Barron's recently questioned whether supermarket (excuse me, lifestyle food center) Safeway (NYSE:SWY) is ripe for a fall or not. It's certainly a good question to ask, especially given the huge rise over the year.

Honestly, I don't know whether the stock price will continue to rise or begin to fall. I can't predict what's going to happen in the stock market in the short term. But I will say this: I have no idea what propelled the stock to rise in 2006.

Safeway is in the process of redesigning itself from a traditional supermarket into a lifestyle center for food. The plan kicked off in 2003 and, strategically, that's probably a good decision. You don't want to compete solely on price. There's only one potential winner in that game, and that's the lowest-cost producer.

So to evaluate how well things are going with the store remodeling, let's look and see how much capital management has spent and how much operating income they generated in the process.

2004

2005

LTM 2006

CAPEX

$1,213

$1,384

$1,640

EBIT

$1,219

$1,325

$1,487
Dollars in millions. Data from CapitalIQ.

Here's what I don't understand. Safeway has spent about $3.7 billion from the end of 2003 through the third quarter of 2006 to remodel stores. Store counts have actually declined, so it's pretty safe to assume that all of the capital is going to the remodeling effort. And yet operating income is up only $268 million. Sure, it's rising, but it's not rising very fast. It's taking lots of capital to make it rise, and it's still far below what the company was making when the strategic makeover started.

And yet, investors are bidding up the shares. I don't get it, I don't want to get it, and I don't think I'll ever get it. Why would I want to bid up the price of a company that's spending billions of dollars to remake itself and essentially not earning very much return on that capital?

What makes the whole situation even more interesting is this comment in the Barron's article from CEO Steven Burd: "The value of our company lies in its management, not assets."

Hmmm. Let's say management spent $2.6 billion to generate an incremental return of $268 million. That's about a 10% return over those two years. And let's not forget that we're talking about a situation where EBIT is trying to get back to previous levels, not rising above them. So I'm not sure that I would agree with the assessment above. I'm sure that there are great managers at the company making good decisions, but sometimes a tough business can run roughshod over even the best managers.

Again, I'm not going to make any prediction about what will happen to the stock price over the short term, but I can use today's stock price to back out the expectations investors have built into that stock price. So let's do just that.

To justify a higher price, the market must be assuming there's more goodness coming down the road. To see what's happening today, let's take a look at sales and margins. That will give us an idea of what we may be able to expect. Also, the trends will allow us to get an idea of what the competitive landscape is like (as if we don't already know it's brutal).

2004

2005

LTM 2006

Sales

$35,823

$38,416

$39,728

Gross Margin

29.6%

28.9%

28.8%

Operating Margin

3.4%

3.6%

3.9%

Net Margin

1.6%

1.5%

1.9%


These are interesting results. Sales have been growing even though the company isn't adding new stores. Gross margins are falling, while operating and net margins have been slowly rising. So during the turnaround, it also looks like management has reduced its cost structure along the way.

That falling gross margin number bothers me, though. On a yearly basis, gross margins are falling (they've been increasing a bit on a quarter-over-quarter basis), and the incessant pressure from the likes of Whole Foods (NASDAQ:WFMI), Wal-Mart (NYSE:WMT), Kroger (NYSE:KR), SUPERVALU (NYSE:SVU), and more upscale supermarkets like Harris Teeter, owned by Ruddick (NYSE:RDK), will likely make it difficult to keep them rising. How fast can management continue to take costs out of the system, and when will the remodeled stores allow them to perhaps increase prices?

I don't have the answers to those questions, but looking at the CAPEX data above, it looks as though it's costing the company lots and lots of money to try to make that happen. Quite frankly, I wouldn't put my capital to use in a company whose capital is barely earning returns above the cost of that capital.

What about the price of the company today? I'll start by taking the average of the free cash flow generated over the last five years, which is about $650 million. If I use that as my starting point, it has to grow at 12% over the next five years, 8% over the five years following that period, and then at 3% after that in order to justify a stock price of about $34. That doesn't seem like a bet that's in my favor, given that the company is spending billions of dollars of capital just to maintain its position. Sorry, I try to keep my investment dollars away from the Red Queen effect.

For more on these retailers, check out:

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Retail editor David Meier is ranked 552 out of 19,068 in CAPS and does not own shares in any of the companies mentioned. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.