Alan Schram has been managing investment portfolios for private and institutional investors since 1997. He founded Wellcap Partners in 2000 and serves as managing partner and portfolio manager, responsible for all investment decisions. Between 1997 and 2000 Mr. Schram served as an analyst and portfolio manager at InterGroup Corp., a Los Angeles-based long/short U.S. equity manager. The below investment thesis was originally posted on SumZero, the leading community for hedge fund and mutual fund investment analysts where professional investors share investment ideas exclusively with one another. Through The Motley Fool, select content from SumZero is now available to individual investors. 

Thesis
Safeway
(NYSE: SWY) is one of the largest food and drug retailers in North America, operating about 1,725 stores, principally in Western U.S. The majority of the company retail stores operate under the Safeway brand, as well as company-owned store brands that include Randalls/Tom Thumb in Texas and Vons/Pavilions in Southern California. The company also provides third-party gift and prepaid cards through its wholly owned subsidiary Blackhawk Networks, and owns a 49% stake in Casa Ley, which operates 146 food and general merchandise stores in Mexico.

With over $40 billion in sales, Safeway has about 7.3% market share within the supermarket category and 4% of total grocery sales. The average size of Safeway's stores is about 46,000 square feet. Sales per square foot ($500) are higher than the supermarket average of $465 per square foot.

In April 2005, the company launched a major brand repositioning in its stores ("Lifestyle") and the service it provides to customers. Lifestyle format stores feature improved lighting and attractive fixtures, and highlights what the company views as high-quality fresh product and unique offerings. Experiencing early success with the concept, the company now has 80% of its stores based in the new Lifestyle format. We believe this capital spending strategy has given it one of the most attractive portfolios of stores in the industry. Furthermore, as the capital spending program now begins to decrease substantially, free cash flow is enhanced.

What we like
Here's a rundown of what we like about Safeway:

  • Strong cash flow, solid balance sheet: Net debt is $4.8 billion, generating $1.4 billion in free cash flow. While returning cash to shareholders through stock repurchase and 2% dividend yield, Safeway also managed to reduce its ratio of net debt to equity from 85% in 2006 to an expected 29% in 2011.
  • Strong brands: Safeway has proven adept at developing its own brands.
  • Counter-cyclical, defensive business: The groceries business is steady even in an economic decline.
  • Built-in inflation hedge: With major real estate holdings and the ability to pass on food costs to consumers, an inflationary cycle should be a growth builder for the company.
  • Competent, experienced, shareholder friendly management: CEO Steve Burd owns approximately 3% of the shares, so his incentives are aligned with those of shareholders.
  • Real estate: Dominant real estate position, which is often impossible to replicate and provides a solid moat. Safeway owns 710 stores, 41% of the total, and we believe the real estate is worth approximately $7/share (albeit difficult to realize).
  • Card business: Blackhawk Network, a wholly owned subsidiary, sells more than 300 brands of prepaid and gift cards and distributes them to retailers in over 70,000 locations, reaching 165 million customers every week. Despite the economic softening, the gift card business has continued to grow rapidly. It dominates the niche and if sold, could be worth $5/share (as an example, Green Dot (GDOT) trades at 47 times earnings).
  • Attractive valuation: With $8 billion in market cap and $12.8 billion in enterprise value (EV), free cash of $1.4 billion a year is appealing.

Catalysts
So what are the catalysts to move Safeway forward?

  • Low valuation: (EV/EBITDA of 4.5).
  • We believe food price inflation will soon start generating earnings momentum for Safeway.
  • With its capex cycle peaking and reaching completion by 2011, it is setting the stage to boost free cash.
  • The Blackhawk business could be IPO'd next year. Ancillary value provided by the real estate and card business, both currently obfuscating the value of the underlying grocery business.
  • Safeway is a low-risk, high-return situation, a defensive, counter-cyclical business trading at a discount to intrinsic value. The current share price offers margin of safety that is rare for a business of this quality. With its steady, predictable business, Safeway could (again) easily become a target for private equity acquisition.

Variant view
To sum up:

  • Deflationary pressures continue to be the deciding factor for grocery store valuations. Deflationary pressures are hurting margins, but they are transient and overstated. While this is priced in, headline risk remains. We believe food price inflation will soon translate into higher prices at supermarkets, and positive operational leverage for Safeway.
  • Price competition: Safeway's move up the quality ladder has hurt the firm in this economic environment. Identical-store sales turned negative in 2009 after averaging 3% growth over the past five years. Consumer perceptions take time to change and with consumers' flight to discounters such as Wal-Mart and Costco, Safeway operates in an increasingly competitive industry. Hence, the steep discount it trades in.
  • Capex spending cycle misunderstood: Most of the Lifestyle project capex has been completed.

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SumZero.com, Wellcap Partners, and its affiliates are not subject to The Motley Fool's trading rules. Wellcap Partners has a position in Safeway and may trade in and out of the position at any time. This report is for information purposes only and is not a solicitation. Read about the Fool's disclosure policy.

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