Recently, we downgraded Safeway (SWY) to Underperform with a target price of $19.00.
We note that the environment for the retail industry is quite challenging. Consumer spending on durable products has, consequently, been very weak. This is evident from the decline in non-fuel identical (ID) store sales growth. The company expects non-fuel ID store sales growth of -1% to -1.5% in 2010. Although the company did witness a marginal recovery in volume during the latest reported quarter following a reduction in prices last year, it is not sufficient to drive revenue growth.
The current economic scenario has made consumers more price-sensitive and they are choosing less expensive products that have impacted Safeway. Moreover, the company is experiencing deflation, which has increased its woes. The issue of deflation came to the forefront in 2009, which witnessed a 0.3% deflation instead of normal 3% inflation of price per item, which has been the average for eight years. The magnitude of retail deflation, much greater than anticipated during the second quarter of 2010, continues to be the deciding factor for Safeway. Persistent deflation has forced Safeway to lower its guidance for 2010. The company now expects EPS in the range of $1.50–$1.70, down from the earlier guidance of $1.65–$1.85.
Although the company had earlier predicted an inflation of 0.5% during the second quarter, in reality, it experienced a 2.4% deflation, marginally better than a 3% deflation witnessed in the fourth quarter of 2009. The deflation at Safeway was driven by the price cuts undertaken in the third/fourth quarter of 2009, growth in lower priced generic drugs and private label products and deflation in produce and dairy. However, the dairy category has been witnessing cost increases in the third quarter, which are being matched by retail price increases. For 2010, the company expects deflation to be at 1.2% compared with the earlier expectation of 0.4% inflation.
Moreover, if inflation returns in the second half, Safeway may find it difficult to pass on increased prices to its customers due to the tough competition. As a result, it will be a drag on its gross margin.