Safeway (SWY)

Safeway Inc. (SWY) is a food and drug retailer in North America. The company's 1,738 stores are located principally in California, Oregon, Washington, Alaska, Colorado, Arizona, Texas, the Chicago metropolitan area and the Mid-Atlantic region, as well as British Columbia, Alberta, and Manitoba/Saskatchewan. In support of its retail operations, the company has an extensive network of distribution, manufacturing and food-processing facilities. Safeway s average store size is approximately 46,000 square feet. Safeway s primary new store format, called the "Lifestyle" store, is typically 55,000 square feet but can vary depending on the factors stated above. Lifestyle stores showcase the company's commitment to quality with an expanded perishables offering. They feature an earth-toned d cor package that is warm and inviting with special lighting to highlight products and departments, custom flooring and unique display features. The company believes this warm ambience significantly enhances the shopping experience. Safeway also operates fuel centers adjacent to some of its stores. With in-store pharmacies in over two-thirds of its stores, Safeway ranks among the 10 largest drug retailers in North America. In addition, Safeway has a 49% ownership interest in Casa Ley, a Mexican food and general merchandise retailer. Blackhawk, a subsidiary of Safeway, provides third-party gift cards, prepaid cards, telecom cards and sports and entertainment cards to a broad group of top North American retailers for sale to retail customers. Blackhawk also has gift card businesses in the United Kingdom and Australia.

We rate Safeway shares a Buy with a six-month target price of $28, or about 11.5x our 2009 EPS estimate.

We are positive on the company's remodeling efforts, its Blackhawk business, and its healthy free cash flow. Safeway is aggressively working to differentiate its offerings and update its stores appearance to respond to an increasingly competitive grocery marketplace. The company continues to remodel its existing stores and open new primarily in its new Lifestyle concept. The Lifestyle concept offers more prepared meals, organic produce, and specialty items, such as a Starbucks coffee kiosk. We are also encouraged by the company's strategy to invest in store remodeling, rather than simply adding new stores because the remodeling efforts should help Safeway improve its long-term competitive position. While the company's brand building and other marketing initiatives are not working in the current environment, business should rebound nicely when conditions finally improve. Meanwhile, the company is doing what it can to cut costs in an effort to avoid contracting profit margins. What's more, Safeway's Blackhawk business enterprise should continue to help boost the company's margins and earnings per share. Blackhawk sells gift cards for client retailers through the point-of-sale of other retailers. Safeway collects a commission on each card sold. Unlike its core supermarket business, Blackhawk sales are growing rapidly and generating huge profit margins with minimal investment required. Growth in this business should remain solid. Moreover, we are encouraged by Safeway's ability to generate free cash flow. Safeway generated free cash flow of $568 million, $427 million, and $422 million in 2005, 2006, and 2007, respectively. Management recently reiterated its 2008 guidance that calls for free cash flow of $500-$700 million. This free cash flow provides Safeway with the flexibility to re-invest in its business, repurchase shares, or pay down debt, while maintaining a solid balance sheet.

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