Safeway F3Q08 (Qtr End 9/6/08) Earnings Call Transcript

Oct. 7.08 | About: Safeway Inc. (SWY)

Safeway Inc. (NYSE:SWY)

F3Q08 Earnings Call

October 7, 2008 11:00 am ET

Executives

Melissa Plaisance - Senior Vice President, Finance

Steven A. Burd - Chairman of the Board, President, Chief Executive Officer

Robert L. Edwards - Chief Financial Officer, Executive Vice President

Analysts

John Heinbockel - Goldman Sachs

Chuck Cerankosky - FTN Midwest

Neil Currie - UBS

Deborah Weinswig - Citigroup

Mark Wiltamuth - Morgan Stanley

Scott Mushkin - Jefferies & Company

Ed Kelly - Credit Suisse

Meredith Adler - Barclays Capital

Andrew Wolf - BB&T Capital Markets

Analyst for Todd Duvek - Banc of America

Bob Summers - Pali Capital

Jonathan Chin - Private Management Group

Operator

Good morning and thank you all for holding. Welcome to the Safeway third quarter earnings conference call. (Operator Instructions) I will now turn the call over to Miss Melissa Plaisance, Safeway's Senior Vice President of Finance. Please go ahead.

Melissa Plaisance

Good morning, everyone and thank you for joining us for Safeway's third quarter earnings conference call. With me this morning is Steve Burd, our Chairman, President, and CEO, and Robert Edwards, Executive Vice President and Chief Financial Officer.

Before we begin, 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, earnings growth, operating improvements, cost reduction, capital spending, free cash flow, growth of Blackhawk, depreciation, product development, lifestyle format, and additional growth vehicles 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 that you refer to Safeway's reports and filings with the SEC for a further discussion of these risks and uncertainties.

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

Steven A. Burd

Thank you, Melissa and let me just make a comment at the outset -- if I don’t sound like myself, it’s because I’ve been nursing a cold and -- but it is me. There’s no stand-in double here.

Let me begin with the earnings for the quarter. Net income came in just under $200 million at $199.7 million. This compares to $194.6 million in the same quarter a year ago. Expressed in terms of earnings per share, we earned $0.46 per share, as contrasted with $0.44 per share, again one year ago.

The earnings per share growth was modest at just under 5%. Frankly in the current environment, we would regard this as a pretty respectable result. This brings our year-to-date EPS growth to better than 8% over last year’s numbers with our strongest growth quarter yet to come, quarter four. Not surprisingly, this was a soft sales quarter but we believe that we have bottomed out in terms of our ID sales.

We also absorbed a $0.04 per share increase in energy costs and our largest quarter LIFO charge in more than 18 years, costing us a full $0.01 per share on the quarter. So inflation continues. We also made significant price investments in the quarter, which clearly appear to be yielding strong results in terms of ID sales growth in the early part of the quarter.

Turning first to sales, total sales increased 3.9% over last year. Comparable store sales increased 2.9% and then when you exclude fuel sales, ID sales increased 0.5%.

ID sales continue to be negatively affected by the two factors that have affected us now for more than a year. The first is the shift from branded to generic drugs and the second is the market share gains that we are making with corporate brands. Those two factors in combination were worth just under 60 basis points and as you’ll recall, those are both profit winners. We make more money on generics and we make more money corporate brand, so not a bad thing to be happening.

As disappointing as the sales were, the marketing adjustments made in quarter three and earlier quarters are delivering much stronger results in the very early part of quarter four. Our run-rate in what now is almost five weeks ending on Saturday in what is admittedly a 16-week quarter, so it’s a long quarter, is running north of 1.5%

Turning to gross margin, our total gross margin rate declined 102 basis points from last year. When you exclude fuel sales, the gross margin rate on our non-fuel business declined 47 basis points. This decline was largely the result of targeted price investments, again focusing on everyday prices, coupled with increases in both LIFO charges and transportation expenses. These negative effects were partially offset by continued great results in shrink, some reduction in advertising expenses expressed as a percentage of sales, and favorable mix changes.

Year-to-date, despite significant investments in price, our gross margin rate after excluding fuel is down a modest 11 basis points. This modest decline is largely the result of really some extraordinary shrink results, coupled with a more efficient advertising spend.

Turning to O&A expenses, O&A expenses declined 82 basis points from last year’s third quarter. Forty-nine basis points of that decline is the result of higher fuel sales. When fuel sales are excluded, the remaining 33 basis points of decline is largely due to lower employee expenses, partially offset by increases in energy costs and occupancy costs.

Year-to-date, largely due to some great retail execution and a strong cost reduction effort, our O&A expenses excluding fuel have improved some 26 basis points, which is more than enough to offset the year-to-date gross margin decline of 11 basis points and thus improving margins on the year, and again we expect to improve margins throughout all of ’08 as we finish the fourth quarter. As indicated in our second quarter earnings call, we expect cost reduction efforts to be even stronger in quarter four as those savings ramp up for us.

Turning to interest expense, interest expense declined $9.2 million, due both to lower debt outstanding and a reduction in our average borrowing rate. The average debt outstanding was lower by $109 million year over year, from $5.9 billion to $5.8 billion, and our average borrowing rate declined some 56 basis points from 6.63% to 5.96%.

Looking forward, we have some debt maturing in November, as most of you know. We have $285 million maturing in Canada. This maturity will be met largely with cash on hand and a modest amount of bank borrowing. The $550 million maturing in the U.S. will be refinanced in a combination of debt capital markets, commercial paper and money market lines, or if needed some bank borrowings.

With an interest coverage ratio of more than eight times, some very stable cash flow, strong free cash flow, stable debt ratings, we are expecting a good reception in today’s difficult debt market.

In terms of capital expenditures, we completed four new stores and 51 remodels during the quarter. Year-to-date, we’ve completed eight new stores and 119 remodels. As a result, we now have 66%, or if you will, 1,151 stores in the lifestyle format. By year-end, we expect to have 1,286 stores in that format. This means that 74% of our store fleet will have been through a major remodel and frankly transformation in just four years time, which is something this company has never been able to say. This will give Safeway we think the best conditioned store system in our sector and gets us very close to a common look and feel, enhancing our opportunity to brand our shopping experience, which has long been our goal.

We’ve invested a total of $1 billion year-to-date and are on track to spend between $1.65 billion and $1.7 billion for the full year.

Looking at cash flow, free cash flow for the quarter was $261 million, compared with last year’s third quarter of $139 million. During the quarter, we repurchased $185 million in stock for a total of 6.9 million shares.

Our year-to-date free cash flow is at $499 million. You’ll recall our guidance for the year is $500 million to $700 million in free cash flow, excluding the effects of Blackhawk, which of course are positive.

Our share repurchases totaled 12.6 million shares at a total cost of $359 million, and then on a year-to-date basis, we paid $97 million in dividends.

Just a few comments on Blackhawk -- Blackhawk continues to grow at really an extraordinary rate in face of a soft retail environment. The face value of [all card] sales increased 53% against last year’s third quarter and on the three quarters so far this year, or year-to-date, [all card] sales are up some 59%.

If we look simply at the retail partner cards, because that’s the sector as you know that has been significantly impacted by the slowing economy, so I’m excluding telcom, [open loop], sports and entertainment, we’ve experienced an increase of 61% for quarter three and we’ve experienced 65% for the first three quarters of this year.

Through three complete quarters, Blackhawk is running slightly above plan on both a sales and income basis, so no surprises there.

In terms of guidance, our annual guidance remains unchanged. Our ID sales for 2008 should be in the range of 1% to 2%. Our EPS is expected to be $2.25 to $2.35 -- again, that’s on a 53-week basis. Those numbers do not include any effects from Hurricane Ike, which we’re still working through those numbers.

Free cash flow excluding Blackhawk again should be in the range of $500 million to $700 million.

So all in all, we think we had a good quarter, despite what is a rough economic environment out there. We expect our sales results to continue to show much stronger results in Q4 relative to Q3 and expect to finish with a strong fourth quarter.

So with that, let me turn it over for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question today is from John Heinbockel and please state your company name.

John Heinbockel - Goldman Sachs

Steve, a couple of things; if you look at the up-tick in ID momentum here in the last five weeks, could you talk about how broad-based that is? Is it traffic or ticket? And do you find the customer, as you look at the data, doing anything strange because there has been a lot of talk in the last couple of weeks about the customer being paralyzed and just kind of going into a bit of a cocoon, so any color on that would be great.

Steven A. Burd

Sure. First of all, I would tell you that the sales up-tick is very broad-based. As I look at what we call our 10 operating regions of the company, virtually all 10 operating regions are running stronger than they ran in the third quarter and we don’t find anything particularly strange about the consumer behavior.

John Heinbockel - Goldman Sachs

Traffic versus ticket -- is there anything interesting there?

Steven A. Burd

Yeah, there is, quite frankly because we’ve struggled as you know with traffic and traffic and ticket are both up through the first almost five weeks of the quarter.

John Heinbockel - Goldman Sachs

All right. Secondly, if you look at the fourth quarter, where it does appear that you are looking for a better EBIT margin performance out of the retail business, is that more comp momentum in what that does to expenses or do you think you dialed back the level of price investment or do you keep that the same?

Steven A. Burd

No, I don’t see any dialing back in the price investment. I see better results on the O&A line. I see a bit of leverage from the sales line and then keep in mind that two things that really drive the fourth quarter in terms of its comparison to last year is we are in a 53-week year and of course Blackhawk's business is largely a fourth quarter game. And with the sales and income growth of Blackhawk, that provides a very nice growth for the fourth quarter.

John Heinbockel - Goldman Sachs

All right, and then finally how is lifestyle doing in this economy? You know, are you seeing the up-lift in comp soften a bit? I imagine maybe you have. And secondly to go along with that, is it at all possible that, I know you were going to basically end lifestyle, the remodel effort at the end of ’09. Could that be moved up a bit, say six months, if the lift from lifestyle has ebbed here in this economy?

Steven A. Burd

John, in terms of the lifestyle results, as we look at the kind of sales lift that we get, the sales lift that we’ve been getting in ’08 is really not any different than it was in the previous three years. What’s different is we are working into a store base that has an average weekly sales level that is lower. So while the percentage lift is essentially equal to what it’s been all along, the absolute dollar lift is going to be lower. But -- and that moderates the returns a little bit but still exceeding our hurdle rate, which we have long set at 22.5% pretax, cash on cash.

So we continue to get good results there. We haven’t laid out all of our plans for ’09 but right now, not really seeing anything that would cause us to change any of our target dates but we remain open on that. We continue to look for ways, John, that we can open these stores much more efficiently because if you think about it, in the last three years we were often introducing a lifestyle store to the market place and so we had to put a lot of effort into that, whereas now almost all of our customers except for remote locations have experienced a lifestyle store, so it’s a welcome addition to their neighborhood when we lifestyle it, so we think there’s an opportunity for us to spend less money on the launch and get essentially the same kind of sales result.

John Heinbockel - Goldman Sachs

Okay. Thank you.

Operator

Thank you. Our next question is from Chuck Cerankosky.

Chuck Cerankosky - FTN Midwest

Going back to the lifestyle a little bit, Steve, as you open these stores in this economic environment, what do you tweak or adjust, given that customers are a little bit more price or a lot price sensitive than they have been and maybe less attracted to the upscale elements of lifestyle.

Steven A. Burd

You know, I think probably the -- in addition to basically making some everyday price movements and making some significant movements in our corporate brand pricing, in terms of the opening I would tell you that we are just a lot more thoughtful about how we merchandise the store and so I think that the merchandising shouts to greater value than it did say a year ago. And it’s not because prices are dramatically difference. We continue to invest in price but we’ve been spending a lot of effort on how we merchandise those stores, whether it be for a lifestyle opening or just our weekly business.

Chuck Cerankosky - FTN Midwest

What can you tell us about sales mix in the quarter, Steve, versus -- things like prepared foods, more discretionary categories, or even say the mix within a department where there is a lot of room to move from upscale to down -- less upscale, I’ll call it, when you’re talking about a seafood counter or the overall meat department and things like organics?

Steven A. Burd

I would tell you that we still see discretionary items struggling more, as you would expect, but I would tell you that as we look at our -- on our perishable mix, we’ve seen a real resurgence in perishables. Again, our sales lift, particularly here in the early fourth quarter, has been a combination of perishable and non-perishable. But you know, it’s always been my feeling that food is -- you know, when you buy food, whether it’s in a restaurant or grocery store, it’s a serious expense and so you want to make sure you’ve got the best quality. So I actually think that our quality is actually helping us a lot right now, the quality differential. So if you are on a tight budget, let’s make sure that you buy some produce that you don’t have to throw away and so we’re seeing a bit of a resurgence in really the entire parameter of the store.

Chuck Cerankosky - FTN Midwest

With the extra week in the fourth quarter, [anything] about how it affects Blackhawk? Does it give you more selling days or is the extra week really not so much a holiday spending period for Blackhawk?

Steven A. Burd

No, I think that our quarter is going to end on the third. I don’t think it’s going to really have a particular effect on Blackhawk and I think it will just be kind of a normal year for them. I don’t think there’s any particular pop that will come from a couple of extra days.

Operator

Thank you. Our next question is from Neil Currie.

Neil Currie - UBS

Thanks for taking the question. I just wanted to ask if there’s any update on the trial that you are running with the pre-prepared meals. I know you were bringing the production over to the West Coast and looking at Northern California as a trial. I wonder whether you are ready to update us with that and any progress.

Steven A. Burd

You know, we continue to make progress there. I think I reported an earlier call that the real challenge with this fresh product was to control the shrink. So our initial test covered about 12 stores. I believe we are up to 50 or 70 stores right now and have done a good job managing the shrink. We are going to be very thoughtful about how we roll that out. You will see it rolled out to the West Coast in all likelihood first but we are just being very measured in how we do that.

Again, the product is well received but we are being careful not to go so fast that we can’t control the shelf life. So we’ve reformulated some of the product, giving it an extended shelf life without sacrificing the quality and it’s just some things take longer than others and this is taking longer but I think we will get good results with it.

Neil Currie - UBS

And obviously that would be, if it works, it would be a good opportunity to offer value of a sort against restaurants and I was just wondering if there are any sort of -- is there any color you can give on that trend in general? How do you feel you are benefiting at the moment from restaurant shoppers, or restaurant --

Steven A. Burd

You know, one of the things that we’ve done is we have -- we’ve been running a promotion recently featuring some of our best meal products. You know, more traditional stuff like meatloaf or rotisserie chicken and turkey breasts, introducing so much more of our consumer base to some old standards and building market share in those areas. And so that’s been going on now for probably 12 weeks or more, and so we are seeing a step up in those traditional meal solutions, and then people come in and buy the other components. So that’s more of the old standards than necessarily pushing because we don’t have critical mass on some of the new meals.

Neil Currie - UBS

Okay. If I could just ask a couple of quick questions -- one on the north of 1.5 number you gave. You said that’s a run-rate. Is there a number you can give for the first, the early weeks in total of the fourth quarter or would that be a good reflection of that?

Steven A. Burd

Well, that’s a reflection of that. I mean that, you know, we’re in our fifth week right now. You know, relative to recent history, both the third quarter and the second quarter, just the numbers are running very strong.

Neil Currie - UBS

Okay, and how did the inflation trends go during the quarter? Did you see an up-tick in inflation or steady against the previous quarter?

Steven A. Burd

You know, still a lot of inflation out there. The fact that the LIFO charge is the highest it’s been in 18 years would suggest at least in our LIFO layers an up-tick. You know, I do think the vendor community is starting to suffer the consequences of less demand. It’s too early to predict that we’ll see some abatement there but that is possible in the fourth quarter.

Neil Currie - UBS

Sorry to hog the questions here, I just want to ask a final one, which is are you seeing -- it’s early days but so far you seem to be balancing well the price investments, the cost reductions, and ID sales seem to have started well in the current quarter. On the cost side, how many more buckets do you have to address? Does it get more difficult as we move into ’09 to continue to balance some of the price investments with cost reductions or will you really move into a situation where the sales increases really need to balance that?

Steven A. Burd

Well, I think that we remain confident that we have a lot of cost reduction we can get due. As you know, there’s a perception out there that we need to invest more in price and that as we do that, there’s this perception that it will damage earnings. We don’t think that’s the case. We believe that we have a lot of opportunity yet to lower cost and we believe that we can use those lower costs to finance necessary price investments. And then if you get the good sales response, that of course begins to leverage some of your fixed costs, so we remain confident that we’re an earnings growth story and we can do what we need to do on price without sacrificing earnings growth, both in ’09 and beyond.

Neil Currie - UBS

Thank you and good luck with that.

Operator

Thank you. Our next question is from Deborah Weinswig.

Deborah Weinswig - Citigroup

Steve, what can you share with us in terms of the marketing adjustments that you stated earlier in the call that are driving the stronger results in the fourth quarter so far?

Steven A. Burd

Well, you know, it’s a combination of things that we have done and while some of them were done in the third quarter, we’ve been making investments in price for a long time. I think the third quarter was probably one of our strongest quarters of price investment yet. But we are just concentrating on the items that matter most to consumers and then we made very significant changes in our corporate brand pricing, which are causing the sales of corporate brands to dramatically outpace those of national brands. You know, we operate with a large number of fueling stations, which allows us to build loyalty promotions that link to fuel. We are taking advantage of what are natural events for consumers and gearing our marketing around that, so that we’ve been running some promotions for food items that you might consumer on a Sunday football game. So just trying to take advantage of natural consumer events and play our marketing to that.

So you know, it’s a whole combination of things. We said at the end of the second quarter call that we thought that we would build momentum because of all of the steps we had taken and I think the sales have popped a little earlier than we expected and it is a long quarter but we expect the fourth quarter to be much stronger.

Deborah Weinswig - Citigroup

Steve, can you provide more color with regard to your comments on corporate brand growth versus national brand growth in the quarter?

Steven A. Burd

I’ve commented on this in the past -- if you look at the center of the store, the center of the store is about 700 basis points higher in corporate brand than it is on national brand. So that means you are building a lot of market share in corporate brand.

Deborah Weinswig - Citigroup

Great, and then last question -- how was shrink improvement so far in ’08 versus company expectations?

Steven A. Burd

We are way ahead. We had set a goal of about $50 million on the year. We’ve got some challenging comparisons in the fourth quarter but we continue to run ahead of that number in the third quarter. So easily 30% higher than our entire goal for the year.

Deborah Weinswig - Citigroup

Well, congratulations and we look forward to seeing you in December.

Operator

Thank you. Our next question is from Mark Wiltamuth.

Mark Wiltamuth - Morgan Stanley

Steve, could you give us a little look at how the comp progressed throughout the quarter and what month did you really bottom out? Or was it an up-and-down trend?

Steven A. Burd

You know, I would tell you it was pretty much kind of an up-and-down trend. You know, it’s a real hard one to sort of pattern so nothing remarkable about the quarter.

Mark Wiltamuth - Morgan Stanley

Okay, but was there a sense that things got a lot better at the end of the quarter, so this is really a trend we are seeing, or is this part of a more up-and-down pattern and we just happened to hit an up month here at the beginning of the fourth?

Steven A. Burd

Well, I think when I look at the beginning of the fourth, particularly given how broad-based virtually every division, you know, transactions up, we don’t think that the fourth quarter is a blip on the screen. We think it’s a result of a lot of work we’ve been doing now for more than a quarter.

Mark Wiltamuth - Morgan Stanley

Okay, and is there any way to quantify the margin sacrifice you’ve made, or the investment you’ve made throughout the third to get into the fourth?

Steven A. Burd

No, I mean, it’s reflected -- you know, the margin investment that we made is reflected in our gross margin rate in the third quarter and we’ll continue to invest in margin as we move through the fourth quarter. I mean, what you really try to do is you try to do things that give you a great demand response and when you invest in everyday price, you try to bring those price changes to the attention of consumers but they don’t always pick up on it so I would tell you that some of the significant investments we made in everyday items, the demand response to that, let’s say the first six weeks versus the last six weeks is probably a three-fold difference. And so it’s a little bit like pump priming, where you make the investment, you know it’s going to pay out but it takes several weeks, whereas if you invested in promotional pricing, there’s an immediate response to that but we want to provide better everyday values for our customers and so that’s where we are concentrating our price investment.

Mark Wiltamuth - Morgan Stanley

And it sounds like you made more investment on the private label price. Was that at the opening price points, at the very bottom of the scale or kind of across the board in private label?

Steven A. Burd

It’s across the board and again, that’s been in place for the vast majority of our corporate brands for more than a quarter but again, it takes a little while for it to take hold and attract the consumer attention, and that’s where good merchandising can affect that more quickly.

Mark Wiltamuth - Morgan Stanley

And I guess the switch-over to inflation, do you feel like we still have a lot more packaged food increases to go and when do you think some of that may start to abate, given that some of that broader soft commodity prices have cooled off a little?

Steven A. Burd

Well, you would think that there would be some abatement coming there because the vendor community has clearly had unit declines and now they’ve had commodity price declines. You know, unless they want corporate brands to continue to build share against them, I think eventually we should see some softening. That has always been the pattern.

Mark Wiltamuth - Morgan Stanley

Okay. Thank you very much.

Operator

Thank you. Our next question is from Scott Mushkin.

Scott Mushkin - Jefferies & Company

I just wanted to poke at the inflation numbers and the sales numbers, just to understand a little bit better. We saw -- but I guess you guys, both you and Kroger, both said September picked up a little bit and I just -- you know, there were huge price increases that went through the packaged good channel, plus there was significant price increases that have gone through the perimeter as well. I mean, how much of what we are seeing is just a reflection in price? I mean, there is some indications that price at retail jumped somewhere between 5% and 10% between August and into September and just trying to tie up the idea of like traffic and ticket being up, although we are seeing probably inflation like we’ve never seen before that rolled through.

Steven A. Burd

Well, I think the quick answer to that, when you consider that transactions were actually up, which we struggled with now for several quarters, that’s a pretty good sign. I’ve never considered inflation to be our friend because when prices go up and we all took some economics, you know, demand goes down. So that’s never been particularly good for us, particularly at these levels of inflation. And then I think realistically, you know, when you are looking on the perishable side of things, often you are recouping your pennies of profit as opposed to your gross margin rate and so you really look for cost of goods declines there because they can help you out a great deal.

So I think when you consider the fact that the sales increase has been coupled with transactional increases and it’s basically across the board, I think that’s a pretty good sign.

Scott Mushkin - Jefferies & Company

Then I just wanted to touch on the restaurant channel. I mean, obviously we’ve seen you guys, the food at home channel gaining share quite a bit over time but now we are starting to see restaurants get a little bit more aggressive with pricing over the last couple of weeks. How do you think this plays out as you look in and how do you look at that channel as far as do you look at them as direct competition and do you think if they get aggressive with pricing, it could affect your business?

Steven A. Burd

We do look at them as competition. I do think the restaurant channel is really hurting. No one really expects the economy to get any better and so I don’t live in fear that they are going to do something on price and win back business. You know, it’s expensive to eat out. You not only have to pay for the food, you have to pay for the service. And so I think that sector is going to be down for the balance of 2009 and it gives us an opportunity to take share.

Scott Mushkin - Jefferies & Company

And then one final one on the refunding needs that you talked about -- now maybe this changes things with the fed announcement this morning but I know Kroger, which I think is pretty comparable from a credit perspective to you guys, had to go and tap their lines of credit, that they have problems rolling over CP. What makes you so confident -- or not so confident, sounded terrible but what makes you confident that you will be able to get this done in early November?

Steven A. Burd

Robert, do you want to address that?

Robert L. Edwards

Scott, I think a number of things. If you’ll recall, we’ve paid off a significant amount of debt over the last five or six years, between $2.6 billion to $2.7 billion. We’ve got very good ratings through the ratings agencies. You know, we’ve continued to have access to commercial paper on a daily basis and I think you are right -- the announcement from the federal reserve this morning I think will make more commercial paper available and hopefully at better rates, and so although it is a challenging environment, based on just the fundamentals of the company we expect to be able to refinance the debt coming due.

Scott Mushkin - Jefferies & Company

All right, perfect. Thanks so much for answering my questions.

Operator

Thank you. Our next question is from Ed Kelly.

Ed Kelly - Credit Suisse

Steve, could you revisit what Safeway will look like from a financial perspective, beginning in 2010 when you are done remodeling stores? I think there’s about $0.17 of non-recurring lifestyle launch costs. How quickly can you recoup those? And then you’ve talked about CapEx of about $1.4 billion but to me it seems like that could easily be lower, so I don’t know if you’d care to comment on that.

Steven A. Burd

Sure. I think that I don’t have all the details in front of me but I think that the lift that we’re expecting at the end of the lifestyle program is about $0.27 per share and there are a couple of pieces of that. One is we are not investing what we’ve been investing to launch these stores. Depreciation begins to moderate and so all of those components add up to about $0.27. I’m sure we published those details before. I can’t break it down for you right here but we still expect that to be the case. And the current expectation would be that that happens in 2010, and so that also frees up a lot of cash flow. You know, conventional wisdom, which I wouldn’t really dispute, is that a typical supermarket company would spend about 3% of supermarket sales revenue and they could easily maintain their fleet of stores and have a reasonable complement of new stores. And so you are probably in that range of $1.2 billion to $1.4 billion, and so yeah, there should be a real step-down in capital, which will dramatically improve the free cash flow in 2010 and beyond.

Ed Kelly - Credit Suisse

Okay. And you talked about the opportunity to spend less on launch costs in 2009 -- is that from a CapEx perspective, from an expense perspective, or both?

Steven A. Burd

No, that -- if we -- you know, right now it’s a little bit of a hypothesis that we have an opportunity to test here. If in fact we can do that for the reasons that I outlined, that would actually bring some of that $0.27 forward.

Ed Kelly - Credit Suisse

So that’s the opportunity, is what you are saying?

Steven A. Burd

That’s correct. We’re talking about expenses, expense money. We’ve already done a great job of reducing our costs, of doing the lifestyle remodel. A disproportionate amount of remodels that remain fall into that category of lifestyle light, which are much less expensive than either a core lifestyle or what we’ve come to call an elite lifestyle.

Ed Kelly - Credit Suisse

Okay, and then last question for you, can you just help us understand how we should look at the gross margin over the next few quarters? I think you’ve indicated that Q4, you’d be making the same type of investment but does that imply the same type of decline in gross margin? And then how do we think about that next year?

Steven A. Burd

Yeah, I think that the way to think about it, in 2008 we stopped giving guidance separately for gross margin and O&A and started giving guidance on operating margin, and so rather than try to piece that apart, because it’s so hard, particularly in this changing environment, to be right on both numbers, we are confident that our operating margin is going to be up on the year. Our guidance puts us in the range of 15 to 35. I commented on this call that on a year-to-date basis, we were 26 basis points to the good on O&A and 11 basis points of net investment in gross, so that’s 15 basis points right there. And obviously in the fourth quarter, Blackhawk helps us out on margin. So it should be a good operating margin quarter in Q4.

Ed Kelly - Credit Suisse

Okay. Thank you.

Operator

Thank you. Our next question is from Meredith Adler.

Meredith Adler - Barclays Capital

Thanks for taking my question. I would like to just start a little bit talking more about the great expense control that you’ve accomplished so far. I think you specifically mentioned that it was coming from labor, and maybe we could just get into a little more detail -- is that mostly benefits and how much of it is tied to the contracts that you’ve signed recently? And then sort of what would be the expectation on the labor side for the next year or so?

Steven A. Burd

Sure. I think that it’s really a combination of things. You know, some of the contracts that we signed, you know, what I often refer to as the restructuring that we began signing in 2003 and beyond, continue to benefit us, particularly on the benefits side of the equation, Meredith. And then a lot of what you see in 2008 would be looking for efficiencies in our operation. You know, we talk internally in the company about harvesting the differences and I’m a big fan of looking at the distribution, looking at the two extremes, and then looking to see what’s different about the stores that are terribly efficient versus those that are much less efficient. And in that you find all kinds value, and then it takes some effort on the part of your field team to execute that, so once you find the value-creating opportunity, sometimes it can take you a year or more to realize that.

But if you were -- and then that causes us to change our labor standards but if you were to ever see our performance against labor standards, they are remarkably consistent over what I would tell you in my own experience is a 16-year period. So it’s not taking labor content out of the store, it’s taking work out of the store and making things more efficient, which allows the labor to be reduced.

And that happens to be sort of my core strength, my history and we believe there’s a lot more yet we can do to improve the efficiency because we look at the distribution and there are vast differences still even today. And so that’s what you will see us address in ’09 and frankly beyond.

Meredith Adler - Barclays Capital

Because I like to look at SG&A growth rates in dollars and you achieved an astoundingly low growth rate this quarter of 0.5%. Do you think that that kind of level would be sustainable? There’s obviously some inflationary pressures on the O&A line.

Steven A. Burd

Yeah, I would tell you that if you look at our -- if you look at the labor agreements that we’ve been signing here over the last year, they carry wage increases and so it really forces us to become more efficient in how we use that. You know, everybody likes to get a wage increase, probably everybody on this phone call likes a wage increase. But if you don’t match that off against productivity improvements, then it’s always going to cost you money. And so we are very good at looking for productivity improvements.

You know for us, just analyzing the check stand and removing a second in a typical transaction is worth millions of dollars and so that’s something that we’ve always been very, very good at and I really don’t see any end in sight. It is a real -- you know, people think we have to invest in price and they think that we can’t find the money to do it and we disagree with that. And if you look at my 16-year history, it says that we’ve always been able to find the money and we have a real determination here to make whatever changes we have to make in the operation to finance good consumer price investments, and so we’ll do that in 2009 and we’ll do it again in 2010.

Meredith Adler - Barclays Capital

Great, and then a just totally unrelated question -- you historically have talked about the fourth quarter benefiting from a mix change, that there are people who will buy maybe more discounted products and they are just feeding themselves but for the holidays, they like to go someplace where they know they are going to get good quality and Safeway has always benefited from that. Do you think that will continue?

And then a related question is this Christmas falls on a Thursday, just like Thanksgiving falls on a Thursday. Do you think that changes the mix between Thanksgiving and Christmas? And Thanksgiving is usually more promotional, so just sort of comments on that.

Steven A. Burd

A Thursday Christmas -- you know, we’d prefer it on a different date but it’s certainly better than a Monday or a Tuesday, so I think it will be a good Christmas and we’ve tended, as you know, to do extraordinarily well on holidays. And as I look at the last couple of holidays, I’m particularly thinking about the July 4th holiday, which was a really big holiday -- I mean, what consumers did, they wanted to have a great fourth and so they just saved for it and the fourth was a great fourth. And so what consumers have a tendency to do, and I’m sure they will do it at both Thanksgiving and Christmas, they may throttle back a little bit in advance of Thanksgiving and in advance of Christmas, but then come Christmas and Thanksgiving, those weeks will be as strong as ever.

Meredith Adler - Barclays Capital

Great. Thank you very much.

Operator

Thank you. Our next question is from Andrew Wolf.

Andrew Wolf - BB&T Capital Markets

Good morning. Steve, this is really a follow-on to a point you were just discussing with Meredith but what inning are you in in price investment as a company? And is this really a fundamental kind of shift in your strategy a bit out of promotion into pricing that we would expect to see in any environment, or is it a little more influenced by the current environment?

Steven A. Burd

No, I think that if you go all the way back to 2004 when we talked about really differentiating ourselves from the balance of the supermarket industry, focusing on quality and building an environment that we think is second to none, we also talk about becoming less promotional back in 2004. And so we’ve been making everyday price investments along the way. We will always be a promotional player and we will probably always be a bit more promotional than others that we compete with, so we are really just talking about a spectrum and getting ourselves off the far end of that spectrum, really not moving to the middle but maybe just north of the middle. And so I don’t think I want to describe it as necessarily what inning are we in. We still believe that there’s no reason why we shouldn’t carry a long-term ID sales growth rate of 3% to 4%, and frankly while it will take us some effort to get back to that level, we’re not allowing the current slow down in the economy to be an excuse for not getting there. We think we are doing the right things to build us back in that direction. We think that a lot of the things that we have done, you have not yet seen play out in terms of ID sales. There’s a lot of effort that is underway in virtually all of our operations and more yet to be done. But I think that you are going to see a nice improvement in sales as we play out the fourth quarter.

Now, the fourth quarter is a very long quarter, so it’s too early for us to predict that we will end north of 1.5 because frankly, we are a little stronger in the early part of the quarter than we expected but clearly fourth quarter is going to be better than -- you know, it’s going to be better than three, it’s going to be better than two and we expect that momentum to continue in the first quarter of next year and then through next year.

Andrew Wolf - BB&T Capital Markets

Okay, just a quick housekeeping question -- on your $4 generic drug program that had launched earlier this year, can you say what percent of the store base offers that and if it had much of a meaningful effect on either your sales or the gross margin?

Steven A. Burd

You know, virtually all stores will offer a $4 generic. Some are promoting it heavier than others but we have a $4 generic matching program really across the board.

Andrew Wolf - BB&T Capital Markets

Okay. Can you say which -- would you care to comment on whether it had any meaningful effect for the business?

Steven A. Burd

You know, I’m not going to comment on the specifics. I think that we felt compelled to offer that, let me put it that way.

Andrew Wolf - BB&T Capital Markets

Okay. Thank you.

Operator

Thank you. Our next question is from Todd [Duvek].

Analyst for Todd Duvek - Banc of America

This is actually Tom [Trexilo] from Banc of America standing in for Todd. I appreciate your comments about the refinancing needs coming up and what your plans are. I was wondering if you could just talk a little bit about the thought process you go through when you are deciding on whether to tap the capital markets, tap your revolver, or try to elevate your CP balance?

Steven A. Burd

Robert, do you want to deal with that?

Robert L. Edwards

Well, a number of things come into play. Essentially where the credit facility is really a back-stop and we’ve been fortunate we have not had to tap that but it clearly is available if we need to but so far we have not had to, and so we look at the mix of what the rates are on commercial paper but the amount that we are refinancing really is long-term debt and so the specific intent now is that we would refinance on a long-term basis. But depending upon changes in the market, as you know, things are quite volatile now, we may use the CP. So it will just depend on what the rates are and the situation as we move through the next three, four weeks.

Analyst for Todd Duvek - Banc of America

Okay, and I heard -- you made a comment about not having a problem rolling over CP. Are you mainly doing that on an overnight basis or have you been able to kind of extend some of that?

Steven A. Burd

Well, it’s a mix of both. I mean, given the last couple -- the turmoil in the market in the last couple of weeks, it’s been primarily overnight but there has been some term and it changed, the mix changes on what’s been available over the last couple of days. Now, with the fed’s announcement today, hopefully there will be more term available.

Analyst for Todd Duvek - Banc of America

Okay. Appreciate the color. Thank you.

Operator

Thank you. Our next question is from Bob Summers.

Bob Summers - Pali Capital

Just a couple of quick questions -- if I recall, I think last year’s fourth quarter ended on a weak note from a comp perspective. I think it was the last two to three weeks, or something like that. Can you frame that again for us?

Steven A. Burd

Boy, your memory on that is a little -- I have to look at a calendar to see that. You know, this year with the 53rd week, we are going to end on the third so essentially the entire year is going to encompass both Christmas and New Year’s, so that should be pretty favorable.

Bob Summers - Pali Capital

Okay, and then just from a housekeeping perspective, you mentioned that all 10 operating divisions were running better than the third quarter over the first five weeks. Are all comping positive?

Steven A. Burd

No.

Bob Summers - Pali Capital

Okay, and then just kind of thinking through the environment that we are in, has there been any thought to maybe pulling the cash flow piece of your story a little forward and maybe pulling back a little more on anticipated lifestyle remodels?

Steven A. Burd

Can you repeat that, Bob?

Bob Summers - Pali Capital

Given the overall environment and given sort of broadly speaking where lifestyle stores are positioned in the consumer spectrum, has there been any thought to maybe pull some lifestyle remodels off the table in ’09 and pull the cash flow piece of your story, which emerges more significantly in ‘010, a little bit forward?

Steven A. Burd

You know, that’s always an option. We’ve been in a bit of a hurry to complete the lifestyle remodels because it works as both a great offense and a great defense, so -- but we always look at the pace and what we ought to do and we haven’t decided yet. We’re in the throes of building the 2009 plan but frankly if we can accomplish what we want here in terms of lowering the launch costs, it gives us that much more flexibility to do what we want there on the remodels.

You know, it’s still -- you know, some people think that -- you know, I’ve read where people think well, we have the wrong strategy because it’s a recession. I mean, strategies are not supposed to be designed around short-term events, which business downturns are and so we think that the lifestyle stores and completing them is a good long-term play for us and it generates good sales increases along the way.

Bob Summers - Pali Capital

Okay, and then last question, I think in the past you’ve described mid-single-digit inflation as a challenging neutral. According to some metrics, we’re running north of that. It seems like you are absorbing it quite well. Can you just talk about what some of the strategies have been in order to accomplish that?

Steven A. Burd

Well, I think that what we’ve had to do is just really stay on top of any of the price movements and whether or not you pass something along immediately is a function of both how the consumer might respond and what the competitive environment might look like, and so it’s a bit of a trial and error type effort. And then I think I’ve commented in the past when you have inflation, most labor models, certainly ours, are built off of sales and so if the sales increases are the result of the cost of goods going up, you have to inflation adjust your sales so that you are really looking at units of work. And we used to do that in the old days. We used to probably do that in six-month intervals but we have really shortened those intervals so that we are managing the labor content in our stores much, much more closely than we did in the past because of that rate of inflation.

Bob Summers - Pali Capital

Do you think you are capitalizing on other operators that may be trying to hold too much onto margin?

Steven A. Burd

You know, I mean, it’s -- I don’t think in any major way. I mean, we always watch what our competition does. You know, we are really just trying to recoup inflation when it occurs and do the smart thing.

Bob Summers - Pali Capital

Okay. Thank you.

Operator

Thank you. Our final question today is from Jonathan [Chin].

Jonathan Chin - Private Management Group

[Private] Management Group. Steve, I was wondering if you can go ahead and comment a little bit on your fresh market in Long Beach and how things are going there?

Steven A. Burd

Sure. That store was actually a remodel. It’s about 15,000 square feet in terms of gross square footage. I don’t know if you’ve had a chance to see it. It is -- it has a very strong perishable presentation. On the outside, it looks like a lifestyle store. On the inside, it looks like a mini version of a lifestyle store. The perishable presentation is easily 50% of the store. We had to dramatically cut back on the SKU count, the stock keeping units. It’s got a richer mix of private label than a typical store and the store has done quite well.

It is an experiment and our approach is to build one, learn from it, build a couple more. You know, we’ll make a good return on this initial one but our current thinking is that we will probably get stronger results from a ground up store as opposed to necessarily a remodel.

Again, making a good return on this and what we are trying to determine is whether or not this is going to make a meaningful difference. We’ve proven that we can build a small store and make money but that’s not what it’s about. If it doesn’t create a market opportunity to build 30 or 50 of these per year, then it was just a nice experiment.

At the same time, we’ve learned a lot about what might be possible in a conventional store and so we would regard the benefits from what we’ve learned on how to adjust maybe the SKUs in conventional stores is going to be the biggest near-term learning out of this, so that we can take a store that is maybe 40,000 square feet that we would consider under-sized. We can create the perishable experience of maybe a 55,000 square foot store without sacrificing kind of the merchandising area that we would normally think we would have to sacrifice because of some SKU opportunities that frankly we wouldn’t realize had we not done the small store because when you put a center store item into a store that small, it causes you to think pretty radically and we’ve got examples of categories where we lowered the SKUs by more than 50% and increased our sales over the previous store.

Jonathan Chin - Private Management Group

Very good. Thank you. Keep up the good work.

Melissa Plaisance

Thank you, everyone, for participating today. [inaudible] and I will be available for any follow-up questions for the balance of the day. Again, thank you for joining us.

Operator

Thank you. That does conclude today’s conference. You may disconnect at this time.

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