Is Safeway Inc. (SWY) a Buy?

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Shares of Safeway Inc. (NYSE:SWY), the second largest supermarket chain in North America, were slammed on April 25 after the company reported an increase in earnings on flat revenue growth for the first quarter.

Did investors completely overreact to its admittedly lackluster earnings report? Is this an opportunity for value investors to load up on shares of this grocer, which has consistently played second fiddle to market leader The Kroger Co. (NYSE:KR)?

Is Safeway Inc. (SWY) a Buy?

First quarter

For its first quarter, Pleasanton, CA-based Safeway Inc. (NYSE:SWY) earned $0.49 per share, or $118.9 million, up from the $0.27 per share, or $72.9 million, the company reported in the prior year quarter. Earnings were boosted $0.14 by an unexpected tax benefit. Analysts polled by Thomson Reuters had expected Safeway to earn $0.36 per share.

Revenue came in flat at $10 billion, missing the consensus estimate of $10.14 billion. The company blamed closures and sales of its Genuardi’s stores in 2012 for the year-on-year decline, which was followed by lower fuel sales in the first quarter of 2013.

Sales growth

Safeway Inc. (NYSE:SWY)’s same-store sales rose 1.5%, excluding fuel sales from its attached gas stations. Unit volume rose 0.5% during the quarter. However, both same-store sales and unit volume were positively impacted by a calendar shift, which allowed Safeway’s first fiscal year, which started on Dec. 30, 2012, to capture a portion of New Year’s holiday sales. Both same-store sales and unit volume were boosted by 0.4% as a result. Same-store sales, excluding fuel, are expected to rise 2% to 3% for the remainder of 2013.

For the full year, Safeway Inc. (NYSE:SWY) expects to earn $2.25 to $2.45 per share. The tax benefits Safeway received in the first quarter were not originally fully accounted for in its original forecast, and helped offset the earnings dilution from its recent spin-off of Blackhawk Network Holdings.

Blackhawk soars

Safeway Inc. (NYSE:SWY) founded Blackhawk Network Holdings in 2001, and its prepaid gift cards, which can be used to purchase products from companies such as Starbucks Corporation (NASDAQ:SBUX), Visa Inc (NYSE:V), the NBA, Barnes & Noble, Inc. (NYSE:BKS) and Apple Inc. (NASDAQ:AAPL), quickly spread from the United States to 18 other countries. The prepaid cards operate using Blackhawk’s in-house technology, which works with its own payment network of 100,000 retailers.

Blackhawk raised $230 million in its recent IPO. The stock immediately soared 8.7% on its first trading day on April 19, but have since settled down slightly.

In 2012, Blackhawk reported a profit of $48.2 million on revenue of $959.1 million, a 31.9% increase in profit and 27.6% gain in sales from 2011. Blackhawk has been credited for making gift cards popular by unifying them under a single payment system.

After Blackhawk’s market debut, Safeway unloaded 9.8 million of its 10 million IPO shares. Safeway will continue to be Blackhawk’s majority shareholder, with its share of the business dropping slightly from 95.4% to 93.8%. Safeway Inc. (NYSE:SWY) stated that the IPO proceeds were used to pay off its long-term debt.

Expenses and margins

Is Safeway Inc. (SWY) a Buy?

Over the past five years, Safeway’s long-term debt level has notably stayed higher than its primary competitors, The Kroger Co. (NYSE:KR) and SuperValu (NYSE:SVU). However, its cash and short-term investments position has notably improved more than its peers.

Therefore, the proceeds of the Blackhawk IPO should lower Safeway’s debt-to-equity ratio substantially against its rivals. Safeway’s operating cash flow rose to $555.2 million during the first quarter, up from $541.8 million a year ago.

Is Safeway Inc. (SWY) a Buy?

Compared to its peers, Safeway Inc. (NYSE:SWY) has done a good job keeping its expenses under control. During the quarter, operating and administrative expenses decreased from 24.95% to 24.90% of total revenue.

However, investors were more concerned about Safeway’s margins, which are still lower than The Kroger Co. (NYSE:KR)’s but higher than SuperValu’s. During the quarter, operating profit margin slid from 1.9% to 1.8%.

Is Safeway Inc. (SWY) a Buy?

Boosting shareholder value

Over the past year, Safeway Inc. (NYSE:SWY) has used loyalty and personalized discount programs to drive market share gains. The company has also been consistent with share repurchases and dividend increases. In 2012, Safeway repurchased 57.6 million shares of its common stock, worth $1.24 billion. It has also grown its dividend at an average rate of 20% over the past five years.

Therefore, on the surface, nothing seems fundamentally wrong with Safeway, and a 17% plunge in its price seems like a good opportunity to load up on this stock, which pays a quarterly dividend of $0.17 per share – a 3% yield at current prices.

Competitors

A day before Safeway’s shares plummeted, shares of SuperValu, which has long slumped in third place, surged 12%. Just as Safeway’s slide seemed harsh, SuperValu’s rally seemed unjustified. For its fourth quarter, SuperValu had reported an adjusted loss of $0.14 per share, down from a profit of $0.02 per share in the prior year quarter. Without adjustments, SuperValu actually reported a loss of $6.65 per share. Meanwhile, revenue declined 2% to $3.89 billion – hardly causes for celebration.

Yet SuperValu is up more than 90% over the past six months, after the company started slimming down its operations. In January, SuperValu sold off 877 of its Albertson’s, Acme, Shaw’s and Star Market chains to Cerberus Capital Management for $100 million. With the sale, Cerberus assumes $3.2 billion of SuperValu’s long-term debt. Judging from Supervalu’s share price action, investors are betting that this slimmed down company will eventually return to profitability.

Meanwhile, Kroger, which reports its first quarter earnings on June 10, is expected to continue growing. Kroger’s bottom line is expected to grow by double digits next quarter, and 9.2% over the next five years. Analysts are growing increasingly bullish on Kroger, with consensus averages rising 6% over the past two months, but the odds are in The Kroger Co. (NYSE:KR)’s favor – the company has already beat earnings estimates for four consecutive quarters.

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