DBRS Confirms Safeway Ratings at BBB, R-2 (middle)

DBRS has today confirmed the Issuer Rating and Senior Unsecured Debt rating of Safeway Inc. and the Second Series Notes rating of Canada Safeway Limited (collectively, with Safeway Inc., Safeway or the Company) at BBB and the Company’s Commercial Paper ratings at R-2 (middle), all with Stable trends. The confirmation is based on Safeway’s capability and intention to return credit metrics to 2010 and 2011 levels (prior to accelerating its share repurchases using debt financing), while recognizing that the Company’s earnings profile, which has been under pressure due to intensifying competition and a difficult consumer environment, must show some stability or modest improvement in the near to medium term. The ratings continue to be supported by Safeway’s large-scale, geographic diversification and brand strength. The ratings also reflect the intense competitive environment, Safeway’s lack of format diversification, sensitivity to economic cycles, and high cost structure.

Safeway’s earnings profile remained under pressure through 2012 after appearing to stabilize somewhat in 2011, following difficult years in 2009 and 2010. Despite continued improvement in the broader economy, competition in food retail has remained intense as cautious consumers remain focused on value. Revenues in the first three quarters of 2012 remained relatively flat versus the same period in 2011 as higher fuel sales and revenue from Blackhawk Network Holdings (Blackhawk, the Safeway-owned gift card distribution network) were mostly offset by a lower number of stores and a decline in the value of the Canadian dollar year-over-year.

EBITDA margins declined modestly as revenues from fuel sales and Blackhawk, which feature lower margins, continue to grow as a proportion of overall sales in addition to higher promotional expenses and costs related to the launch of loyalty program “just for U”. As such, EBITDA declined to approximately $2.19 billion for the last twelve months (LTM) ended Q3 2012, versus $2.28 billion in 2011.

In terms of financial profile, Safeway is relatively consistent with expectations after its announcement on December 1, 2011, that it would use incremental debt to accelerate share repurchases and subsequently deleverage through the end of 2013. Cash flow from operations in the LTM ended Q3 2012 improved modestly versus 2011 due to lower pension contributions, while capex was relatively flat as the Company continued to open new and remodeled Lifestyle format stores. Total dividends paid on common stock declined modestly despite an increase in the dividend on a per-share basis in Q2 2012 (due to the high number of share repurchases). As such, free cash flow before changes in working capital increased to $423 million for the LTM ended Q3 2012. Pursuant to the previously announced plan, the Company used free cash flow and incremental debt to complete approximately $1.3 billion of share repurchases in H1 2012. In accordance with this plan, the Company began to use free cash flow to repay debt in Q3 2012, repaying approximately $468 million of balance sheet debt, ending the quarter with approximately $6.4 billion of balance sheet debt. DBRS confirmed the Company’s ratings despite the plan in December of 2011 based on the expectation that metrics would peak in 2012 (i.e., lease adjusted debt-to-EBITDAR of approximately 3.3 times (x)) and would return toward prior levels by the end of 2013 (i.e., lease adjusted debt-to-EBITDAR of 2.8x). At Q3 2012, lease-adjusted debt-to-EBITDAR was approximately 3.5x, due primarily to weaker-than-expected operating performance and higher levels of commercial paper used to fund working capital.

Going forward, DBRS expects that Safeway’s profitability should improve over the near to medium term as the U.S. economy continues to recover and the Company introduces new sales initiatives and leverages existing ones. Revenues should increase in the low- to mid-single-digit range in 2013, based on improving volumes, while margins should remain stable as the Company seeks to offset competitive pressures and higher fuel sales by reducing costs and improving efficiency. As such, the Company’s EBITDA is expected to be relatively flat or grow modestly on a comparable basis in 2013.

DBRS expects that Safeway’s financial profile should continue to revert to 2010 and 2011 levels as the Company deleverages subsequent to its accelerated share repurchases. Operating cash flow should continue to track operating income, while capex levels could decline modestly as the pace of new store openings, remodels and property development slows somewhat. Dividend policy should remain consistent after the recent increase on a per-share basis. Seasonal cash flows from Blackhawk are expected to be used to repay outstanding commercial paper; Safeway has also announced that a potential initial public offering of a minority interest in Blackhawk could occur in H1 2013, the proceeds of which could be used to further reduce debt. Should credit metrics not be tracking a return toward prior levels (i.e., lease-adjusted debt-to-EBITDAR of 2.8x) as 2013 progresses, due to weaker-than-expected operating performance or insufficient debt reduction, a negative rating action will likely result.

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

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The applicable methodology is Rating Companies in the Merchandising Industry, which can be found on our website under Methodologies.