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Grocery store chain Safeway (SWY) reported soft third-quarter results Thursday morning. Revenue slipped 0.2% year-over-year to $10 billion, slightly worse than consensus expectations. Earnings from operations grew 18% year-over-year to $0.45 per share, a few cents better than consensus estimates.

As we've noted several times, and specifically with respect to Supervalu (SVU), the grocery segment remains under intense pressure from warehouses and discounters. To read how our Valuentum Dividend Cushion tool helped financial advisors keep clients out of SuperValu before it cut its dividend, please click here. Same-store sales in the quarter ticked-up 0.1%, compared to the 6% same-store sales growth we saw from Costco (COST). However, the firm noted that same-store sales in the fourth quarter are currently running at 1%, driven by the popularity of the "just for U" program. This program gives sporadic, unexpected deals to shoppers and may include heavily-discounted, frequently-purchased items, as well as free items that the company's personalized program identifies as attractive to the specific consumer. Given the frequency of the deals as well as sizable incentives possible (depending on total spending), we expect the program to grow in popularity, though it may come at the expense of margins.

Not surprisingly, gross margins experienced downward pressure during the third quarter, falling 56 basis points to 26.44%. The firm blamed 11 basis points of the decline on lower fuel margins, with the rest due to the disposal of Genuardi stores and the ramp up of the "just for U" program. We expect weak margins to persist, as macroeconomic weakness and stiff pricing competition from Walmart (WMT), Target (TGT), Costco, Trader Joe's, and Aldi put downward pressure on the entire industry.

Keeping other expenses flat will be crucial. With margins running so thin, Safeway will have to use free cash flow to reduce interest expense, which it did, retiring $468 million of debt with its $505 million in free cash flow during the third quarter. At the same time, management may be tempted to under-invest in storefronts to save cash. We think such a move would be a huge mistake, as both Supervalu and Walmart attempted to do this, and it didn't work out well for either one. Luckily Walmart had a strong enough cash position to successfully invest in stores later, while Supervalu is (likely) a little too late given its recent troubles.

Going forward, the firm reiterated its full-year earnings guidance of $1.90-$2.10 per share, with free cash flow totaling $850 million to $950 million. Though these numbers imply a very low earnings multiple, the number is in-line with Roundy's (RNDY) and not terribly low given the risk of the business being in a secular decline.

Overall, we thought results were decent, but far from great. Unfortunately for Safeway, the entire grocery market is undergoing a massive transformation, so we expect that lower levels of profitability will prevail in the long run. Shares trade at the low end of our fair value range, but we think more downside pressure will push prices down even lower. Safeway is much better positioned to survive than Supervalu, but we won't be adding either to the portfolio of our Best Ideas Newsletter at this time (please click here for more information on our portfolio).

Source: Safeway's Earnings Beat But The Grocer Remains Weak