We are initiating coverage on Safeway (SWY) with a buy and a price target of $33.00. We expect stabilization in the gross profit margin slightly below 26.5% and slight percentage improvements in operating and administrative expenses to drive larger than expected EPS over the next six quarters. Currently, Safeway is gaining unit volume, indicating sufficiently competitive price points, and the economy is showing signs of stabilization. We note the shares' current yield of 4.25% (over 100% above the S&P 500 average) and the company's real estate holdings which have a purchase cost of $8.3 billion (land and buildings only). The price target is based on 6 X 2013 EBITDA and correlates to 13 X our 2013 earnings estimate of $2.46 per share. Safeway is expected to reduce total debt by $1 billion in the next six quarters through free cash flow and the proceeds from the Blackhawk IPO. The current dividend is safe and is covered 5.3 X by 2012 mid range free cash flow.
Grocers operate on thin margins that are normally expressed in percent of percents or basis points. The operating profit margin of Safeway has contracted from 4.2% in 2008 to a projected 2.4% for the end of 2012. We are forecasting a slight recovery in the operating profit back to the 2.9% area by the end of 2014. We expect the operating and administrative costs to grow at a slower percentage rate than the revenues through the next ten quarters. This is due to cost containment initiatives. Although we do not predict that Safeway will regain its full potential, the slight recovery combined with the grocer's recent share buybacks will drive earnings over $3.00 per share for 2014. The company could exceed this estimate if gross margins improve.
Current Economic Environment
There has been a contraction in the per capita spend for groceries. The current economic environment is weighing on all store types that sell groceries and is the most important factor for all participants. The primary reasons are higher unemployment and underemployment, and lower consumer confidence. A recent survey noted that 38% of people felt that their economic situation had deteriorated during the past year. This has led to lower average selling prices and slightly lower unit volumes. The most important factor for SWY is the general economy, not competition. We believe that the economy can slightly improve over the next 24 months leading to stronger revenues for all grocery formats. This is more relevant to the traditional grocers due to their strong convenience proposition. The second consideration is the evolution of shopping behavior and the competition between different store types for grocery sales.
The easiest grocery category in which to gauge market share amongst the different store types or "channels", is consumer packaged goods or CPG. The CPG category includes the items that we find in the center of the store, such as soda, coffee and chips. It is the most price competitive category because any retailer can sell packaged non-perishable items. Year over year consumer packaged goods (CPG) sales volumes are down 1.6% due to the economy.
CPG Dollar Share by Channel
Point change Vs. 2011
Source: Symphony IRI Group. Note: Convenience channel excluded as data are not fully representative; share will not total to 100%
The table above shows the changes in dollar share for the CPG category for each channel year over year. The share loss for the grocery group is 30 basis points and includes the weaker grocers. Stronger stores such as Kroger and Safeway are currently indicated to be gaining unit volume. Supervalu is losing around 300 basis points of revenue and is weighing down the channel comparison.
Safeway sales by category
% of sales
Below we highlight some of the information for each channel.
Drug and Dollar stores have gained over the last two years. Mass merchants, such as Target and Wal-Mart, have not fared as well and they have slightly lost market share. We group these channels together because they are similar. These alternative grocers are only competitive in CPG. CPG includes well known brands and the consumer has little risk in switching retailers. These stores are less competitive in categories such as meat, dairy, deli and produce. Therefore consumers need to save a certain amount in order to make the extra trip. A primary consumer strategy involves visiting different types of stores to buy the cheapest items available in each type of store. With the weaker economy, consumers are striving to maximize their purchase dollars. An additional consideration for the Mass, Drug and Dollar channels is convenience.
Supercenters (which include Wal-Mart and Target) and Club stores are essentially full-service grocers (with some limitations). Supercenters have lost dollar share slightly over the last two years. Club stores have shown strong gains of around 100 basis points in the last three years due to their strong value proposition.
Specialty stores, such as Trader Joes or Whole Foods, are gaining popularity, but these hybrids are small and are not competitive in items such as paper, cleaning, healthcare and beauty products. Both formats are less than 3% of the entire industry. Most consumers only shop for certain items at these stores.
Drug stores, dollar stores, hybrids and mass merchants, such as Target, which offer groceries as part of an overall store strategy, are not attracting consumers for solid full-spectrum shopping missions. The volume losses for the grocers have been concentrated in the weaker operators. Market share stability or gains by stronger grocers are the result of pricing and promotional strategies to directly compete with other channels. For instance: additional discounts for certain volume purchases. New programs, such as Just for You at Safeway, closely monitor consumer shopping habits and strategically offer discounts on certain items. At some point, the traditional grocers will be able to add additional convenience by offering delivery of certain items directly to the consumer through programs such as Just for You.
Safeway is Gaining Volume Share Across All Channels
CPG market gains by alternative grocers slowed in the first half of 2012 and reversed in the second quarter. According to the management of Safeway the trend continued to grow stronger in the third quarter. Safeway is growing market share at these price points and does not need to lower average prices. Managements of Kroger and Safeway have both predicted that their gross margin percentage will remain the same or improve slightly going into the second half of the year. Competitive pricing has reduced the attractiveness of multi-channel shopping, while promotional programs are helping to improve unit volumes and return price conscious consumers back into the traditional grocery channel.
Safeway is winning back business and there are early signs of economic improvement. Consumer confidence has gained throughout the third quarter and the stock market has risen. At this time margins have stabilized and unit volumes are improving for Safeway. Our enterprise value price target is $14.3 billion based on 6 X 2013 EBITDA and total debt of $6.3 billion by the end of 2013. This correlates to a per share value of $33.00 and 13 X 2013 earnings per share of $2.46. We note the company's $8.3 billion, original cost, real estate portfolio and the 4.4% dividend. We also note that Safeway could possibly realize enterprise values above this level by, either spinning-off or converting to a REIT.
% growth rev
y over y
Sales and other revenue
number of stores
Cost of goods sold
Gross profit %
O & A expense
% O & A
% operating profit
Income before taxes
Income net of tax
Safeway Earnings Estimates ( based on 239.5 mm shares)
3rd Q 2012: .48
3rd Q w/ item .71
4th Q 2012: .80
2011: 2,424 mm
Trailing 2,351 mm
( rolling 12 months as of June 2012)
2012 2,288 mm estimated
2013 2,380 mm estimated
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