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Safeway Inc. (SWY - Analyst Report) reported adjusted earnings per share (EPS) from continuing operations of 28 cents in the second quarter of 2013 compared with 20 cents in the year-ago quarter. Adjusted income from discontinued operations was 23 cents in the quarter, based on the company’s agreement to sell the assets of Canada Safeway Limited.

After including the impact of discontinued operations (primarily the Canadian operations), Safeway posted adjusted earnings of 51 cents. The Zacks Consensus Estimate for the second quarter of 2013 was pegged at 50 cents. Following the earnings announcement, share price of this food and drug retailer climbed 3.79% higher during early trading hours.

Quarter in Detail

Total sales declined 1.6% year over year $8.7 billion in the second quarter, well short of the Zacks Consensus Estimate of $10.5 billion. The lower top line was attributed to soft fuel sales and the disposition of Genuardi’s stores in 2012. The decline was partially offset by a 1.2% rise in identical-store (ID) sales (excluding fuel) in the quarter.

Gross margin in the quarter increased 29 basis points (bps) year over year to 26.23%. However, excluding the impact from sluggish fuel sales of 32 bps, gross margin decreased 3 bps as benefit from lower advertising expenses were negated by investments in price, higher revenues from the lower-margin Blackhawk business and shrink expense.

Operating and administrative expenses rose 28 bps to 24.65% of sales in the reported quarter. Excluding the impact from fuel sales of 49 bps, operating and administrative expense margin dropped 21 bps on the back of lower store occupancy charges and property impairment charges. However, Safeway faced higher labor costs and increased legal reserves in the quarter.

Nonetheless, operating margin improved a marginal 2 bps to 1.59% in the quarter. Operating profit, excluding fuel sales, increased 18 bps.

Safeway ended second quarter with cash and cash equivalents of $441.1 million compared with $352.2 million at the end of 2012. The company’s long-term debt was $4.6 billion, lower than $5.2 billion at the end of 2012 as it used the net proceeds from the initial public offering (IPO) of Blackhawk Network Holdings (HAWK - Snapshot Report) to reduce debt level.

In the reported quarter, Safeway incurred $125.4 million in capital expenditures compared with $203.7 million in the year-ago quarter.

Safeway made no share repurchase during the first half of 2013. We note that the company repurchased 57.6 million shares for $1,240.3 million (including commissions) during 2012 and is now left with $0.8 billion of authorization to buy back shares.

Guidance

Following Blackhawk IPO and the decision to shed its Canadian operations, Safeway revised its expectations for 2013. It expects EPS to hover around the lower end of the previously guided range of $2.25-$2.45. On the other hand, based on the assumptions of no gains from the sale of Safeway Canada, the company expects adjusted EPS in the range of $1.02-$1.12.

Non-fuel ID sales growth is anticipated to be between 1.5%-2.0% compared with prior outlook of 2% and 3%. Adjusted operating margin, excluding fuel, is expected to improve 15-25 bps.

Accounting for the sale of Safeway Canada, the capital expenditure is envisaged in the band of $900-$950 million for 2013. Fee cash flow guidance is forecast in the range of $600-$700 million.

Our View

After starting 2013 on a dismal note, Safeway witnessed an eventful second quarter as it reached a conclusive decision with respect to its Canadian operations in June and settled the Blackhawk IPO earlier in April.  The company plans to use the proceeds to boost shareholders’ value. Management also claims that it gained 20 bps in the U.S. supermarket channel and 2 bps in the all outlet channel.

However, the quarterly sales trailed the Zacks Consensus Estimate and the year-ago mark. Further, ID sales remained sluggish for another quarter.  Margin pressure is another area of concern as Safeway’s Canadian operations have been more profitable than the U.S. operations, as seen in the level of operating profit over the past few years.

Although the company asserts that the agreement to exit Canada reflects a deft plan to sharpen focus on the U.S. market, we remain apprehensive due to the lack of clarity on management plans to gain momentum in the domestic market. Macroeconomic woes might worsen the situation for this food and drug retailer. Amid these concerns, the stock carries a Zacks Rank #5 (Strong Sell).

While Safeway is presently out of favor, other players such as Koninklijke Ahold N.V. (AHONY) and Ingles Markets Inc. (IMKTA - Snapshot Report) appear impressive. These stocks carry a favorable Zacks Rank #1 (Strong Buy).

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