DBRS Revises Safeway’s Long-Term Trend to Stable from Positive

DBRS has today revised the trend on Safeway Inc.’s (Safeway or the Company) BBB-rated Senior Unsecured Debt to Stable from Positive. The trend change reflects DBRS’s view that Safeway’s operating performance will no longer support an upgrade of the rating in the near term, due to weaker-than-expected year-to-date results and a significant reduction in F2009 earnings guidance. Its Commercial Paper ratings, including that of its wholly owned subsidiary Canada Safeway Limited (Canada Safeway), remain unchanged at R-2 (high), with Stable trends.

On June 12, 2009, DBRS confirmed Safeway’s ratings and maintained the Senior Unsecured Debt trend Positive, despite noting declining same-store sales growth and a reduction in Safeway’s operating margins in Q1 2009. Same-store sales became increasingly pressured in F2008 and Q1 2009, due largely 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. Operating expense reductions could not keep pace with the ongoing investment in pricing and increased promotional spending, which led to the drop in operating margins. Despite these pressures, DBRS was optimistic that promotional activity would return to more normal levels and that further gains from operational efficiencies would help to keep F2009 results and the Company’s earnings profile relatively stable, potentially supporting an upgrade of the long-term rating.

Safeway’s operating environment become more difficult than expected in Q2, however, due in part to greater-than-expected deflation in dairy and produce, increased trading down and a competitive environment requiring higher levels of price investment. For the six months ended June 20, 2009, Safeway saw its total sales decline by 7.1% year-over-year (YOY) to $18.7 billion and its operating earnings decline by 25.1% YOY to $639.1 million. Comparable same-store sales declined by 2.2% in the quarter compared with an increase of 0.2% in Q1. Safeway’s operating margin for H1 2009 dropped to 3.4% compared with 4.2% for F2008. Despite the Company’s continuing efforts to drive traffic with lower pricing and reduce operating costs, Safeway expects that current pressures will remain significant throughout F2009 and has therefore lowered its earnings guidance for the year to between $1.70 and $1.90 per diluted share, from the previously lowered guidance at Q1 of $2.10 to $2.30 per share. Given the revised earnings per share range and number of shares outstanding (assuming some additional share repurchases out of free cash flow in H2), DBRS estimates that net income will be below $800 million for the year, compared with net income of $965 million in F2008. Given the Company’s significantly lowered earnings outlook, DBRS no longer believes an upgrade will be possible in the near term; the trend, therefore, has been revised to Stable.

We note that despite the lowered earnings guidance, Safeway continues to expect free cash flow (cash flow from operations less capex) of between $1.1 billion and $1.3 billion in F2009, due in part to a reduced capex budget of $1.0 billion. While DBRS expects free cash flow may be slightly below current guidance, we continue to believe that it will remain sufficient to allow Safeway to maintain a stable financial profile, keeping the Company well placed in the BBB category.

Over the longer term, DBRS believes Safeway’s 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 will keep the Company well positioned relative to its peers. Furthermore, while building Safeway’s value proposition remains challenging, if successful, this strategy, combined with the Company’s strong asset base, should position Safeway well for a recovery as economic conditions improve in F2010 and beyond.

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.