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We have reiterated our Neutral recommendation on Safeway Inc. (SWY - Analyst Report) with a target price of $17.00.

In the third quarter of fiscal 2012, the company reported a nominal 0.2% year-over-year decline in total sales to $10.04 billion, marginally missing the Zacks Consensus estimate of $10.22 billion. The quarterly sales result was impacted by the disposition of Genuardi's stores during the quarter along with lower Canadian exchange rate, and was partially offset by higher fuel sales.

Net income from continuing operations was $108.0 million, much lower than $130.3 million in the year-ago quarter. However, the company's earnings per share (EPS) of 45 cents in the reported quarter were 3 cents ahead of the Zacks Consensus Estimate and 18.4% above the year-ago quarter’s 38 cents. This was possible on the back of an approximately 31% reduction in the outstanding share count.

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. In the reported quarter, Safeway recorded a mere 0.1% increase in identical-store (ID) sales (excluding fuel).

However, volume growth is set to improve in the upcoming quarters on the back of its successful rollout of the “Just for U” loyalty program. The success of this program is all the more evident from the fact that households registered for this program now represent 40% of company’s total sales. We believe that the company is on track to have 5 million “Just for U” registrants by the end of 2012, representing about 45% of sales. Meanwhile, volume for the fourth quarter is on an improving trend with slightly higher inflation leading to better ID store sales (excluding fuel). This trend is expected to continue along with the gradual recovery of the economy.

Safeway has also undertaken cost reduction initiatives focused on cost of goods sold and supply chain efficiencies, which are expected to improve its margins in the upcoming quarters. Moreover, continued operating loss forced the company to close its distribution centers in British Columbia and Vancouver. Safeway also decided to exit the greater Philadelphia market to control its operating expenses and to focus on areas where it has a strong presence.

In addition, Safeway is turning its attention toward further expansion in international markets, which is quite impressive. We are also encouraged to note that despite sluggish revenue growth, Safeway has been rewarding its shareholders by paying dividends and repurchasing shares. We believe that the company’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 was spent to support the company’s gigantic share repurchase plan. 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). 

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

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