotion today than we had a year ago. Maybe even a couple of quarters ago. However, that is a fluid thing. So you pick things that you think will work in certain geographies and in certain periods of time. So we are comfortable with today's fuel promotions and think that its not only has added to sales but it is one of those moves that we think has a building momentum.

Because generally before we make a change that might have multiple divisional impacts it is tested somewhere. So, that is why we are so confident that some of the things that we’ve done will build, because as we’ve experimented in one geography or another, and that is exactly the pattern we’ve experienced.

Deborah Weinswig - Citigroup

Okay, great. Well, thanks so much and best of luck.

Steve Burd

Thanks.

Operator

Your next question comes from Karen Short. You may ask your question, please state your company name.

Karen Short - Friedman, Billings, Ramsey & Co

Friedman, Billings and Ramsey. So, a couple of questions. Obviously the market appears to be the way your stock is acting, the market thinks you will have to lower your guidance in '08. So the first question is how weak can your IDs be for you to still make your guidance? Then second question is you have talked about a $0.27 flow-through to the bottom line when your CapEx spend declines at the end of '09, is it worth the risk, if all of that has to go reinvested in price and then I had a third, as well.

Steve Burd

Okay. Essentially, I will go back to the guidance. Our guidance is in the 1% to 2% range. We think if we are in that range, given the robustness of our cost reduction efforts plus all of the plans that we’ve to invest in price to build sales that we make the guidance. So in probably early in the first quarter at some investor or analysts, I had to give two analysts presentations.

I try to tee up for people just how strong this cost reduction effort was and why we were so confident in the guidance. For people that are looking at our stock price today what they do not seem to be focusing on, is that when retail in general is falling apart, but for a few players, we are going to put a 13% to 18% earnings increase off of a couple of years that we’ve been in the 20%.

Whether you are a retailer or a bank or financial institution, you are down, and people do not seem to focus on that, we certainly do. So, I am not going to give you a specific number except to tell you that we believe we make the earnings guidance with ID sales in the 1% to 2% range, and remember cost improvements are going to get better, and we think sales are going to get better. So, those are a couple good reasons for it.

The $0.27 that you are referring to is when the Lifestyle program ends. What we’ve said that we are investing so much and opening almost 300 stores a year both from operating standpoint as well as promotional standpoint. When that goes away, $0.27 in earnings freed up that you can add the general momentum. We still think that is $0.27. Now, we are going to continue to invest in price and build sales because we believe that long-term, our sales, non-fuel need to be in the 3% to 4%. We still believe in the long-term, we could be there. We believe that long-term, you are not in a soft economy. We believe we will do things that will improve our sales performance in a soft economy.

So it is really too early to tell, how much we would invest in price, if any. If it is 2010 and consumer confidence is at 56, we might invest some of that $0.27. I do not think anybody on this call thinks in 2010 consumer confidence is going to be at 56. So, the point is that it is early to tell, but if I had to make the judgment today, I think that it is largely additive to earnings. Part of my reason for saying that is that, we feel very confident about surgical, self-financing ways to invest in value to consumers which will drive top line sales. So, do not believe we need that. Think now about how to use $0.27 in 2010. You had a third question.

Karen Short - Friedman, Billings, Ramsey & Co

Well, not to beat a dead horse here, but obviously going back into the 2001 and 2002 period, you pursued a dramatically different strategy from Kroger with your rest of remodel. So, how do you get us comfortable that, this is not a day reckoning where your margins are not sustainable at the levels that they are at? That you are going to have to lower prices across the board and we are going to see several years of margin declines to get you in line.

Steve Burd

I do not know if you are comfortable with way I would generally address that issue, is to say that, I am not saying anything new when I tell you that this is a soft economic climate. I have tried to lay out for you and I have invited you to look at history, okay? What happens in soft economic times?

There is a bit of a movement away from quality, okay? There is a movement towards, price and value. Just go and look at the ID sales of department stores, specialty retailers, food, others, just go look, and you will see what I am talking about. If you look at previous soft economic events, you will see how that pops after the event.

So, we believe our strategy on quality is right. We believe we’ve the best shopping experience; we’ve the best perishable content of anybody out there. We believe that when you look over the course of time and you look at a 10-year period, there are more good years in that 10-year period than there are years that lack consumer confidence.

So, we basically are preparing ourselves for normal times, and we’ve always said the piece of our strategy is to provide a better everyday value to consumers. When you get hit with a soft economic environment, you are a bit more challenged because your image has been quality, and you are playing a little catch-up on the value side of the equation.

However, we think we are up to that task. So, we are confident that sales will build. We are confident that our earnings will be there. We are confident that we’ve the right strategy; no one else has the quality strategy. So I would invite you to look at retail in general, and I could probably give you examples in other industries as well.

Karen Short - Friedman, Billings, Ramsey & Co

Okay, great. Thanks.

Operator

Thank you. Our next question comes from Mark Wiltamuth. You may ask your question, and please state your company name.

Mark Wiltamuth - Morgan Stanley

Hi Steve, Mark Wiltamuth, Morgan Stanley. I wanted to ask about gasoline. You have talked in the past about how rising gasoline prices can lead to compression of your margin. I think in this environment with credit card fees based on percentage of sales, that is also got to be a drag. So I was curious, how you did on gas in the quarter? Were you even profitable on gas in the quarter? What was the drag versus a year ago in earnings terms?

Steve Burd

Yes. I mean, there is no question that fuel was additive to our business, but the reason I called out energy, included in energy was the piece of fuel. Fuel margins were actually down on the quarter and cost it is a penny a share. Okay?

Not a big deal. If fuel margins had cost us $0.03 a share, I would have put some real focus into that. Right now this week margins are lower than what they were in the second quarter. However, this thing changes so fast and so dramatically, and our history is that when we look at a year, or look at the last five years, you are not going to find more than a penny difference at the end of the year in what our average margin is.

So it was not worth calling out by itself, but it was negative. Now, if fuel costs were to stabilize, margin would turn to normal, if fuel costs were to go down, then margins will increase. So, our view right now is that the quarter is going to end, the first week of the quarter, I believe we were above normal. So I think that the quarter is going to end in pretty much the normal range, give or take a penny.

Mark Wiltamuth - Morgan Stanley

Have the credit card fees been a problem? Because they are based on a percentage of sales and with gas going up to $4 plus then that is got to put some pressure on the margin per gallon?

Steve Burd

No question about it. You are absolutely correct that basically what is dominant in the fuel stations are credit and debit, which carry fees. Much stronger mix in the fuel stations because, people like to avoid people, just do it mechanically, so that is a drag. That is a drag on the earnings, but it is a drag that we know is there, and we can forecast that.

Mark Wiltamuth - Morgan Stanley

Okay. Then getting back to your pricing strategy, we just recently did a big survey and we looked across shelf pricing, promotional price and private label pricing. Do you think you get more bang for your buck lowering the shelf price now, or really getting more aggressive on private label pricing, because we were finding that Kroger was much lower on private label pricing than most competitors out there, and just want to get your thoughts on those different price points.

Steve Burd

I think that because people are focused on private label, I think that price changes in private label corporate brands probably have a more immediate response than national brands, because they are hunting in that direction, I do think you get a quicker demand response on promotional, whether that be, national brands or corporate brands.

However, one of our challenge is to alter our D&A a little bit, we are renowned as, one of the, if not the most promotional operator out there. So long-term it is useful to change that impression, which creates more of a need to invest in everyday price, particularly the items that people are most interested in. So that works against creating a hockey stick sales curve, but it works in favor of long-term value creation.

With the management, investment in this company, we think, aligns us with shareholders; we are a whole lot more focused on long-term value creation than we are a quarter. Some people probably think I should, be all bummed out over today's stock price. I have gotten accustomed to the fact that we announced our earnings. It is an overreaction of the market. It takes four to eight days for things to settle out, understand the story.

So, we think that we had a very good quarter. We think that we got some sales things to work on. We think we put in place things to do that. We think we’ve just hired a Chief Marketing Officer that has extraordinary talent that knows how to build share. So we think we are making all the right moves. We think the strategy is right. We just get hurt a little bit, and just watch the retail numbers that get reported. We are not in last place.

Mark Wiltamuth - Morgan Stanley

Okay. Thank you.

Operator

Thank you. Your next question comes from Meredith Adler. You may ask your question and please state your company name.

Meredith Adler - Lehman Brothers

Meredith Adler from Lehman Brothers. Good morning. Couple of questions for you. I do not think that Safeway did any big promotions tied to the stimulus checks. Were you able to see anything in your numbers that would say that people decide?

I mean we hear that Wal-Mart sales of electronic items are very strong, and that might have gotten people into the store. Did you see anything in your numbers that seemed to see that people were spending those checks elsewhere and that took traffic out of your stores?

Steve Burd

We did not, and we thought about whether or not we should do something. Before making that decision, what we did as we looked at the consumer survey, and it told us the best thing we ought to do to get consumers response.

So, we did not do the identical thing that some other people did. However, we played to that a little bit, but it did not require that people put their entire check on the table. Our survey said that people did not want to do that. So I think that we saw a minor effect from that, but nothing major.

Meredith Adler - Lehman Brothers

Great. Then another question I have is you commented that the biggest improvement in O&A was from lowered labor, I know you are getting some benefit from contracts that have been signed recently. Was that more significant in bringing down labor costs than the change in processes that I think you have talked about as well?

Steve Burd

Well, one of the things, Meredith, that we are focused on is I think we’ve taken a leadership position, frankly not just in the industry but in the country, is on health care. When you look at the benefits side of the equation there are huge benefits there. Because we’ve embedded in our contract and in our approach here the notion that of personal responsibility and making lifestyle changes and getting people to live a healthier lifestyle and make behavior changes and that affects costs. So now, had we not done some of the contractual changes some years ago, and had we not taken a leadership position in health care, we would not be achieving those kinds of benefits.

Meredith Adler - Lehman Brothers

Okay. Then I had a question about Blackhawk. Last year you signed Kroger, which was a great coup. We are just wondering, is there anything else really big that will come? Is the network still growing very substantially, the distribution network? Then also, can you comment at all about same-store sales of cards, if you are still growing the network very strongly?

Steve Burd

If you look at second quarter versus a year ago, probably not. Well, I am not sure, second quarter compared to first quarter, not major changes in the network. Keep in mind, the backbone of the network is grocery. When you look at the top 50 super markets out there, you are hard-pressed to find people we haven't either signed or that have in the network. So we’ve got some signings that are not activated yet because of technology reasons which will be additive to that. However, when you look at these sales, they are in the main ID sales.

Now, we are pursuing non-grocery that could add significantly to this. The reason you see such large increases despite the fact that the retailers whose cards we sell in Blackhawk are experiencing soft times is that over time you build awareness in all of these retail outlets. Then awareness translates into higher productivity in the stores. We are putting in merchandising fixtures that do a better job displaying the array of cards, trying to put them in the right places so they generate good sales.

So when you look at Safeway's numbers, which we do not reveal publicly, we are in our eighth year and there is not a retailer anywhere that could match the ID sales of Safeway's gift cards in Safeway's stores in year eight. So, but the bigger increases are coming from the guys who joined the network a year ago, two years ago, three years ago, four years ago. So in the case of Kroger, for example, there is not even a year-over-year comparison yet because they have not been in the program a year. So I would say it is largely putting aside and maybe a few other it is largely an ID number.

Meredith Adler - Lehman Brothers

Okay. Then I had just one final question and maybe this is a tough question. However, many years ago, eight years ago, Kroger got very aggressive about improving their price position and it was painful to earnings. However, we can see that that along with other things has really paid off for them. You are doing a great job of cutting costs but seem to be very focused on balancing improvements in your price position with making earnings. The question is, whether you should be moving faster to try to narrow that gap in pricing.

Steve Burd

Yes. I think that, first of all keep in mind they are not the only competitors we face. If I have learned anything in this business over 16 years, mimicking somebody else's strategy is never a winning strategy because then all you have is the ability to how to execute.

We chose in 2003 to differentiate. We’ve been very consistent saying that we need to couple that with a better value proposition which we’ve done, we’ve done a lot more than I am prepared to talk about on this call for obvious competitive reasons and we’ve a lot more yet to do. Our intention is to be able to build share against all of the different players that we compete with.

We as a general rule, have a much higher earnings growth. We think that this game is about a combination of earnings growth and sales growth. So, we think that we can probably excel over the long-term with a higher earnings growth rate than a lot of people we compete with, while having a very respectable sales growth and one that builds market share.

This may disappoint some people, but, and if I had to pick a choice between having the best ID sales and okay earnings versus having very strong ID sales and great earnings, I would take the second one, okay? So, only the reason we’ve talked about cost reduction is it finances are price investments. If it were not for the fact that there is a lot of inflation out there, the price investment would be a lot more visible to everybody. However, it is not that visible to a consumer in this inflationary environment. So this is an unusual event.

You have to see two consecutive quarters of decline in GDP, which is a standard definition of recession. We see what by my measures an all-time low with consumer confidence. I am not going to rattle off all the other economic metrics out there. We see that coupled with the highest inflation that we’ve seen in 16 years. So, if I had predicted the timing of the softness and the duration, I might have been invested a little bit earlier, but I would not change my strategy about quality.

I think I would go back to the fact that in a 10-year period, probably eight of those 10 years our differentiation is going to win. It does not mean that we should not invest in price and do some very creative things, we will, but meet at the balance. Right now, to some it may look like we are out of balance, it is the nature of what we chose as strategy.

However, we are not ignoring sales growth, but we happen to just be in a league of our own on cost reduction and investors should be comforted by the fact that we are exploiting that strength; we are exploiting our corporate brand strength at the expense of top-line IDs. We are playing in a generic game at the expense of top-line IDs, and we are confident those numbers are going to improve because in test markets they did. So, we are not going to shrink from the strategy path that we are on.

Unidentified Analyst

Thank you.

Operator

Thank you. Our next question comes from Ed Kelly. You may ask your question and please state your company name.

Ed Kelly - Credit Suisse

Yes, Credit Suisse. Steve, given that price and value is obviously resonating more with consumers currently, than the Lifestyle strategy, I think you make a pretty good case that what is taking place right now is going to continue into next year. Have you thought about on the remodel side, either suspending temporarily the Lifestyle remodel concept, or maybe spending less on the stores that are remaining, as you look out from here?

Steve Burd

It is a good question. I think that because we’ve always regarded the Lifestyle remodel effort as both, a defense and an offense. We are not planning today to shrink from that effort. In other words, we are contemplating that 2009 at this point would look like 2008 and would finish that program off.

However, to your point on being able to remodel stores and accomplish nearly the same look and feel for less, we created what we call the Lifestyle light remodel, which up to this point and we’ve got, I think 18 months worth of experience, and smaller-volume stores tend to be older stores, many in rural markets, but delivering better sales increases than before.

We’ve now went up ourselves and done something, call it the also light if you want. So, we’ve found ways to spend less money and the very nature of the Lifestyle stores that remain, more than half of those would fit into either the Lifestyle light or the ultra light category. So, I think we will get very efficient spend of capital and very good sales increases for the balance.

Because of the stores that are left you are seeing, those stores are not generating the same sales increases that non-Lifestyle stores did in the past, which really reinforces the need for Lifestyle. So, I do not think it is a slowdown, but we’ve in fact found a cheaper way to do it and that will be reflected not only in a number of stores that we do in 2008, it will be significantly reflected in 2009.

Melissa Plaisance

We’ve time for one last question.

Operator

Thank you. Our next question comes from Chuck Cerankosky. You may ask your question.

Chuck Cerankosky - FTN Midwest Research

Just a follow-up, Steve. Could you talk a little bit about how pharmacy did during the quarter?

Steve Burd

Pharmacy is challenged on the sales line, obviously by the generic shift. It is also challenged as I am sure you know, by a shift in mail order. So it remains a good business for us and some of the sales building strategies that we’ve put in place are in fact focused on pharmacy. We’ve done some other pharmacy programs that are focused on loyalty in select markets where we’ve had an opportunity to be first.

I think most people know that if you do the exact same thing that somebody else does, it is not as effective as when they do it. So we are working on pharmacy, and we think that we will be successful there.

Chuck Cerankosky - FTN Midwest Research

Thank you.

Melissa Plaisance

Well, thank you everyone. For the balance of the day, Christiane and I will be available if there are follow-up questions. Thanks for participating.

Operator

This does conclude today's call. We thank you for your participation. At this time you may disconnect your lines.

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Source: Safeway Inc. Q2 2008 Earnings Call Transcript

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