4 Red Flags for This Ailing Grocer

Shares of grocery store Safeway (NYSE: SWY  ) have been on quite a run -- up almost 70% over the past year. And, given that it's still at 14 times forward earnings with a prospective dividend yield of 3%, investors might be tempted to pick up a few shares. However, I'd be very wary of purchasing Safeway shares. Below are four red flags that investors should consider during their analysis of Safeway. 

1. Deluge of competition
Safeway, and indeed the entire supermarket channel, is subject to heavy competition. On one hand, superstores like Wal-Mart and Target and wholesales clubs like Costco compete fiercely with Safeway on price and convenience.  On the other hand, specialty and organic stores like Trader Joe's and Whole Foods Market compete fiercely on quality and experience. That leaves Safeway stuck in the middle without a compelling angle to lure in consumers. In fact, according to Morningstar, traditional grocery stores have lost nearly 20% market share over that past 25 years to new entrants. Add in competition from Amazon.com, dollar stores, and pharmacies, and Safeway is in a tough spot. 

2. Stagnant sales and plummeting profitability
As you might expect in this competitive environment, Safeway has struggled with both growth and profitability. Since 2008, sales have grown less than 1% annually. In other words, sales aren't even keeping up with inflation. Operating margins have fallen four years in a row. In 2009, the company generated 4.3% operating margins, but that had fallen to 2.5% by 2012. And I expect operating margins will continue to fall. Safeway recently sold off its Canadian stores, which were generally more profitable than the U.S. stores, which generated only a 2% operating margin in 2012. 

3. Obligations on and off balance sheet
And Safeway doesn't have a lot of flexibility if profits continue to fall. The company has significant debt to go along with pension and lease obligations. Safeway has $5.7 billion in debt, and only $542 million in cash. The company does plan to use $2 billion of the proceeds from selling Safeway Canada to pay down debt, but this will still leave the company with $3.7 billion in debt. The company's pension is underfunded, with $2.6 billion in pension obligations and only $1.8 billion in assets. Additionally, Safeway contributes to a multi-employer pension plan for some of its employees, of which the total obligation is difficult to calculate. In 2012, a Credit Suisse analyst estimated that Safeway's total pension obligation exceeded $7 billion. The company also leases more than half its stores, and it has lease obligations of more than $4.8 billion, the majority of which aren't accounted for on the balance sheet.

4. Unhappy unionized workforce
New CEO Robert Edwards, former Safeway CFO, has inherited a tough company to manage. Nearly 80% of Safeway's employees are represented by collective bargaining agreements -- in other words, they are unionized. To keep its employees on the job, Safeway needs to negotiate with nine different international unions. Certainly not an easy task, and at present Safeway has over 430 collective bargaining agreements that typically last three to five years. Thus, management is almost always negotiating. And, despite being represented by unions, the workers aren't very happy. According to Glassdoor.com, only 36% of employees would recommend Safeway to friend and only 37% approved of former CEO Steve Burd. By contrast, 75% of Wegmans employees would recommend the company to a friend, and 86% approve of CEO Danny Wegman. 

Foolish bottom line
Safeway is facing stiff competition, falling margins, slow growth, debt, and off-balance-sheet obligations. And its management and employees will face an uphill battle to turn the business around. For now, investors should tread carefully around this stock. 

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