Description

• In a yield-starved world where cash is king, we believe that Safeway (SWY) is a prince, disguised as a court jester. Our base case valuation of the stock is ~$35 per share, or approximately 45% above current levels, and we believe there is a significant near-term catalyst NEXT WEEK in the form of a potential sizeable increase to the dividend.
• Main Thesis Points
  • SWY stock offers a ~16% free cash flow yield, and free cash flow is poised to grow at a double digit percentage rate (per mgmt guide)
  • Over the next 5 years, based on mgmt’s free cash flow guidance, SWY will generate enough cash to cover the entire market cap of the company!
  • SWY mgmt has a long track record of returning excess cash to shareholders. They have bought back ~40% of the company in the past ~3 years. We believe SWY will be in a position to start buying back as much as 15% of the company each year beginning in 2014.
  • There is a potential hard catalyst in 4 days: We believe a significant increase in dividend is possible at the SH meeting on 5/14. Dividend yield could increase from the current ~3.0% to potentially over 4.0%.
  • SWY is currently gaining market share in the retail food industry, and there could be further significant operational upside potential from a stronger economy, improving fundamentals in core retail food business, and company-specific initiatives (although these are not underlying assumptions for our base case)
  • SWY still has significant short interest, at ~23% of the float
  • Our base case valuation is ~$35 per share, or ~45% upside from current levels
  • Our upside case valuation is ~$60 per share, or ~150% upside from current levels
  • Our downside case valuation is ~$21 per share, or ~12% down from current levels
• Business Overview
  • SWY is a retail food (grocery store) operator which generated nearly $40bn of retail sales, and ~$2.2bn of EBITDA in 2012. SWY has an equity value of ~$5.7bn, and an enterprise value of ~$11.0bn, when including ~$5.2bn of net debt. SWY currently has over 1600 stores, with an average store size a bit under ~50,000 sq ft, average sales per square foot of ~$500, and average sales per store of ~$24mm per year
  • SWY US operations are primarily located on the West Coast, and has a large concentration of stores in California (~550 stores, split roughly evenly btw Northern and Southern CA), ~200 stores in Seattle, and over 100 stores in each Portland, Denver, Phoenix and Texas. SWY also owns ~400 fuel stations, located adjacent to its US grocery stores. US retail food operations generated an est ~73% of EBITDA in 2012
  • Additionally, SWY has ~225 stores in Canada…  This represents~15% of stores. Canada operations generated an est ~23% of EBITDA in 2012
  • SWY also owns ~80% stake in BlackHawk Networks, a prepaid gift card distributor, which recently IPO’d under the ticker “HAWK”. BlackHawk contributed an est ~5% of EBITDA in 2012
  • Finally, SWY owns a venture called Property Development Centers (“PDC”). PDC uses SWY internal capital to develop strip centers where SWY is the anchor tenant. PDC rents out space to other tenants in the strip center, and when the center is fully rented, PDC sells the real estate to a 3^rd party.
• The big reason why we like SWY: The Cash Flow Story
  • In this market, with interest rates at very low levels, and financial markets increasing seemingly every day, it is getting harder and harder for investors to find yield. We believe that SWY offers an extremely attractive and growing ~16% free cash flow yield, a 3.0% dividend yield seemingly set to move close to 4.0%, and a management team that has a history of returning capital to shareholders. As such, in a world where cash is King, we believe SWY is a prince, disguised as a court jester.
  • SWY stock trades at a ~16% free cash flow yield on the midpoint of mgmt’s guide for 2013E… what’s more is that mgmt guided to FCF increases of $100mm/yr (low double digits pct) for each of next several yrs… The 2015E FCF guidance represents a ~20% yield to the equity at the midpoint, and the 2017E midpoint represents an ~24% FCF yield.
  • Based on midpoint of mgmt’s FCF guidance over the next 5 years, SWY will generate the entire market cap of the company in cash over the next 5 yrs
  • Importantly, we do not believe that mgmt’s FCF guidance is based on an inflection in fundamentals… rather, we think that the increase in cash flow can be obtained without operational improvement, driven by 1) PDC (described above) and 2) pension contributions, both of which are misunderstood/unappreciated by the market in our opinion…
  • PDC: PDC has been a drag for the past few years, as mgmt has used a fair amount of capex to get this business up and running (~$500mm cumulative through YE 2013), while only harvesting ~$120mm of proceeds through 2012.. PDC should turn into a tailwind in 2013E, and by our calculation, should be incremental ~$50-100mm of cash flow per annum for the next several years
  • Pension: In 2012, SWY expensed $142mm for their company-owned pension. In 2013E, SWY expects pension expense to decline by $17mm. Importantly, cash contributions were $152mm in 2012, are expected to decline to ~$90mm in 2013, a much larger drop than pension expense through the PNL, which will help cash flows. The drivers of this are a) improving markets and b) the benefit from favorable legislation enacted last year.
  • In summary, we believe the combination of PDC drag reversing, and lower pension cash contributions, should account for more than all of the FCF increases by our calculations, which will allow SWY to increase capex spending, and hit their FCF guidance without any improvement in future operational results
  • Note: for an analysis of SWY’s pension liabilities, we would point you to egec’s write up of SWY on 10/8/12. In the write-up and also in the comment section, egec outlines the pension issue, including both SWY’s company-owned pension, and their multi-employer pension liabilities. For the purpose of our analysis, we assume that the pension liability is reflected in the EV/EBITDA multiple that the market ascribes to the stock (and the industry, since most competitors have similar liabilities), and we flex our multiple down in our downside case to account for the pro-cyclicality of pension contributions. We believe this is reasonable given the very long-dated nature of these liabilities.
• What will they do w/ the cash?
  • So if you believe us and management that SWY is poised to generate over $5bn of cash in the next 5 years… the next question becomes, what will they do with it?
  • First we can look to history, and we don’t have to look that far back to get some clues… SWY has returned over $5bn to shareholders in past 5 yrs (share repo and dividends)… this is the equivalent of ~87% of the current market cap
  • Mgmt has not been shy about levering up to buy back stock… they bought $1.5bn in 2011 and 1.3bn of stock in 2012… SWY paid ~$21/shr for the stock, and took advantage of the commercial paper markets for a very attractive interest rate (~3%) They were a bit early in their purchases, as the stock traded down to a low of near $15 per share in July of 2012 , but the trade looks pretty good right now with stock at ~$24, and if we are right, should only look smarter with the passage of time. In total, mgmt has reduced shares outstanding from ~400mm at YE 2009 to ~240mm currently, a ~40% reduction in a tad over 3 years
  • In terms of near term future cash uses, mgmt has stated that their first priority is to pay the dividend, then to reduce debt, and then to buy back shares.
  • Currently, SWY has net debt of ~$5.2bn at Q1 (PF for HAWK IPO proceeds), which is a seasonal high point for debt, 2013E EBITDA of ~$2.2bn, and ~$900mm of cash flow expected in 2013E. We believe they can get to ~2.0x Debt to EBITDA by YE 2013, which should put mgmt in a position to use FCF to fund further share repurchases starting early ’14.
  • In 2014, with $1.1bn in expected cash flow (low end of mgmt guidance), We calculate that mgmt can purchase ~35mm shares of stock, or ~15% of the company, after paying the dividend, at a $26 share price (up ~10% from current levels)… with cash flow increasing by ~$100mm per year per mgmts guidance in 2015-2017, mgmt can continue to buy in ~15% of the shares outstanding each year, despite assuming the value of the stock increases by ~10% per year, and the dividend increases each year
• What about the underlying business?
  • So hopefully you agree with us that SWY is poised to generate a lot of cash, the lion’s share of which mgmt will likely return to shareholders. But what are the risks with respect to the operations of the company, and the industry? It is our view that there is more upside potential than downside potential for this industry, and that there is a much higher probability that operation performance inflects upward versus taking a leg down.
  • Macro/Industry Upside Potential
    • Very simply,
      as consumers begin feeling better about their finances (driven by home values increasing, stock market rising, credit markets loosening, etc), we believe people tend to eat more and eat higher quality food. This is borne out by not just common sense, but also by looking at SWYs ID Sales (grocery equivalent of same store sales) back in the good times of 2005-2007… during this time, SWY had ID sales growth of >3% per year on avg… EBITDA dollar growth was high single digits %
    • Right now, SWY is doing about a ~1.5% IDs… By our calculations, at a 20% incremental margin, each 50bps of IDs is worth ~$40mm of EBITDA, or ~$1.00 per share in value to SWY stock, at a 5.0x multiple
    • More importantly, the difference btw a 1.5% IDs and 2.0% IDs could very well be the difference between a flat or slightly declining EBITDA stream, and a growing one. If EBITDA starts to embark on a growth trajectory, this could be a catalyst for significant multiple expansion, which is not included in our valuation analysis.
  • Improving Industry Dynamics in the Grocery business
    • Currently, inflation is running at a modest pace (was ~1.0% for SWY in Q1). This is driving positive volumes for SWY for the first time since 2010. At a high level, it is logical to assume that a prolonged era of easy money should at some point produce some increase in inflation (other than in financial assets). An uptick in inflation from here should be positive for SWY, as inflation in the 2-3% range seems to be kind of the sweet spot for the industry
    • There is also less new competition from new store openings. Mgmt believes that we have seen competitive openings decline by ~50% from 2008 (from ~450 new stores per year in 2008 to ~225 stores in 2013E)
    • More rational existing competition. Anecdotal evidence suggests that the competitive intensity from the large players could be easing somewhat. Generally, improving business conditions give retailers the ability to dial back somewhat on their promotional cadence. To be clear, the retail food business is intensely competitive, however we believe we have just witnessed a period of rapid expansion into grocery from WMT, Target (Pfresh remodels) among others, which seems to be reaching a level of maturation.
  • SWY Company-Specific Initiatives
    • On their Investor Day in March, SWY mgmt team outlined several initiatives to drive sales. These initiatives include an expanded health and wellness offering in their stores, expanding their fuel partnership program, and revamping the center of the store.  
    • We are not ascribing a lot of value here, but don’t think the market is either. However, some of the things they are doing are basic blocking and tackling and should improve results. For example, the fuel program. SWY instituted a partnership w/ Exxon in Southern California in Q4, beginning a partnership w/ Chevron in Northern California in Q1, and will have 94% of all stores associated with a fuel partner by Q2. Mgmt states that stores with fuel centers have ID sales 2-3% higher than those that don’t have fuel.
    • Generally, we think this is a management team to which ppl don’t give enough credit. Mgmt should be gaining some credibility as the market recognizes the success of SWY’s recent online rewards program Just4U, which was just rolled out and has helped to increase sales and has allowed SWY to gain share, and the market begins to better appreciate the cash flow dynamics and mgmts willingness to buy back shares and increase the dividend, especially as the 2011-2012 share repurchases get further into the money.
  • It is important to note that we believe that our base case valuation does not factor in any upside from macro/economic factors, improving industry dynamics or SWY company-specific initiatives, all of which would provide upside.
• So how do we value this business?
  • We believe SWY stock is worth ~$35 in our base case, and has downside risk down to $21 in a downside, double-dip recession type scenario. We think that in an upside case, the stock can be well more than a double in a year. Therefore, with what we perceive to be limited downside (based on the sizeable free cash flow), a nearly 4 to 1 base case versus down case ratio (~$11 up v ~$3 down), and the potential for 100+% return in an upside case, we believe SWY is an extremely attractive investment.
  • Historicals
    • EBITDA
      • 2010: $2322
      • 2011: 2283 (-1.6%)
      • 2012: 2240 (-1.8%)**
      • 2013E: 2200 (-1.8%)
      • ** adjusted to exclude J4U costs and expenses from East Coast operations disposition (detail given on Q2, Q3 conference calls)
      • These results were generated on ID sales of -0.6%, 1.2% and 0.5% in 2010-2012 respectively. We believe that SWY should be able to generate flat EBITDA on ID sales of ~1.5%, which is where they were running in Q1’13. At 2.5% ID sales, can grow EBITDA mid single digits. In 2005-2007, IDs were in the ~3% range, and EBITDA growth was high single digits percent.
  • Projections (deleverage case)
    • We believe the most conservative valuation case is a case in which SWY uses their FCF to delever. In our base case, we assume this is the case. We assume that SWY EBITDA declines each year by ~2% per year, reaching ~2.0bn in 2017. We assume FCF at the low end of mgmts guidance ($850mm in 2013, growing to $1.3bn in 2017). This would allow SWY to delever from ~$5.2bn of debt down to ~$800mm of debt by YE 2017 (after paying out dividends). Applying a 5.2x target multiple (where the stock is trading currently) yields an equity value of ~$40 per share in 2017. Adding cumulative dividends of $4 per share yields a total equity value of $45 per share. Discounting this back at an 8% rate for 3 years gets to a $35 current share price, or ~45% upside from current levels. Please see the table below for a layout of the math.
    • Importantly, note that based on these FCF projections (which again are at the low-end of mgmts guidance range), SWY generates cumulative FCF of ~$5.5bn over the next 5 years, which represents ~95% of the current market cap

• Projections (deleverage in 2013, and share repurchase in 2014-2017)
  • We believe that a more realistic case is one in which SWY uses their FCF to delever in 2013, and then to repurchase stock in 2014-2017E. In this case, we assume the same operational and FCF assumptions as above, but that in 2014E SWY begins to buy back shares. We assume a price of $26 in 2014 (up ~10% from current), and annual share price appreciation of ~10% PA thereafter. In this case, SWY is able to repurchase over 50% of the current shares outstanding over the course of the next 5 years. This translates into an equity value of ~$56 per share in 2017, or $44 per share discounted, offering ~85% upside from current levels
  • Projections (upside case)
    • In a true upside case, we believe SWY shares could be worth much more. Assuming EBITDA is flat (which is again still much lower than the high single digit growth experienced in 2005-2007), FCF is at the high end of mgmts guidance range, and using a target EV/EBITDA multiple of 5.7x (v 5.2x currently), and using FCF to buy back shares beginning in 2014 (in this case we assume 15% share price appreciation per year on the shares repurchased) one can arrive at an equity value of ~$74 per share in 2017 (including dividends), or ~$58 discounted. Importantly, this assumes no increase in leverage to buy back shares. In this case, SWY would keep leverage at 2.0x Net Debt to EBITDA. Assuming an additional 1.0x turn of debt (and recall SWY was just a few quarters ago near the 3.0x level), there could be additional share price upside.
  • Projections (downside case)
    • In our downside case, we assume EBITDA declines by ~4% per year, reaching ~$1.8bn in 2017E. We assume cash flow of $800mm this year ($50mm below low end of guidance), and declines 3% per year thereafter. We assume an EV/EBITDA multiple of 4.2x (v 5.2x currently, and a trough around ~4.0x last cycle). We arrive at a discounted value of ~$21 per share.
    • It is important to note that the total cumulative decline in EBITDA we are assuming is 18%, which matches the ~18% drop in EBITDA SWY experienced from 2007 through 2010, which to us feels conservative, given the dire state of the economy during the Great Recession.
  • One other valuation point… multiples
    • Grocery stores are one of the few subsectors we have come across where multiples are below historical average levels… Multiples are up from the trough, but we can envision a further re-rating of the group (and SWY in particular) if we get an increase in IDs due to better industry dynamics/macro, and sentiment in grocery-land continues to trend closer to being considered a more consistent “staple” industry... we are not counting on much incremental multiple expansion in our upside case, but wanted to flag as a potential further upside option
• Catalyst: Potential Dividend Raise
  • If you have continued reading this far, we thank you. Now we are getting to the really good part…
  • Here is what Mgmt said about the dividend on their Analyst Day: “we've had a habit of having some relatively high increases on -- as we evaluate that dividend on a once-a-year basis” (per Seeking Alpha transcript)
  • That certainly does appear to be true… here is a historical table of the dividend by year
    • 2008: 32c
    • 2009: 40c
    • 2010: 48c
    • 2011: 56c
    • 2012: 72c
  • Our best guess for 2013E (to be announced at their Shareholder Meeting next Tuesday)… 88c… but they could surprise and give us 96c or even $1.00…
  • A few points 1) each 10c in divs is only ~$24mm per year, so even at $1.00, total dividend payments would only be ~$240mm, very manageable 2) this mgmt team is fairly market savvy, and likely understands the value that the market is placing on dividends currently. 3) the Chairman, newly retired former CEO Steve Burd, owns ~1.25mm shrs, so $1.00 per share would be a nice way for him to supplement his Social Security check!
  • At 88c, the dividend yield on SWY stock would be ~3.7%; at 96c it would be ~4.0%, and at $1.00 it would be ~4.2%
  • In this market, where investors are going crazy for dividends, we think that a company going from yielding 3% to 4% is a big deal. It doesn’t seem unreasonable to us that SWY could trade back to a ~3.5% yield fairly quickly, which would be a $28 stock on a 96c div… at a minimum, the dividend increase should put the stock on the radar of more investors.
• Other points worth mentioning
  • The short interest, despite coming down from the peak of of 82mm shares (~34% of the float), is still 54mm shares (~23% of the float)… Based on ADV of ~6mm shares, this represents ~9 days to cover
  • Canada/Sum of Parts Analysis: this is another item worthy of mention, over which a lot of ink has been spilled, but one in which we are simply going to flag as another potential catalyst, but ascribe merely option value. As we touch on in the overview, SWY owns a very profitable business in Canada, which we believe owns a sizeable amount of its own real estate. Loblaw’s (L.TO), a competitor in Canada, decided in December to pursue a REIT strategy. Upon announcement, shares immediately spiked up nearly 30%, and have only gone higher since. SWY has ruled this out for their US assets, but is evaluating the potential for their Canadian assets. Another option for SWY’s Canadian assets are an outright sale. Much has been written about this on the sellside, and estimates of what the Canadian business is worth have been as high as 10x EBITDA.
  • This valuation begs at least a mention of a sum of parts valuation (which we typically don’t like but could be instructive in this case)… Very simply, total SWY EV is ~$11bn. SWY’s stake in HAWK is worth ~$800mm. At a 7.5x multiple, Canada is worth ~$3.8bn, which implies a value of ~$6.3bn for the US business. On over ~1.6bn of EBITDA, this is an implied multiple of under 4.0x. To sensitize, each 1.0x EBITDA multiple on the US is worth ~$7 per share, and each turn is worth ~$2 per share for Canada. So in a more realistic case of 5.0x for the US business (still a substantial discount to peers like KR), SWY would be worth $31 on a SOTP basis (up 30%). In an upside case of 10.0x for Canada and 6.0x for US, one can arrive at a ~$43 share price for SWY (up 80%).

Catalyst