DBRS Confirms Safeway at BBB and R-2 (high)

DBRS has today confirmed the Senior Unsecured Debt and Commercial Paper ratings of Safeway Inc. (Safeway or the Company) at BBB and R-2 (high), respectively, and the Commercial Paper ratings of its wholly owned subsidiary Canada Safeway Limited (Canada Safeway) at R-2 (high). The trends remain Positive for the Senior Unsecured Debt rating and Stable for both Commercial Paper ratings.

On May 8, 2008, DBRS revised Safeway’s long-term trend to Positive, based on the significant improvement in the Company’s credit profile over the past few years. The improvement was due mainly to the Company’s successful Lifestyle-format conversion program, which has contributed to the generation of consistent same-store sales growth and improved market share, as well as brought an improvement in operating margins toward historic levels and an earnings profile that should be generally more resilient to economic pressures over the long term. At the time of the trend change, DBRS expected Safeway’s earnings profile to remain relatively stable over the near term, as top-line growth was expected to moderate and benefits from cost reductions and improved product mix would be mostly offset by continued margin pressure. Therefore, in its May 2008 report, DBRS stated that an upgrade of the ratings could be possible, provided F2008 performance remained stable.

Safeway did maintain its strong earnings profile in F2008, as consistent top-line growth and stable margins resulted in a 4.6% increase in operating earnings to $1.85 billion; however, a more difficult operating environment resulted in F2008 same-store sales growth (excluding fuel) of only 0.8%, compared with 3.4% in F2007. Same-store sales became increasingly pressured in F2008 due to the general decline in consumer spending, the continued increase in generic drug and private label product sales, greater investment in pricing, and deflation in certain product categories. This trend continued in Q1 F2009, as same-store sales (excluding fuel) and adjusted for the shift of Easter into Q2 were up by only 0.2% in the quarter. Furthermore, operating expense reductions could not keep pace with the ongoing investment in pricing and increased promotional spending, which led to a 1% drop in operating margins and 30% decline in operating earnings for the quarter.

Given this recent decline, before considering an upgrade DBRS would like to evaluate Safeway’s results over the next couple of quarters to ensure that its business model can successfully deal with current pressures and stabilize performance. That said, DBRS is optimistic that current pressures will not affect the Company’s strong earnings profile, given that the impact of the Easter shift should benefit Q2 F2009 results, promotional activity is expected to return to more normal levels and further gains from operational efficiencies should help keep F2009 results relatively stable. The long-term trend, therefore, remains positive. DBRS expects net earnings will be slightly lower in F2009, however over the longer term as the Company’s Lifestyle format conversion is completed and consumer spending recovers, DBRS expects Safeway’s earnings growth to return (+3% to 4% per annum).

Safeway’s financial profile remained stable in F2008, as higher cash flow from operations ($2.5 billion) continued to support ongoing capital expenditures ($1.6 billion), increased net share repurchases ($331 million) and modest debt reduction ($130 million). With higher operating cash flow and lower gross debt of $5.5 billion at year-end (compared with $5.66 billion at year-end F2007), the Company’s leverage and coverage metrics continued to improve in F2008, albeit at a more modest pace. While DBRS expects Safeway’s operating cash flow to decline in F2009, the Company has reduced budgeted capex substantially to $1.0 billion, which should result in an increase in net free cash flow to approximately $1.0 billion compared with $657 million in F2008. The increase in net free cash flow should allow for increased shareholder returns and further debt reduction, which should keep Safeway’s financial profile stable. DBRS expects that lease-adjusted cash flow-to-debt will remain around 0.30 times (x) for F2009, compared with 0.32x at year-end F2008.

Safeway’s credit profile continues to be supported by its position as the fourth largest food retailer in the United States (with a number-one or -two share in most of its markets) and its geographically diversified store base. Given these strengths and the operational and financial improvements realized by Safeway, DBRS believes the Company will be able to maintain a credit profile supportive of an upgrade of the Senior Unsecured Debt rating in the near term. In the unlikely event that Safeway is unable to stabilize performance and full-year results are expected to be materially lower year-over-year, the trend could be revised to Stable, leaving the Company well placed in the BBB rating category.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The applicable methodology is Rating Food Retailers, which can be found on our website under Methodologies.

This is a Corporate rating.