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We reiterate our Neutral recommendation on Safeway Inc. (SWY - Analyst Report) with a target price of $23.00.

We note that the retail environment is quite challenging. Consumer spending on durable products has been very weak. In the face of economic uncertainty and price competition, Safeway has been witnessing sluggish revenue growth over the past few quarters.

Although the improved ID store sales were a reflection of an improved economic scenario, considering the nearly 4.7% retail inflation during the fourth quarter 2011, ID store sales effectively declined 3.2% year over year. Accordingly, the company’s ID store sales guidance for fiscal 2012 was moderate in the growth range of 1–2%.

Inflation, which is hitting the entire retail industry (largely through food and fuel), will likely dampen sales growth of the overall industry. Safeway may find it difficult to pass on increased prices to its customers due to tough competition. This tough scenario has led certain consumers trading down to a less expensive mix of products or searching for discounts on grocery items, which in turn have impacted Safeway’s sales.

The company expects these difficult economic conditions to persist for a while. The company confronts a wide spectrum of competitive threats, especially from players like SUPERVALU Inc. (SVU - Analyst Report), The Kroger Co (KR - Analyst Report) and Wal-Mart Stores (WMT - Analyst Report). 

However, we are encouraged by Safeway’s constant efforts to capture market share with its value-added offerings, which are expected to enhance its brand equity and reduce its dependency on price.

Safeway has undertaken cost reduction initiatives focused on cost of goods sold and supply chain efficiencies. The company is developing its distribution network in the US where some of its existing card content providers are becoming distributors, thereby reducing the number of retailers in the market.

Safeway decided to exit the greater Philadelphia market in January 2012 in order to control operating expenses and to increase its focus on areas where it has a strong presence. The company entered into an agreement with Giant Food Stores, a division of Ahold US to sell 16 of its Genuardi's stores in the greater Philadelphia area. The company also plans to close 3 Genuardi's stores in Pennsylvania.

Despite sluggish revenue growth, Safeway is in a perfect position to reward its shareholders by paying dividends, repurchase shares and reduce debt given its consistent cash generation ability, disciplined investment and limited balance sheet risk.

In addition, Safeway is turning its attention to penetrating international markets, which is quite impressive. The company is expanding its overseas business especially in Canada, Australia and UK.

Currently, the company retains a Zacks #3 Rank, which translates into a short-term Hold rating.

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