The 18% Gain That Wasn't

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

If you see a company report earnings growth of over 18%, normally that's great news. However, I'm not impressed when a company reports higher earnings because of huge share repurchases that are financed by leverage. That is called buying earnings growth, which is not related to strength in the business. This is exactly what happened with Safeway (NYSE: SWY) in their recent earnings report. Overall the company's business is not doing well, and if you go beyond the reported numbers, things are getting downright scary. 

Anyone who has followed the traditional grocery stores, knows that they are struggling. In particular, I've noticed a trend that seems clear with two of the losers in this battle Safeway and Supervalu (NYSE: SVU). I've mentioned before that I noticed some similarity in their financials, and with Safeway's recent report those similarities are just getting more obvious. While Kroger (NYSE: KR) operates in the same industry, the company is more diversified with grocery stores, jewelry stores, convenience stores and more. The two disruptors in the grocery business are clearly Wal-Mart (NYSE: WMT) and Target (NYSE: TGT). Both of these retailers have put an increased focus on building out or converting their existing stores to offer groceries. Since Wal-Mart and Target offer much more than traditional grocers, customers can make one stop and buy groceries, clothes, housewares, and more. Both of these disruptors have generally higher margins because of the diversity of their selection, which allows them to compete more effectively on price in their grocery offerings. This leaves a traditional grocer like Safeway feeling the pinch. Looking at the company's recent earnings, you can see problems everywhere.

Safeway reported total sales down 0.2%, but reported EPS increased 18.42%. The company's same store sales were up 1%, and management pointed to the “just for U” loyalty program as a driver of better results in the future. Here is the problem, the one real positive number in the report is an illusion and investors need to understand there are serious problems below the surface. While the company's reported EPS was up, income from continuing operations was actually down 17.11%. The only reason the company reported higher EPS was because of massive share repurchases. Specifically, the company has now retired over 30% of its diluted shares since last year. On the surface this sounds like great news. The problem is the way the company accomplished these share repurchases was by destroying its balance sheet.

I wasn't able to find much positive in the company's financial statements. The company said its operating margin falling to 2.17% was due to non-recurring items like the costs related to “just for U,” but the company's operating margin of 2.47% without these charges still is nothing to write home about. Though sales were down 0.2%, inventory increased 11% since the beginning of this year. This inventory build up worries me for a company already struggling with sales. Considering that the company closed 23 stores during the quarter, you have to ask why inventory would increase?

Where things get really scary is the company's cash and debt balances. Operating cash flow decreased a mind numbing 49.57% and cash had dropped 72.2% since the beginning of the year. In the meantime, long-term debt has increased 39.11% during the same time frame. What is really crazy is long-term debt increased primarily due to share repurchases. I'm usually impressed when a company uses free cash flow to repurchase shares. However, when a company weakens its balance sheet significantly to buy back shares, this puts both the company and its shareholders at risk. Higher leverage on the company's balance sheet drives a higher interest expense, and this line item is the biggest risk to Safeway going forward.

In the grocery and retail field, one of the biggest risks to companies is too much debt. Companies with too much debt go the way that Supervalu is currently, having to eliminate their dividend and adopt austerity measures to survive. While it's true that Safeway isn't quite as bad off as Supervalu, take a look at the comparison of these two companies relative to their competition. Specifically, let's look at interest expense compared to operating income and levels of long-term debt. I think you'll see the same thing that I noticed:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Interest Expense to Operating Income</strong></p> </td> <td> <p><strong>Long-Term Debt To Total Assets</strong></p> </td> </tr> <tr> <td> <p>Kroger</p> </td> <td> <p>19.85%</p> </td> <td> <p>27.81%</p> </td> </tr> <tr> <td> <p>Safeway</p> </td> <td> <p>32.66%</p> </td> <td> <p>37.73%</p> </td> </tr> <tr> <td> <p>Supervalu</p> </td> <td> <p>74.16%</p> </td> <td> <p>49.26%</p> </td> </tr> <tr> <td> <p>Target</p> </td> <td> <p>14.51%</p> </td> <td> <p>32.18%</p> </td> </tr> <tr> <td> <p>Walmart</p> </td> <td> <p>8.29%</p> </td> <td> <p>22.58% </p> </td> </tr> </tbody> </table>

What I notice right away is Target and Wal-Mart are using much less of their operating income on interest expense. Second, I notice that both of these retailers have less leverage than two of the three traditional grocery store chains. What really jumps out though is the similarity between Safeway and Supervalu. Both companies have the highest interest expense relative to operating income, and both have the highest relative long-term debt to total assets. As I said before, Safeway isn't as bad off as Supervalu, but if the company continues to leverage up its balance sheet, it won't be long before this comparison becomes even more relevant.

I guess the big problem I have is, if you own Safeway why would you risk this investment given the alternatives out there? Safeway pays an attractive dividend of over 4.4%, but if that dividend were cut or eliminated then what would you have? By comparison, Kroger, Wal-Mart, and Target all look like better options. All three companies show similar or better growth rates compared to Safeway. All three pay dividends that are much safer, and all three have stronger balance sheets. Given the weakness in the company's current results, and multiple better alternatives, I wouldn't stick around Safeway stock to see how this one turns out.

MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Supervalu. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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