Safeway Grows The Organics Way (SWY)

Supermarket stocks are hot again with Whole Foods (WFMI) posting gains of over 30% and even Wild Oats (OATS) showing a meteoric 100% rise in its stock price over the last year. Supermarket investor Ron Burkle increased his stake of Wild Oats to 15% through his hedge fund Yucaipa. I understand that by this point you are thinking, "Wait a minute, is he not talking about good old Safeway (SWY)? How does that compare with Whole Foods or Wild Oats and the massive growth associated with the organic food industry"?

While Albertsons has been busy selling itself to a consortium led by Supervalu Inc. and CVS Corp., Safeway quietly embarked upon a strategy to introduce organic food products in its stores under the brand name "O Organics". The most interesting part about this strategy is that these organic products are not placed in a separate aisle nor are they priced higher than conventional items. The "O Organics" version of the famous Oreo cookies taste very similar to the original Oreos and in fact costs a little less. Safeway has rolled out 150 organic products under this new brand and the feedback has been positive from consumers. I got a chance to sample a few of their organic products and liked most of them.

Safeway is not alone in recognizing that organic products are gaining widespread adoption and even Walmart has recently introduced organic products in some of its stores. All of this brings to mind the question, what about margins? Organic products usually command a higher margin and hence could prove to be more profitable.

However with Safeway pricing the products at or below the price of conventional items, they could loose the potential gains in gross margins. It is entirely possible that Safeway is using this pricing strategy primarily to introduce its organic line of products and may increase prices in the future. I have seen the upstart Progresso (a division of General Mills) line of soups effectively steal market share from Campbell Soup (CPB) with a similar introductory pricing strategy.

Another concern with Safeway aggressively rolling out their organic line of products is supply. There are only so many certified organic farmers out there and some organic lines such as dairy have been known to have periodic shortages. It was not long ago that I found it hard to lay my hands on a gallon of Horizon organic milk. Horizon Organic was acquired by Dean Foods (DF) and a supply problem could be very negative to a highly leveraged company like Dean Foods. Dean Foods currently carries $3.3 billion dollars in long-term debt, $108 million in short-term debt and just $25 million in cash on its balance sheet.

My current interest in Safeway does not just stem from its introduction of this new "O Organics" product line. Large supermarkets and grocery stores usually operate on razor thin margins and generate much of their income from high volume and revenue. Safeway has been focusing on operating margins and it increased its operating margin to 3.3% in 2005 from 1.6% in 2004. This was done without sacrificing sales and revenue for 2005 was up 7.2%.

While Safeway carries an intimidating $5.60 billion in debt, it also lists $9.1 billion in property and equipment on its balance sheet. Given that many of these properties are in prime locations, their actual value is probably a whole lot more than what is stated on the balance sheet. The company is also profitable and generated over half a billion dollars in earnings last year. With a forward looking P/E of 14.27 and a P/S of just 0.29, Safeway could be a good stock to hold for the long-term.

Competitors:
Safeway faces competition from the Walmart (WMT) Superstores as well as the usual suspects such as Albertsons (ABS) and Kroger (KR). With its decision to sell organic food you could also consider Whole Foods (WFMI) and Wild Oats (OATS) as competitors. The United Kingdom's largest grocer Tesco also plans to make its debut on the West Coast of the United States in 2007.

The Good:

• The new "O Organics" line of products has received positive feedback and could spur revenue growth.
• Operating margins improved in 2005 and the company generated $561.1 million in net income.
• Attractive valuation with a forward P/E of 14.27 and current Price/Sales of 0.29.

The Bad:

• Margins may be impacted in the short-term due to the cost of rolling out this new product line.
• The United Kingdom's largest grocer Tesco plans to spend $400 million to start rolling out stores on the West Coast in 2007.
• A heavy debt load of $5.6 billion.

The Numbers:

P/S 0.29
P/E 20.14
Cash $373.3 Million
Long Term Debt $5.60 Billion

SWY 1-yr Chart

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