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There's Nothing Safe About This Company

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I beat up on Safeway (NYSE: SWY  ) a lot. It's my go-to comparison against Whole Foods (Nasdaq: WFM  ) when I want to show how much organic and specialty-food sales are growing compared to their conventional counterparts, which, well, aren't. But after a recent article, I started wondering if it was fair to treat Safeway that way. Read on to see why, after a closer look, I've decided that, yes, it is fair, and I am going so far as to make an underperform CAPScall to back that up.

The best of the worst?
Safeway is not the worst of the so-called big three grocery retailers, which also includes SUPERVALU (NYSE: SVU  ) and Kroger. That distinction goes to SUPERVALU, whose hemorrhaging profits and SVU ticker always make me think of Law and Order: Special Victims Unit. Really, Safeway is the best of the three, with the highest margins, the most free cash flow growth, and the lowest valuation. Unfortunately, that just makes it the best of the worst.

EBITDA Margin TTM data by YCharts.

Let's look at the three by comparing EBITDA margin, to account for Safeway's $2 billion writedown in 2009 and SUPERVALU's almost annual writedowns. All three have been on the decline for a while now, and while Safeway leads the pack, it's easily beaten by competitor Whole Foods. It may be tempting to explain this away with Whole Foods' emphasis on premium products, which command a higher margin, but even Wal-Mart (NYSE: WMT  ) is almost as profitable, and Dollar Tree (Nasdaq: DLTR  ) blows them all out of the water.

One of the problems Safeway faces in this regard is that it doesn't know whether it wants to be a low-cost or premium retailer. Its store brand O Organics line of products are priced similarly to conventional name brands, preventing it from capturing much of the premium that organic products command. On the other hand, it's hard for Safeway to safely compete with the likes of Wal-Mart and Dollar Tree, which have both been aggressively stealing market share at the low end.

Declining margins wouldn't be the worst thing in the world if Safeway could outpace the declines with sales growth, but that isn't happening. Safeway has the impressive distinction of having experienced consistently flat sales for five years now, while competitors either grow or fall. This would indicate that Safeway's declining margins have simply been the cost of retaining customers as the industry becomes increasingly bifurcated between the high end and the low end.

Not a safe way to invest
Because Safeway's sales and margins have both suffered, its relatively decent free cash flow growth over the last five years is best explained by a decline in capital expenditures -- which is to say, Safeway is reinvesting less and less in its business. That's a strategy that can only work for so long, and really, it's not working well for Safeway already. The five-year growth is still benefiting from a surge from 2007-2009, but since then, free cash flow has fallen by nearly half.

Safeway's rapidly declining free cash flow is especially problematic for investors attracted to its 4% dividend. A year ago, the company put its investment-grade credit rating on the line, earning downgrades from Fitch and Moody's by issuing over a billion dollars in debt in order to buy back stock in the belief that interest rates were low, its stock was undervalued, and it could grow operating cash flow to repay the debt. Both the stock and operating cash flow have fallen about 15% since the buyback program was announced.

The Foolish bottom line
The fact is, Safeway and the rest of the big three are caught between customers who want to save money and customers who want to upgrade their menu. Their margins have been increasingly compressed as they fight a seemingly losing battle to retain market share against stores that specialize in either customer group. Safeway's new strategy of reinvesting in its stock instead of its business seems particularly ill-founded, and won't be good for shareholders in the long run.

Safeway may be on the decline, but Whole Foods has booked more than 30 times the initial investment for those who saw the organic trend coming some 20 years ago. However, it may not be too late to participate in the long-term growth of this organic foods powerhouse. In this brand-new premium report on the company, we walk through the key must-know items for every Whole Foods investor, including the main opportunities and threats facing the company. We're also providing a full year of regular analyst updates to go with it, so make sure to claim your copy today by clicking here.

Jacob Roche has no positions in the stocks mentioned above. Check out his Motley Fool CAPS profile or follow his articles using Twitter or RSS. The Motley Fool owns shares of Supervalu and Whole Foods Market. Motley Fool newsletter services recommend Supervalu, Whole Foods Market, and Wal-Mart Stores. 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.

Read/Post Comments (4) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 01, 2012, at 3:05 PM, goatwig wrote:

    A simple way to look at it is "times are tough" organic is over-rated and my grocery bill is 2x when I shop at WFM.

    WFM is essentially a high-end retailer.

    As for the stocks WFM PE of 39.96 vs SWY PE of 7.62 is similar to my disparate grocery receipts.

    SWY open nature in-store brand is getting a lot of traction.

    I spend a lot of money at SWY and I am long the stock.

    I am also SHORT WFM.

  • Report this Comment On November 01, 2012, at 3:23 PM, goatwig wrote:

    "Its store brand O Organics line of products are priced similarly to conventional name brands, preventing it from capturing much of the premium that organic products command."

    I missed this point you made. What you are pointing out is lower priced competition for organics (which are a joke anyway) which should hurt WFM margins if anything.

    I am adding to both positions :)

  • Report this Comment On November 01, 2012, at 10:40 PM, TMFTheDoctor wrote:

    The point was that Safeway is selling a high end product at a low price, which is partially responsible for its margin compression. The company is getting squeezed because it's trying to compete with a high-end retailer (WFM) on the one end and a bunch of low-end retailers (WMT, TGT, DLTR, COST) on the other end. The whole middle group of grocers has been suffering because of this situation.

    I do, however, agree that WFM is overpriced. Whole Foods is a great business, but a few months ago I ended my outperform CAPS call on WFM purely on the basis of valuation, and I haven't changed my mind (although the stock has continued to outperform since then). But a look at the chart I posted should tell you that Safeway is doing anything but hurting Whole Foods' margins.

  • Report this Comment On November 01, 2012, at 11:18 PM, GETRICHSLOW2 wrote:

    Don't disagree with anything the article says but I like SWY. It does need to decide which groove it is going to run in. At it's current valuation and 4.3% div. I am keeping it on my watch list. Not everyone can afford to shop at Whole Foods.

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Related Tickers

1/30/2015 4:05 PM
SWY.DL $0.00 Down +0.00 +0.00%
Safeway CAPS Rating: **
DLTR $75.97 Up +0.26 +0.34%
Dollar Tree Stores CAPS Rating: ***
SVU $4.47 Down -0.03 -0.67%
SuperValu CAPS Rating: **
WFM $28.27 Up +0.19 +0.68%
Whole Foods Market CAPS Rating: ****
WMT $69.19 Up +0.85 +1.24%
Wal-Mart Stores CAPS Rating: ***