Safeway: In The Discount Aisle For A Reason

| About: Safeway Inc. (SWY)
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The purpose of this article is to determine the attractiveness of ("Safeway Inc. (NYSE:SWY)") as an investment option. To do so, I will review the company's recent performance, most recent quarterly and annual reports, and current trends in the industry to attempt to determine where the stock may be headed from here.

First, a little about SWY. SWY is a food and drug retailer in North America and operates around 1650 stores. The company's U.S. retail operations are located mainly in the West Coast, Texas, the Chicago metropolitan area and the Mid-Atlantic region. SWY's Canadian retail operations are located principally in British Columbia, Alberta and Manitoba/Saskatchewan. Safeway owns and operates Operating Company, an online grocery channel. The company competes with major players such as Walmart (NYSE:WMT), Target (NYSE:TGT), Whole Foods (WFM), and other local grocery store chains and independent retailers. SWY's stock is currently trading at $23.27/share and the company pays a quarterly dividend of $.20/share, which translates to an annual yield of 3.44%.

Recently, the stock has performed strongly. Year to date the stock has climbed over 28%, excluding dividends, and over the past 52 weeks the stock is also up about 28%, also excluding dividends. Even with this stock appreciation, SWY is trading at under 10 times earnings, making the stock look cheap compared to competitors such as Walmart, Whole Foods, and Target, which have current PEs of 15, 37, and 16, respectively. Couple with a yield over 3% and a low beta of .77, which indicates the stock is less volatile than the market as a whole, on the surface SWY would seem to be a compelling buy. However, after digging into some of the company's SEC filings, I see some areas of concern.

I reviewed the company's 10-Q report, part of which compares the first quarter results of 2013 with the first quarter results of 2012. During this time period sales revenues have declined. While the decline is small, at less than 1%, this is during a period of increased consumer spending. Also, cost of goods sold has increased in comparison. Again, this increase was small, at under 1%, but it still represents a trend of rising costs and slowing sales. This is an area I would continually monitor to see if these trends continue or if SWY is able to positively reverse them. Second, and not surprisingly, net profit dropped, which would make sense given the slowdown in sales and the rise in costs. However, the decline was around 5%, indicating that SWY is struggling from more than just a decline in sales. A final area of concern is that the cash used for property additions in the first quarter of '13 was less than half the amount in the first quarter of '12. While it makes sense to me that SWY is not expanding rapidly, I do not like to invest in companies that are seeing such rapid contraction in growth. That indicates to me that management is not optimistic about making future investments.

SWY also operates in a very competitive retail industry. Walmart has become the dominant retail player in North America, pressuring other companies like SWY to cut costs, hurting their margins. Additionally, specialty food stores, such as The Fresh Market and Whole Foods, have popped up in wealthier areas to differentiate themselves by selling organic, local, and premium priced products. That leaves average grocery store chains such as SWY in a tough position as their customers are being courted away by different types of companies for different reasons. Add in the fact that Amazon (NASDAQ:AMZN) is piloting an online grocery delivery service, and SWY could soon be facing a competitor differentiated on convenience. Essentially, I see the retail market as already extremely competitive, yet getting even more so. Companies such as SWY are being pressured on every angle, and that is ultimately hurting their ability to grow sales and their customer bases. This is evident in the fact that sales and margins are both down in a year over year comparison.

There are some positive findings in these reports. One, SWY has had a strong commitment to its dividend since it began paying one in 2005. SWY has never decreased its dividend payout, even during the 2008-09 period. Additionally, SWY increased its dividend recently from $.18/share to $.20/share, an increase of over 11%. Dividend investors can find some comfort in this, as the dividend seems safe, and lucrative, for the time being. Second, SWY management have begun an aggressive stock repurchase program, repurchasing over 370,000 shares at an average price of $24.32/share. While the merits of stock buybacks could be debated endlessly, this indicates some confidence by management in the current share price as they only repurchased 1300 shares a year prior when the price per share was 20% lower. Management could be indicating they are optimistic about the future and expect the stock price to rise, hence the substantial increase in repurchases at these levels. Finally, SWY has seen sales revenue growth every year since 2009. While the decline from first quarter '12 to first quarter '13 is definitely important, it is only a small blip in an otherwise impressive legacy. If SWY is able to grow sales throughout the year and continue this year over year revenue growth, I may rethink my opinion on the company.

Bottom line: SWY has rebounded since the 2008-09 recession and, after a major drop in share price in 2012, the company has rewarded investors handsomely in the short-term. With such impressive performance and an attractive yield, all priced at a PE of under 10, investors could easily look at SWY as a standard value play. However, I do not see a bright future for SWY, or any discount retailer that is unable to differentiate itself in a sustainable manner. With competitive pressure from major players like Walmart and Amazon, companies like SWY will face, and already do, declining sales and customer loyalty consistently over time. Additionally, SWY operates solely in the North American market, and its sales are heavily reliant on the U.S. While unemployment has dropped and consumer spending has been a bright spot in our economic recovery, a reverse of either of these trends will hit SWY disproportionately compared to its peers that operate on a global level, such as Walmart. Finally, SWY has a substantial amount of debt, around $6 billion. With interest rates set to rise, this could become a big burden to the company as its interest payments could potentially increase. For these reasons, I would caution investors away from SWY at this time.

Disclosure: I am long DVY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.