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Skeptical of Safeway's Spin

By Salim Haji
April 26, 2004

Last week, Safeway (NYSE: SWY) made a presentation (pdf file) to a group of institutional investors. The presentation, which the company filed with the Securities and Exchange Commission, provides some interesting insights into how Safeway is positioning its stock to large investors and into its strategy to defend its business against Wal-Mart (NYSE: WMT) and other discounters.

In the first part of the presentation, entitled "Committed to Creating Superior Shareholder Returns," the company argues that long-term returns have been greater than the market and than its "peer group," which includes Alberstons (NYSE: ABS), Kroger (NYSE: KR), A&P (NYSE: GAP), Ahold (NYSE: AHO), and Winn-Dixie (NYSE: WIN).

Over the current CEO's tenure, from Oct. 1992 to April 2004, Safeway has returned 667% versus 239% for the S&P 500 and 80% for its peer group. While the company concedes that in more recent years (since April 1999), it has significantly underperformed the S&P 500, the presentation reassures potential investors that "recent share price performance is in line with our peer group." Looking at it that way, the stock perhaps doesn't sound like a bad investment.

But the real comparison should not be against other struggling business models in the "peer group," but against new, innovative retailers like Wal-Mart and Whole Foods Market (Nasdaq: WFMI). In April 1999, $100 invested in Whole Foods would be worth $315 today and worth $132 if invested in Wal-Mart. Invested in Safeway, that $100 would be down to $44.

The presentation also provides some insight into how Safeway and other traditional grocery stores are trying to fight back against discounters. The strategy articulated by Safeway is two-pronged. First, it is "positioning for long-term competitiveness," which is no more than a fancy way of saying that the company is trying to cut costs wherever it can. Also, it is "creating a superior retail offering," which involves a series of actions taken to try to create differentiation, with higher-quality perishables and better service as the key factors.

In my opinion, the strategy is doomed to fail on both fronts. Conventional grocery stores will simply never be able to match the low-cost structure of Wal-Mart or Costco (Nasdaq: COST). And they certainly won't be able to create meaningful differentiation in perishables and service as they squeeze concessions from their workers or cut costs in other ways. Discerning customers increasingly have the option to shop at high-end stores like Whole Foods, where the quality of the perishables and service are significantly better than at a conventional grocery store. Stores like Safeway are simply stuck in the middle, and they are fighting a losing battle.

With the stock valued at an enterprise value-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) number of 8.4, it's clear that certain investors are buying Safeway's story. But a more critical look at its recent presentation indicates that the viability of the underlying business model is questionable and that its strategy to defend against innovative retailers is fundamentally flawed.

Costco is an existing Motley Fool Stock Advisor selection, and Whole Foods is a former one. Check the newsletter out for six months, risk-free.

Fool contributor Salim Haji lives in Denver, Colo., and owns shares of Costco and Whole Foods.

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