A Safe Bet in This Economy

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

Over the past few years we have seen all of the major indexes – the Dow, S&P, and NASDAQ – rebound nicely from their lows.  During the course of that recovery, once investors were convinced that the economy was growing substantially, money was taken out of many of the low beta, safety stocks and placed into many of the high beta, high growth stocks.  Because demand for growth stocks increased investors bid their stock prices up. 

In contrast, over that same time period, some of the safety stocks either became dead money or even saw modest decreases in their valuations.  That is why Safeway has not only lagged the market, but also why it has an attractive valuation.   

How has the Competitive Landscape Changed?

Over the past decade we have seen consolidation in the Grocery channel.  As a result, the key players are now even larger than they were, the balance of power between the manufacturers and retailers has shifted, and the barriers to entry are more significant than they once were.  Because of the use of data in decision-making, it is a lot more difficult now to dethrone a Safeway (NYSE: SWY) or Kroger (NYSE: KR) or Costco (NASDAQ: COST) or Wal-Mart .  After all, all of the manufacturers want to win with these companies and partnerships focus on joint value creation.                 

These companies have all invested in sophisticated data systems that allow their buyers or category managers to monitor sales and profitability on a daily basis, measure the effectiveness of promotions, minimize out of stocks, and ensure that products are priced appropriately.  Stores are divided into several categories and each category tends to have a buyer who has P&L responsibility for his category.  So owning one of these companies is in many ways like owning several diversified smaller companies.                

How Do the Valuations Stack Up?

Nearly all of Safeway's competitors currently have P/E multiples greater than 13.  In fact, most of them have multiples in the 14 to 16 range, a multiple that is on par with an average stock in the S&P.  For nearly all of those companies, that multiple tends to reflect both stability and a modest growth rate of about 5%.  The exception is Costco, a company with a higher rate of growth and therefore a slightly higher multiple, which is currently over 20.  Compared to its competitors, Safeway has not only the lowest P/E ratio (around 9) but also the highest dividend (around 4%).  Plus the dividend represents only about 1/3 of the company’s forecasted earnings.  That means that there is no reason to expect it to go away anytime soon.                     

What Are Safeway’s Critical Challenges?

On the positive side, selling groceries tends to be a very stable business.  On the negative side, it is a very competitive business with low margins.  A significant risk is that price conscious shoppers switch stores.  Another significant risk, which is also the largest opportunity, is that it is essential to have efficient operations. 

High labor costs resulting from a significant Union presence, increased product costs, and macroeconomic factors such as inflation and the volatile costs of raw materials, all have the potential to impact margins and therefore earnings.  In addition to these risks, Safeway faces increased competition from Target, which has expanded its food offering, as well as increased competition from Costco, Wal-Mart, and smaller grocers.     

What Is a Fair Valuation?

Safeway’s current forward multiple is less than 9.  There are many reasons for such a low multiple: the “decline of the grocery store,” higher commodity prices, and increased competition from Target and Wal-Mart to name a few. 

But all of the retailers mentioned above have more or less the same sophisticated data systems (e.g., AC Nielsen point of sale data) and buyers that allow them to keep their pulse on the business, monitor trends, and increase their negotiating power with suppliers, which makes it very unlikely that any of them are going to see a rapid deterioration of their bottom line.  That is in sharp contrast to many of their smaller and ironically less agile competitors like Supervalu.  For that reason, I feel that Safeway merits a higher valuation.  If we were to use Safeway’s 5-year average P/E of around 12 times earnings, that would suggest a valuation of $2.07 (earnings estimate) x 12 = $24.84.       

3 Reasons to Buy Safeway

  1. Safeway is attractively valued.  With a forward P/E of less than 9 and a dividend of around 4%, Safeway appears to be a safe haven for money.  Safeway has a strong foothold in the grocery business and is seeing its business grow despite increased competition.
  2. A slowing economy.  As the economy slows and the major indexes (Dow, S&P, NASDAQ) stabilize, companies like Safeway benefit in three ways: first, investors take their money out of the high beta, high growth stocks and move it into the low beta, low growth stocks; second, consumers eat out less and go to the grocery store more often; and third, consumers trade down, meaning that instead of purchasing name brands they tend to purchase private label brands, which have higher margins.   
  3. Loyalty programs.  Safeway has made a commitment to reward loyal customers.  That means that Safeway has a significant amount of data that they will use to generate awareness, increase cross-selling, create demand, stock their shelves with the right products, ensure pricing is on target, and sell more high-margin products. 

My Foolish Take

If Safeway can increase identical sales by 2 – 3% and improve gross margin trends as a result of personalized promotions, Safeway has a very solid chance at delivering a total return in the 20-40% range over the next 2 years.  That implies a price of around $21 –$24 a share, which is aligned with previous earnings multiples, with what appears to be minimal downside risk.         

RyanPeckyno has no positions in the stocks mentioned above. The Motley Fool owns shares of Costco Wholesale. Motley Fool newsletter services recommend Costco Wholesale. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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