Safeway a Penny Ahead, Sales Meet

Safeway Inc. ( SWY - Analyst Report ) reported net income of $122.7 million in the second quarter of 2012, much lower than $145.8 million in the year-ago quarter. However, the company's earnings per share (EPS) of 50 cents in the reported quarter were a penny ahead of the Zacks Consensus Estimate and above the year-ago quarter’s 41 cents. This was possible on the back of an approximately 32% reduction in the outstanding share count.

The company reported a 1.9% year-over-year increase in total sales to reach $10.4 billion during the reported quarter, at par with the Zacks Consensus Estimate. With 0.8% rise in identical-store sales (excluding fuel), Safeway experienced market share gain in the grocery channel and a marginal gain in all food-related channels. Besides, volume trends are expected to improve further with easing of inflation.

Gross margin in the reported quarter contracted 73 basis points (bps) year over year to 26.3%. However, excluding the 47 bps impact from fuel sales, gross margin declined 26 bps on the heels of higher expenses associated with the launch of ‘just for U’ loyalty program, partially offset by lower LIFO expense. Operating income during the quarter decreased 10.8% year over year to $247.2 million resulting in a 30 bps drag in operating margin to 2.4%.

Safeway exited the quarter with $252.5 million in cash and cash equivalents, down from $729.4 million at the end of December 2011. Net cash flow used by operating activities in the first 24 weeks of 2012 was $90.8 million compared to net cash flow provided by operating activities of $187.6 million in the year-ago period due to greater use of cash for working capital in 2012, driven by inventory renewal and the settlement of Blackhawk payables, partly offset by lower pension contributions.

The company repurchased 11.6 million shares during the quarter for $240.4 million and is now left with $0.8 billion of authorization to buy back shares.

In the second quarter of 2012, Safeway incurred $219.2 million in capital expenditures. The company opened 1 new Lifestyle store, completed 1 Lifestyle remodel and closed 10 (including 3 Genauardi’s) stores during the quarter.

Outlook

Safeway reiterated its 2012 EPS guidance of $1.90–$2.10. Also, the company still expects identical-store sales, excluding fuel, to rise in the range of 1–2%. Operating profit margin change, excluding fuel, is expected to range from positive to negative 5 bps. The company also expects free cash flow in the range of $850–950 million.

In fiscal 2012, Safeway expects to incur approximately $900 million in capital expenditures to open 10 new Lifestyle stores and complete 10 Lifestyle remodels.

Recommendation

We were expecting a subdued quarter from Safeway as the adverse macro situation has affected the industry as a whole. This was reflected in the disappointing first quarter fiscal 2013 performance from a major grocery chain Supervalu ( SVU - Analyst Report ) .

Although the company has been trying to improve its bottom line driven by a continuous share buyback program, we believe this is not sustainable for the long term if sales remain sluggish. Given the challenging macro economic situation, the stock retains a Zacks #4 Rank (Sell) in the short term.

All said, we are also impressed by Safeway’s constant efforts to capture market share with its value-added offerings, which are expected to enhance brand equity and reduce the company’s dependency on price. Further, we like the company’s cost savings loyalty program ‘Just for U’ and investment in store remodeling. These long-term initiatives will help the company gain market share from competitors, reduce costs and enhance shareholder wealth. Over the long term, we have a Neutral recommendation on the company.