Does Safeway Have More Upside Potential?

Shareholders of Safeway (NYSE: SWY  ) must be quite happy that its share price has risen by nearly 124% in the past twelve months. The share price rise has also been fueled by the rumors that Safeway was a potential acquisition target for several private equity firms. Is a total market value of $8.60 billion too expensive, or does Safeway have more room to run higher?

Business restructuring to enhance shareholder value
Safeway is the second biggest mainstream grocery store in the U.S. with around 1,406 stores. After the third quarter of 2013 the company decided to exit the Chicago market, where it has around 72 Dominick's stores, by the beginning of next year. The exit is expected to deliver a cash tax benefit of around $400 to $450 million.

Previously, the company reached an agreement to sell its Canadian operations to Canadian food retailer Sobeys for around C$4 billion after taxes and other related expenses. This deal could close by the end of this year. Indeed, these divestments will help maximize shareholder value because Safeway plans to pay down $2 billion of debt and repurchase its shares. 

Aggressive share buybacks financed by debt
Safeway has been considered an aggressive buyer of its own shares. As of September 2013, its treasury stock has grown to nearly $9.13 billion, while its equity stayed at more than $3.2 billion. The share repurchases have been supported by both Safeway's cash flow and debt financing.

Currently, the debt and pension benefits obligation for Safeway is around $6.25 billion. Along with the Canadian divestments, the company has confidently increased its stock repurchase authorization by $2 billion. This authorization has no expiration date. The future share buyback might increase Safeway's EPS over time due to a lower total share count. However, if Safeway repurchases its shares at an overvalued price, shareholders will lose, not benefit from the buyback.

Highly leveraged but not so expensive
At around $36 per share, Safeway is valued at around 6.33 times its EV/EBITDA, or enterprise value/earnings before interest, taxes, depreciation, and amortization. Interestingly, this valuation does not seem pricey at all compared to larger grocery retailers Kroger (NYSE: KR  ) and Wal-Mart  (NYSE: WMT  ) . Kroger, at nearly $22.4 billion market value, trades at around 6.44 times its EV/EBITDA. Wal-Mart is the most expensive among the three, trading at 8.04 times its EV/EBITDA. 

Previously, what made me worry is Safeway's high leverage ratio. Its debt/EBITDA ratio has stayed above three, while Kroger's leverage ratio is only 0.16. Wal-Mart's debt/EBITDA is quite compatible with the industry average at 1.76.  Interestingly, both Wal-Mart and Kroger have also repurchased significant amounts of their shares from the market in the past.

In the past four quarters, Kroger returned more than $920 million to shareholders through both buybacks and dividends.  In the second quarter, Wal-Mart paid out $1.5 billion in dividends and bought back $1.9 billion worth of shares. In its $15 billion buyback authorization Wal-Mart still has as much as $13.9 billion remaining, which accounts for 5.6% of its current market value. 

Attractive or not?
I personally like the Canadian business divestment, which Safeway got a good price for. The Canadian business generated around $530 million in EBITDA so it was valued at nearly 11 times its EV/EBITDA, which is nearly double the current market valuation of Safeway. With the planned debt reduction, ongoing share repurchases, and a decent valuation, Safeway could bring more returns to its investors. 

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