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We reiterate our Neutral recommendation on Safeway Inc. (SWY - Analyst Report) with a target price of $16.00.

We note that the retail environment is quite challenging and consumer spending on durable products has also been very weak. Amid economic uncertainties and price competition, Safeway has been witnessing sluggish revenue growth over the past few quarters.

However, Safeway recorded a 0.8% increase in identical-store (ID)sales (excluding fuel) during the second quarter 2012 compared with flat sales in the first quarter of 2012. Despite a 300 basis points (bps) decline in price-per-item, the increase in ID sales was primarily on the back of the company’s successful roll out of “Just for U” loyalty program. This also represented a volume improvement of 160 bps year over year and 360 bps sequentially.

Amid a difficult economic scenario, we are thus pleased with the company’s reaffirmation of ID sales growth guidance of 1–2%.

Safeway has also undertaken cost reduction initiatives focused on cost of goods sold and supply chain efficiencies. The company decided to exit the greater Philadelphia market to control its operating expenses and better focus on areas where it has a strong presence. The company is on track to dispense with 27 Genuardi's stores in this region and sold 3 in the second quarter (3 in the first quarter and 16 in the third quarter to Giant Food Stores).

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

We are also encouraged to note that despite sluggish revenue growth, Safeway has been rewarding its shareholders by paying dividends and repurchasing shares. During the second quarter, the company repurchased 11.6 million shares for $240.4 million and is now left with $0.8 billion in its existing share repurchase plan. We believe that Safeway’s effective capital deployment policy should benefit its shareholders over the long term.

However, we remain highly concerned about the high borrowing level of Safeway, a portion of which were spent to support the company’s gigantic share repurchase plan. Notably, in the first quarter of 2012, the company made a huge stock repurchase of $1 billion. We also remain concerned about the company’s share buyback policy to improve its EPS despite sluggish sales.

Moreover, higher fuel prices are likely to dampen overall consumer demand impacting Safeway’s sales. These difficult economic conditions may continue for the rest of 2012. 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). 

Notably, the recent disappointing first quarter fiscal 2013 performance of Supervalu also reflects the global economic slowdown badly hitting the entire retail industry.

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

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