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Safeway (SWY - Analyst Report) reported net income from continuing operations of $255 million in the fourth quarter of 2012, up 17.6% year over year. The company's earnings per share (EPS) shot up 58.2% year over year to $1.06 in the reported quarter, representing a beat of 39.5% over the Zacks Consensus Estimate.
 
This was primarily due to a 26% reduction in outstanding share count and benefit from legal settlement which led to a gain of 17 cents and 12 cents, respectively.
 
Annual EPS rose 52.3% to $2.27 in 2012, surpassing the Zacks Consensus Estimate by 12.9%. The company also exceeded its 2012 EPS guidance. Apart from a 32 cents benefit from a reduced share count, lower income tax expense helped 2012 EPS exceed projection as well as the prior-year level.  
 
Total sales increased 1.2% on a year-over-year basis to $13.8 billion in the fourth quarter, edging past the Zacks Consensus estimate of $13.7 billion. Growth was led by higher gift and prepaid card sales combined with a 0.8% increase in identical-store sales (excluding fuel), partially offset by the disposition of the Genuardi’s stores.
 
In 2012, total sales inched up 1.3% to $44.2 billion, higher than the  corresponding Zacks Consensus Estimate of $44.1 billion. The quarterly as well as annual sales were negatively impacted by calendar shifts as the fiscal year ended on Dec 29, 2012 and did not include the entire impact of New Year’s holiday sales.
 
Margins
 
Gross margin in the fourth quarter contracted 21 basis points (bps) year over year to 26.5%. However, excluding the impact from fuel sales and fuel partner discounts of 10 bps, gross margin declined 11 bps as benefit from the generic wave in the pharmaceutical industry was negated by investments in price.
 
Operating and administrative expenses declined 60 bps to 23.24% of sales in the reported quarter. Consequently, operating income increased 15% year over year to $448.8 million in the quarter. This resulted in a 39 bps expansion in operating margin to 3.3%. Excluding the impact from fuel sales and fuel partner discounts, operating margin expanded 29 bps. 
 
Balance Sheet
 
Safeway exited 2012 with $352.2 million in cash and cash equivalents, down 51.7% from 2011. Net cash flow provided by operating activities in 2012 declined 22.4% from the prior year to roughly $1.6 billion due to greater use of cash for working capital.
 
Safeway made no share repurchase during the fourth quarter of 2012. However, 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.
 
In the fourth quarter of 2012, Safeway incurred $240.4 million in capital expenditures. The company opened three new Lifestyle store, completed two Lifestyle remodel and closed six stores during the quarter. During 2012, the company opened nine new Lifestyle stores, completed four Lifestyle remodels and closed 46 stores (including 25 Genuardi’s stores).  
 
Our Take
 
Safeway reported a strong quarter to end 2012 on a positive note. Its strategy to improve identical-store sales on the heels of ‘Just for U’ loyalty program yielded positive results as the loyalty program was a major positive catalyst increasing market share and profitability. The fuel loyalty program was another impetus in the quarter.
 
Like recent quarters, the reduction in outstanding share count led the EPS upside for Safeway. However, this might not be sustainable over the long haul. Despite the various costs saving measures, gross margin also remained under pressure.
 
The stock carries a Zacks Rank #3 (Hold). While we remain on the sidelines for Safeway, stocks such as CVS Caremark (CVS - Analyst Report), Cardinal Health (CAH - Analyst Report) and Rite Aid Corporation (RAD - Analyst Report), carrying a Zacks Rank #2 (Buy), are expected to do well and warrant a look.

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