Investment Report

Supermarket Industry
BENTLEY UNIVERSITY

ANDERSON MIKE
CHAHROUR FARAH
ESTABROOKS IAN
GILMAN ANDREW
FI 640
Dec 9th 2010

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Supermarket Industry
Rating: BUY

WHOLE FOODS MARKETS, INC

(WFMI)
Current share price: $48.89
Market capitalization: $8.08 B

12-M price target: $59.69

Chahrour, Farah (MSF candidate)
As of Dec,8 2010

WFMI

PROFILE

Interactive Chart

YTD WFMI vs S&P 500

Shares outstanding (in M):
Earnings per share:
2011 EPS (Cons):
PE (fy1):
52 wk Range:
Avg Vol (3m):
Revenue (in B):
EBITDA(ttm in M):
EV/EBITDA:
Debt/ Equity (mrq):
Dividend yield:
return on equity:
Free cash Flow (in M):

172
$1.33
$1.71
27.9
$24.94 - $48.02
2,818,970
8.74
716.1
10
22.33
0%
11.13%
320

Investment Thesis

Organic food market is capturing market share from overall

supermarket industry
WFMI has first mover advantage in national organic food retail
driving visible store growth
healthy lifestyle is driving min 3% same store sales growth in the
coming years
WFMI offers stable cash flows + option value on store growth
Unlevered balance sheet gives Whole Foods the opportunity to open
or acquire stores
Price Target of $59, representing ~22% upside based on numerous
valuation metrics
My EPS 2011 is $1.84, street is at $1.7
Organic food market is capturing market share from traditional food
Investment Risks

Intensive competition from all grocery stores who started imitating

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According to the Nutrition Business Journal, by 2011 the sales of natural/organic food products
are expected to grow 10%-13%. Whole Foods Market is the leader in organic foods with $9.B in
sales in 2010 where the overall U.S organic food sales are $26.6B which means 34% market
share according to Organic Trade Associations 2010 Organic Industry Survey, then I think
Whole Foods will be able to capture market share from the overall supermarket industry. During
recession WFMI lost just 2%, while economy is recovering I expect WFMI to gain market share.

WFMI has first mover advantage in national organic food retail

Whole Foods have 300 stores at end of fiscal year 2010 located at different states. Customers
have built strong relation with WFMI brands. People are going more into healthy lifestyles and at
the same time eat more at home since they want to save money; WFMI has developed ready
products for those customers. WFMI has room for more stores opening hence attracting more
customers. Compared to its peers, WFMI having just 300 stores while average stores for its peers
is 2900 stores and management is forecasting another 50 stores by 2013. The below chart shows

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that as the sales of organic food goes up, same is for WFMI sales. In 2009, 2% loss in market
share will be recovered with recession recovering the coming years.

4% minimum same store sales

As the below chart shows, sales growth of WFMI were exceeding on average the industry
growth except for the recession, but as current year 2010 WFMI were able to recover its sales
and exceed the industry which was little above 5%. I am being conservative and assuming a 4%
minimum growth for SSS although there is opportunity for higher growth.

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WFMI offers stable cash flows + option value on store growth

Supermarkets are considered to be defensive. With the expected growth of WFMI investing in
such type of company which has stable cash flows is good considered a good investment.
Demand for food is inelastic hence people will keep buying food and in an environment where
people started to care about being healthy and going green, WFMI is not just a company offering
stable cash flows but expected to grow as well.
Unlevered balance sheet

Unlevered balance sheet gives Whole Foods the opportunity to open or acquire stores. For
example, excess cash led to pay off $210 Million of their long term debt in 2010. Since WFMI is
planning to open new stores either by expanding or acquisitions, it will need capital and since it
is low levered, it has more chance to get those loans and hence grow.
Price Target of $58, representing ~26% upside

Based on DCF valuation model to get FCFF and 3 chosen multiples: PE, P/sales and
EV/EBITDA; and by assigning 50% to DCF and 50% to the average price got by the different
multiples I got a $56 12 months estimate stock price versus $46 currently which means there is
20% upside assuming conservative sales growth rate.
Forecasted Financial Statements:
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Income statement: My forecast was based on 5 years historical financial data. Basically, I
forecasted the number of store openings in last quarter of year 2010 (Sep-Dec) then years 20112015 quarterly. To do that, I relied in the management discussion at Whole Foods where that
mentioned how many stores they are planning to open in years 2011 (14 stores) and 2012 (20
stores). From there I assumed same number of stores will be opened in years 2013, 2104 and
2015 (20 stores), I was conservative on how much they are going to open to get a conservative
view on their growth strategy. Then I forecasted the sales per store for 2010 4th quarter to be 9%
as its previous quarter year over year, but then I assumed a 4% for a base case scenario of same
store sales growth for 2011 quarters and 4% for the later quarters. That was based on IBISWorld
estimate for industry growth revenues for 2011. Whole Foods management is expecting a higher
growth for SSS but I didnt put a high bet on that. I have then forecasted the sales by multiplying
same store sales by number of stores. I assumed an average for gross margin of 34.6% which
allows me to compute gross profit and cost of sales. I assumed an average of 29% for SG&A as
percentage of sales for 2011 and 28% for later years because I think Whole Foods will try to
reduce its costs. Interest rate ( cost of debt was calculated as Q3 2010 to be 7.3/508.3*4 which is
5.75%) was assumed to remain unchanged but I assumes a 0.1% deposit rate on their cash
available which decrease their interest expense every quarter. I assumed a 40% tax rate as
average of their historical tax rates. Since there is no news on new share issuance, I assumed
constant shares outstanding as Q3 2010 (171.9 M). (Appendix A)
As for the Balance sheet items, my forecast is still quarterly and the yearly data will be the last
quarter items. To mention the major assumptions, I can start by cash which was projected based
on capital expenditure forecast (management report 375 M in 2011) which affects their FCF
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hence the cash ( FCF= cash from operations- capital expenditure and cash = net change in cash +
beginning cash balance). Now cash from operations are forecasted is forecasted NI+change in
NWC+ D&A. Net working in capital is forecasted based on the forecast on current assets and
current liabilities: one example is Receivables which was forecasted as following: (forecasted
revenue* average days receivables outstanding for the last 5 years)/days in quarter, similarly
accounts payables, inventories and accrued salaries and wages). Depreciation and amortization
are forecasted to grow 20% in 2011 and remain constant in the following years and that is
equivalent to past D&A year that had similar number of new stores opened. Long term items as
net PPE is equal to last year PPE + forecasted capital expenditure D&A. Long term debt was
decreasing the last 2 years but I assumed it is going to be the same as ending year 2010 since
they will keep opening stores which they will need capital for it but wont increase since they are
not opening huge number of stores as in 2007. From the above forecast 2011 EPS is forecasted to
be $1.84 and $2.97 in 2012 with no lease adjustments and $0.94 in 2011 and $1.84 in 2012 using
adjusted statements. (Appendix B)
Note: adjustments for leases were made historically which affects LTD, PPE, interest expense,
depreciation and SG&A expenses. To be consistent in my pro-forma statements I assumed same
adjustments for 2010 to be done for next 5 years
Free Cash Flow To Firm and DCF Model:
Since Whole Foods is a non paying dividend on average, and since FCFF accounts for capital
structure, I think it is a relevant valuation metric. The major assumptions are:

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The discount rate which is the WACC = 6.19% assuming a 40% tax rate 2.84% risk free rate, 8%
market risk premium (updated) and bottom up beta of 0.49. The terminal growth rate is assumed
to be 2% since IBISWorld is expecting a growth higher than the last 5 years industry average of
0.6% based in expected population growth. After discounting the cash flows and deducting the
debt of 508.3 (ending 2010 debt) and adding back cash and marketable securities, I got: $65.24
equity value per share (unadjusted FCFF) and $54.46 for adjusted data ( current price : $48.85).
Since WACC and the perpetuity growth rates are a key in discounting the FCF, I run a sensitivity
analysis to see the impact on the price when changing the discount rate and growth rate. A high
growth rate of 4.5 % (which is possible for WFMI since it has always exceeded the industry
growth which is higher than 4%) will result in prices that range $45.75 and $456.79 depending
on the discount rate (ranging from 4.5% to 9%) but still a high discount rate which means high
cost of capital will still give a price which is close to the current price, which I think supports my
investment thesis. (Appendix C)
Relative Valuation

I chose PE, EV/EBITDA, and P/Sales as metrics to look at when comparing

WFMI with its competitors. It looks like all multiples for competitors as
Kroger, Publix and Safeway are smaller than WFMI multiples, one reason is
that those supermarkets are in mature phase and I think WFMI has still a big
opportunity to grow. Looking at WFMI gross margin 34% which exceeds the
industry average of 23%, this tells me that a higher multiples for WFMI are

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reasonable. For this reason I chose to use the historical forward multiples for
WFMI:

Then using current forward multiples gives:

I have run a scenario analysis where I assigned probabilities for a base (60%)
high (25%) and low scenarios (15%) to study how the prices changes with
changing scenarios for sales growth, different multiples, and other critical
numbers that change the whole valuation as the number of stores expected
to be opened. Using those scenarios: I got $80.2 using EV/EBITDA multiple
and $34.68 using PE multiple. Blended price: I used 40% for DCF and 60% for

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the average prices I got scenario analysis multiples. I got a $59.69 forward
12 month price for WFMI. (Appendix D)
Where Could I be wrong? My recommendation VS Risks:
My valuation assumptions have been conservative and still I have a BUY recommendation. I
think it is time to buy the WFMI before its price reaches its historical peak again ($76.7 in the
last 5 years) where I believe organic industry will keep improving since more education is held
on how important is to eat organic and its effect on ones health. On the other hand, WFMI
should spend more on advertising its products and rely on media to attract new customers and
not only keep its current ones especially in a market where all supermarkets started to have
organic shelves. Because larger grocery chains have more flexibility in their product offerings,
they are more likely to promote products through sales, a strategy Whole Foods rarely practices
(How to Grow in an increasingly competitive market? By Patricia Harasta, Erasmus University).
WFMI strategy is to grow through store openings but that is costly especially when every store
has a customized design. Operating costs can go down if Whole Foods focus on a standardized
operating strategy.

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Rating: BUY

Publix Supermarkets , Inc (Push)

Current share price: $19.85

12-M price target: $23.98

Market capitalization: $15.6 B

Mike Anderson
As of Dec 4, 2010

PUSH
PROFILE

Shares outstanding
:
788M
Earnings per share:
$2.03
2011 EPS (est):
$2.07
PE (fy1): 9.6
52 wk Range:
$15.00 - $105.00
Revenue (in B):
24.8
EBITDA(ttm in B):
2.941
EV/EBITDA:
6.89
Debt/ Equity (mrq):
53%
Dividend yield:
2.3%
return on equity:
23.5%
Investment Thesis

Charts

EPS
2.50
2.00
1.50

4q

3q

2q

1q

1.00
0.50
0.00
2007

2008

2009 2010 est2011 est2012 est2013 est

Gross margin will continue to improve due to expansion of private

label brands
Revenue growth based upon successful store additions
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Current PE and EV/EBITDA at historical lows as operating
performance increases
Investment Risks

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Supermarket Industry

Publix forecasted financial statements

Forecasted Revenue
The future revenue for Publix was forecasted using several methodologies. The
total retail square footage, the historical revenue per square foot, the average
number of new stores being opened on a yearly basis, and the average revenue per
store were all considered. Using this methodology I am estimating that the number
of stores will increase to 1056 and the revenue will increase to $25.5B by the end of
FY11. The average revenue per store of $24.2M is expected to continue. This
revenue forecast was then compared with the Publix historical sales growth average
over the last 5 years and the recent company guidance for FY10. 3.3% growth per
year is the average for the last 5 years. The forecast sales growth for the next 5
years is expected to be in the 2.9 3.3 range based upon this combined
methodology.
Forecasted Income statement and balance sheet
The 5 years trends for Publix were considered in all the future income and balance
sheet items. The financial statements were recasted to account for operating to
capital lease conversion and LIFO to FIFO inventory adjustments. The historical 5
year average was utilized and adjusted for specific items. Gross margins were
increased slightly in line with improved trends over the last several years and SGA
was decreased slightly due to expense controls and more recent trends. Since the

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company has non-operating income of $120M per year from investments, future
growth in non-operating income is estimated to be in the 5-7% range in the future.
In the past this figure has been more volatile and 5-7 % better reflects what can be
expected from bond investments more recently. The dividend payout ratio was
increased to 30% because I believe the board of directors will increase dividends in
the future. Since Publix is private only employees and members of the board own
shares and increased dividends will encourage stock ownership and retention.
Publix Valuation
Below DFC analysis using the FCFF indicates a fair value of $35.82 based upon the
assumptions listed on the left. The 3% risk free rate, 4% cost of debt, and 2%
perpetuity growth rate are all conservative estimates. The 3.2 average revenue
growth rate for the next 5 years is below the 3.3 average growth rate for the last 5
years as well. In addition Publix just won a superior quality and customer service
award from a recent American Customer Service Index survey. Since revenue
growth is primarily based upon opening new stores this dedication to quality and
service shows Publix is able to duplicate their success as they continue to expand.

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Below sensitivity analysis on market risk premium / gross margin and market risk
premium / perpetuity growth rate shows how dramatically changes in these factor
can impact the valuation price and highlight again the conservative assumptions
used in the $35.82 valuation estimate.

Publix relative valuation

Below are the historical PE ratios for Publix, Safeway, Whole Foods, and Supervalu.
In the case of Publix the stock price dropped dramatically in FY10 and this resulted
in a current PE which is now much closer to the competition. Scenario analysis on
the forward PE ratio results in a 12-month stock price target of $20.64.

Publix historical PE Ratio with competitors

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Publix Forward PE Scenario Analysis

Publix Forward PE
base

best

worst

2.07

2.15

1.55

PE multiple

9.6

10.6

8.6

Price

19.872

22.79

13.33

Prob

0.25

0.6

0.15

Avg. stock price

$20.64

Below are the historical EV / EBITDA ratios for Publix, Safeway, Whole Foods, and
Supervalu. The dramatic drop in Publix stock price in FY10 reflects a ratio which is
now much closer to the competition and can be seen in scenario analysis which
results in a 12-month stock price target of $27.32.
Publix historical EV / EBITDA with competitors
EV / EBITDA

2006

2007

2008

2009

Publix

26.7

44.8

41.6

37.9

AVG

37.8

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Safeway
Whole Foods
Supervalu

8.5

7.5

5.3

4.9

6.6

17.9

14.3

6.9

9.6

12.2

5.7

9.5

5.2

4.4

6.2

Publix EV / EBITDA Scenario Analysis

Publix EV / EBIDTA

base
avg.

best

worse

FY11 est

2941

3034

2321

EV multiple

6.89

7.64

6.14

Implied EV

20263.49

23179.76

14250.94

Near Cash

444

444

444

Implied Market cap

20707.49

23623.76

14694.94

# shares

788

789

790

Implied stock price

26.28

29.94

18.60

Prob

0.25

0.6

0.15

Avg. stock price

$27.32

The blended stock price of these two scenarios results in a blended stock price of
$23.98
Publix blended price target
Price

weight

EV / EBITDA

$27.32

50%

PE

$20.64

50%

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Avg. stock price

$23.98

Publix Investment Thesis

Publix is rated a buy and the $23.98 Dec 2011 price target is based upon a
weighted, blended PE and EV/EBITDA (50/50 weight). Publix price at 9.6x my 2011
EPS is well below historical PE averages for both Publix and the industry. EV/EBITBA
at 6.8x is below the historical average for Publix, but in line with peer historical
average.

Publix is focused on providing superior quality and service and it has

been one of Fortunes 100 best companies to work for in America for the last 13
years. Publix will continue to grow by profitably adding new stores and this should
allow ROE and ROA to remain well above the competition. The focus on private
label brands with higher gross margins is a winning strategy for Publix. The biggest
risk factors are constraints on adding additional stores, price increases on inputs
such as corn, and the stock price is set by the board of directors not the stock
market.
Publix Summary
At $19.85 Publix stock is a buy for employees and the board of directors. The one
year price target is $23.98 and the conservative fair value using FCFF is $35.82.

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The current PE and the EV/EBITDA are well below historical averages and the
prospect for continued profitable expansion is very good. The upside price potential
far outweighs the risk and the employees should buy as much stock as possible.

Recommendation: Buy
Current Price: 20.68
The Kroger
Target Price: 23.62
52 week Range: 19.08 24.14Company
Market Cap: 15.18 B
Analyst Name: Ian Estabrooks
P/E
P/B
2.9x
93.2x
P/S
0.2x
EV/EBITDA 5.4x
Total Debt/EV 0.4x
EV/Sales

Investment Thesis

Kroger has been able to maintain a healthy growth in ID sales. This is

evidence that their number one strategy of Customer 1 st is working to
maintain ties with existing households.
Kroger looks to improve its profit margins over the coming years to get
back to 2007 and 2008 levels. Increased efficiencies in distribution and
also a cap on debit/credit card fees are positive moves towards this goal.
Competitors have eased up on price investment in the recent quarters
which gives Kroger some breathing room after what was thought to be an
over investment in price in 2009.
Kroger is focusing on reigning in capital expenditures by shifting from new
store growth towards projects that will help drive ID sales and increase
efficiencies.

Investment Risks

Deflation in many of the dry grocery items as well as hypercompetitive

products like milk put pressure on margin performance. Recent trends
have signaled that deflation is coming to an end however it remains
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primary risk.
EBIT margins have shrunk over the past year to about 40 basis points
below average. Some of this can be attributed to over investment in price
however SG&A expenses need to be addressed by management in the

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Forecasted Financial Statements:

Revenue:
Revenue forecasts were projected by looking at the firms historical
performance in the ID sales and sales per square foot as well as how recent trends
and the economic outlook will affect the future growth. The Jan 2011 fiscal year end
sales can be forecasted with a good amount of confidence given that the first three
quarters have already been reported. Currently Kroger is on pace for growth of 7.5%
compared to the same periods a year ago. Although the company has reduced its
forecast for future sales, it is unlikely that the 4 th quarter will derail the current
growth rate for 2010. According to the companys 10Q report, the growth is largely
attributed to same store sales. This is a good indication that the management
teams Customer 1st strategy is getting results. Kroger is gaining brand loyalty in
which familys are coming back repeatedly and also spending more money.
However, the strong growth does need to be taken with a grain of salt as it is
coming off of a very stagnant year in 2009. The year over year growth in 2009 was
just under 1%. Looking over the past 2 fiscal years Kroger has grown at a yearly
average of about 4.7%. That said 2010 has still been a nice rebound year despite
the continued pressure from unemployment and other macro economic factors.
Household income remains suppressed by the economy and will continue to put

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pressure on Kroger and other retailers for the foreseeable future. Deflation in most
of the dry goods has occurred due to the lack of demand from households as their
discretionary income is not what it used to be. However it is evident that deflation is
easing up and possibly coming to end. Looking to the future, new store growth is
still a major part of the picture although a lot of investment will go into store
renovations to keep current customers attracted. I expect the strong ID sales to
maintain their performance for the next several years in addition to increased
square footage from new stores. I projected the revenue growth to trim down to 6%
by 1/31/2015 and maintain a stable growth rate of 3% thereafter.
Pro-Forma Statements
The pro-forma statements were driven from the projected sales growth. The
line items were determined as a percentage of sales based on various factors and
assumptions. Many of the items are a simple average of the past five years of actual
data. Some of the critical line items such as Gross income and SG&A expense were
modified manually based on assumptions and recent trends. The historical
operating margin is around 3.2 3.3 % however recently it has been 30 40 basis
points lower due to recent economic conditions. I dont see this number returning
to historical values in the near term but perhaps over the next few years. Currently
the operating margin is on pace for 2.89% for 2010. This has been taken into
consideration and the cost of goods sold and SG&A expense were adjusted down to
what I think are realistic numbers. However I do think the operating margin will get
back to 3% or higher by year 3. This has been reflected in the target price. Krogers
management is focusing on increasing efficiencies in distribution which should cut
into the SG&A expense. Other factors include the recent cap that has been put on
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debit and credit card transactions. Most of todays shoppers use plastic as a form of
payment and these costs have been racking up for Kroger over the past few years.
The cap on these fees is a big win for all firms in the industry. Risks to the operating
margin are primarily tied to the deflation issue that has been gripping the industry
over the past year to year and a half. However, recent data suggests that deflation
is easing up and could be coming to an end.

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Dividend Pay out was also manually adjusted for the reason that the firm just
began paying dividends 4 years ago. Furthermore the 2009 dividend payout ratio
was extremely distorted due to a very small earnings number. This is very
misleading because the firm posted a very large impairment charge on the income
statement. Of course, this charge did not impact cash flows but actually increased
them by acting as a tax shield. When the impairment charge is removed, the payout
ratio returns to a normal level and there is trend where the ratio increases over the
past 4 years. I have used 22% as a payout ratio for each of the next 5 years.

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Valuation:
In my valuation of Kroger I used free cash flow to equity and free cash flow to
firm to estimated the present value of the firm today. Because the firm is highly
leveraged the FCFF method was optimal once capital leases were converted to
operating leases. The price estimated is $24.26 FCFF and $24.01 FCFE. All of my
assumptions remained consistent therefore the prices are very similar. I also used
PE and EV/EBITDA ratios in a relative valuation method and then blended the target
prices equally to get a price of $22.99. From there I blended the relative valuation
blend price with the FCFF price at equal weights to come to my final predicted price
of $23.62
The free cash flow valuations required big assumptions on 2 key variables,
cost of equity and stable growth rate. My final cost of equity in the FCFE is 9.87%
and the WACC for FCFF is 7.43%. This was derived from the S&P 500 and also the 10
year t-bill. I came to a stable growth rate of 3% because it is close to the industry
growth rate and given that the market is highly saturated I dont think I could go
much higher than this number. Kroger has been consistently attracting more
customers and ID sales remain in the 2.5 3% range. Given that Kroger only
operates in the United States there is a lot of room for expansion in the international
market. I used sensitivity analysis on these two variables to show how my valuation
would change. Keeping my WACC the same a growth rate of 6% would yield a price
of $50.65 and a growth rate of 1% would yield $16.63. By keeping the growth rate

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the same a WACC of 5% would yield a price of $29.05 and a WACC of 9% would
yield a price of $21.48. See the table below for detailed sensitivity analysis.

One number that I had to adjust is the capital expenditures. Over the past
few years Kroger has spent about $2 billion a year in cap-ex however the change in
net property plant and equipment was around $0.9 billion. I believe that this is
largely due to the renovation expenses. Because Krogers main strategy is to keep
its stores looking fresh this will be a major expense going into the future. Due to
this I forecasted the capital expenditures independently from the projected change
in net PPE. Only using the change in net PPE generated capital expenditures that
were far less than what has been reported by Kroger in recent years. This also
generated an abnormally high valuation price. After completing the FCFE and FCFF I
determined that the later was a better option because Kroger is highly leveraged.
Therefore, my predicted price using the present value of free cash flows is $24.26.
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I chose PE and EV/EBITDA for valuation multiples to compare to peers.
Krogers earnings over the year have been very volatile because of large
impairment charges the company lists on its income statement. Therefore the
outlier PEs were removed when calculating the average for the company. The
average over the past ten years is 14.2x and the stock is currently trading at 11.36x
using my 12 month projected earnings. This lags behind competitors and other
firms within the industry as well as the companys own average. I think there is
some moderate upside to be seen in the future. Using a scenario analysis of 10x in
the worst case (25% chance), 12.5x base case (50% chance) and 16x best case
(25% chance) I got a forward PE of 12.75x which translates to a 12 month target
price of $23.72 based on future earnings. EV/EBITDA currently stands at 5.29x and
is in line with industry and peers. Using scenario analysis of 5x worst case (25%
chance), 6x base case (50% chance) and 7x best case (25% chance) I came to 6.0x
which translates to a 12 month target price of $22.26. I blended the two target
prices from the relative valuation using equal weights and came to a blended target
price of $22.99.

Kroger
PE worst

25%

10x

PE base

50%

12.5x

PE best

25%

16x

EV/EBITDA worst

25%

10x

EV/EBITDA base

50%

12.5x

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EV/EBITDA best

25%

16x

PE Target Price

$23.72

EV/EBITDA Target Price

$22.26

Blended Multiple Price

$22.99

Summary
In summary I recommend Kroger as a buy with a blended target price of
$23.62. I had recently had Kroger as a hold but due to recent market news I have
changed my recommendation. When the third quarter earnings results were
released Kroger met analyst expectations but also reduced its forecasts for futures
sales. The market reacted strongly to this news and the stock has lost roughly 13%
since this news broke. I have adjusted my forecasts however I was more
conservative than initial forecasts by the company so my forecasts were only mildly
affected. Based on my new target price I think the market has over reacted to the
news and this has created the potential for a profit gain. I think Krogers future
performance will regain the markets trust over the coming months and see price
inflation.

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Investment Report

Safeway, Inc.

Supermarket Industry

Key Ratios and Statistics

Analyst:
Industry:

Andrew Gilman
Retail, Food & Drug

Ticker:

SWY

Position:

Hold

Price:

$22.87

52-week Range:

$18.73 $27.04

Price target:

$22.87

Current Price (12/8/10):

$21.55

Market Cap:

$8.00B

Shares Out (MM):

372.8M

Avg Vol (MM):

4.79M
SWY Price Performance

$29
$27
$25
$23
$21
$19
$17
$15

SWY

Indexed S&P 500

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Supermarket Industry

EPS ($)
1Q

2009
A
$0.34

2010A/
E
$0.25

2Q

$0.57

$0.37

3Q

$0.31

$0.33

4Q

$0.53

$0.56

FY

$1.75

$1.51

P/E

15.86
x
5.46x

14.34x

0.40x

0.38x

2011
E

2012
E

2013
E

$1.5
7
13.7
4x
5.71
x
0.37
x
3.1

$1.6
1
13.4
2x
5.55
x
0.36
x
3.1

11.1

11.3

ROA (%)

3.0

3.0

$1.5
3
14.1
0x
5.85
x
0.38
x
3.1

ROE (%)

9.5

11.0

10.8

EV/EBITD
A
EV/Sales

5.92x

Investment Thesis:

Safeway revised EPS guidance for 4Q to the low end of the $1.50-$1.70 range.

Gross margins stabilized in Q3, remaining relatively flat throughout compared with Q2. As
economic conditions improve expect to see gross margins follow right along.

Safeway has eased back a bit on the gas pedal, focusing their attention to renovating existing
stores, buying back shares and paying a strong dividend to shareholders.

Improved cost controls implemented in 2009 will begin to pay-off in Q4 and 2011 as Safeway begins to cycle its price
investments. Benefits will go straight to the bottom line by enhancing operating margins.

Investment Risks:

Deflation continues to eat away at the gross margin. With flat volume year over year, the -2.0% growth yr/yr in sales is
directly attributable to continued deflation.

Sales recover slower than expected.

Weaker than expected results from Blackhawk Network.
Gross profit margin continues to decline.
Rapidly increasing competition throughout California, Walmart is specifically gunning for

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Supermarket Industry
Investment Thesis:
Gross margins remained relatively flat in Q3 coming in at 31.0%, down
slightly YOY, however, subtracting out the impact related to severance
charges, gross margins were actually up in Q3. Gross margin improvement is
largely attributable to lower advertising costs, reduction in shrink and
improved sales of private label brands, which carry a higher profit margin. I
expect improvements to continue, at least in the near term.
Identical store sales in the third quarter were down -2.0%. Although
SWY is finally cycling investments made in pricing last year, sales continue to
remain flat, if not negative, compared with sales in Q309. The -2.0% decline
in ids is directly attributable to lower volumes, despite managements
continued efforts to drive sales and compete more effectively on price.
After lowering FY2010 EPS guidance in Q2 from $1.65-$1.85 to $1.50$1.70, on the Q3 earnings call, management indicated that they expect
FY2010 EPS to come in at the low-end of the $1.50-$1.70 range. Based on
my forecast, I believe that this range is still a bit optimistic. I estimate Q4
EPS of $0.56 and FY2010 EPS of $1.51. I expect sales to remain sluggish
throughout Q4 and into early 2011, picking up towards the end of 2011 and
into 2012. I also expect deflationary conditions to remain at least until early
next year. In addition, Safeway continues to generate strong FCFs. In Q3
Safeway generated nearly $370MM in FCF. Managements expectations

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remain positive for FY2010 FCF, expecting FCF to come in the middle of the
$900MM-$1.1B range.
Improved cost controls implemented in 2009 will begin to pay-off in Q4
and 2011 as Safeway begins to cycle its price investments. Benefits will go
straight to the bottom line by enhancing operating margins.
Investment Risks:
If deflation continues longer than expected, margins will continue to
take a beating. With flat volume year over year, the -2.0% growth yr/yr in
sales is directly attributable to continued deflation. Since sales are the main
drive of net income, if sales recover slower than expected 2011 results will
be anything but spectacular. Yr/Yr identical store sales continue to
underwhelm the masses and expectations are not high for Q4 yr/yr sales
growth. Well have to wait and see where things stand come January and
reevaluate.

If

benefits

arent

realized

from

price

improvements

or

management isnt able to keep a tight grip on costs, gross profit margins
could be impacted and could potentially decline, continuing a declining
streak of nearly 8 consecutive quarters.
Revenue Forecast:
The two main components used to drive my top line forecast include
total retail square footage and average sales per square foot. Because
Safeway has been closing more stores than they have been opening, I found
it problematic to base my top line forecast on the number of stores. Instead, I

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used historical data and trends in average sales per square foot to come up
with a projected growth rate for average sales per square foot. I determined
that average sales per square foot would increase by 2% in Q410 and 1%
during 2011. For the time period between 2012-2015 I assumed that average
sales per square foot would increase by 0.5% per year, growing by 4% in
2015, then reverting the a constant growth rate of 3% thereafter. My
assumptions for average revenue per square foot growth drive the following
yr/yr growth rates for revenue. 0.6% growth in 2010, 1.2% growth in 2011,
2.4% growth in 2012, 2.9% growth in 2013, 3.4% growth in 2014 and 4.2%
growth in 2015. My assumptions project a 2010 2015 CAGR of 2.8% which
is 10bps higher than the previous five year CAGR of 2.7%.
I am projecting such a low growth rate for Safeway primarily due to the
current economic conditions that have been weighing on Safeways top line
for the past eight quarters. One of the primary drivers of revenue for
Safeway is inflation; deflationary conditions are detrimental to profit margins,
especially operating margins. Safeway estimates that every 1% change in
PPI impacts operating margins by 29bps. Safeway estimates that for every
10bps change in operating margins, EPS will increase or decrease by $0.07.
Its clear that operating margins are a significant variable and small changes
plus or minus will have a significant impact on the ending valuation. I expect
to see inflation in 2011, however, based on my gut, I expect deflation will

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persist longer than expected and we wont see true inflationary conditions
return until mid to late 2011.
Pro-Forma Statements:
For the most part, most of the items on the income statement and
balance sheet were forecasted using a percent of sales methodology. The
assumptions driving each of the line items are, for the most part, based on
historical averages and then adjusted, if needed, to take into account my
assumptions or current trends that may differ from historical trends. Items
such as gross margin, payout ratio and SG&A expense were manually
adjusted to better reflect recent trends that differ from historical trends. Two
main drivers behind the model include gross margins and operating margins.
Small changes to either of these items has a significant impact on ending
cash flows to the firm. Historically, Safeways gross margin has been around
31.5%, however, due to recent pricing investments, changes in product mix
and better overall management practices, I feel gross margins will improve
from 31.5% in 2009 to 32% in 2010. Because Safeways margins have been
historically stable, I assume that gross margins will stay constant at 32% of
sales. Operating margins have historically been around 4.3%, however, I feel
operating margins will feel increasing pressure going forward as competitors,
such as Wal-Mart, gain a presence in California, Safeways largest and most
lucrative market. Deflation is the biggest threat to the operating margin,
small changes in PPI significantly impact operating margins mainly because

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Safeway is so highly leveraged, small changes are amplified, for better or for
worse.
Another adjustment I made was to manually adjust the payout ratio.
Safeways management has stated repeatedly that they intend to continue
paying out a healthy dividend to shareholders, historically the payout ratio
has been about 11.2%, however, in order to come close to Safeways
estimated 2010 DPS of $0.48, the payout ratio was increased to 26% which
will result in an expected 2010 DPS of $0.39. The payout ratio will remain
constant at 26% projected five year period.
For the balance sheet, most of the items are based on a percent of
sales using 2010 values to calculate relevant percentages. The only major
change made to the balance sheet was an increase in long-term debt to
account for the significant operating leases that Safeway currently operates.
I assume that gross margins will remain stable at roughly 32%, this
represents a slight improvement over the historical gross profit margin for
Safeway. Historically, gross margins have been fairly stable with little
variation from the average gross margin of 31.5% over the last 10 years. The
increase in gross margins to 32% reflects positive changes made by
management including price investments last year, reduced advertising
expense a reduction in shrink and an increase in sales of private label
brands.
Valuation:

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To value Safeway, I chose to use the FCFF model mainly because
Safeway has a significant amount of operating lease commitments and is a
highly leveraged firm. This particular valuation uses a five year FCFF,
projecting cash flows over a five year period from 2011 to 2015. My
assumptions assume a WACC of 4.97%, a beta of .601, optimal debt-toequity weightings of 35% and 65%, a 35% tax-rate and a terminal growth
rate of 3%, which is the average growth rate for the grocery store industry in
which

Safeway

operates.

Based

on

my

forecasted

cash

flows

and

assumptions I arrived at a price target of $23.44, representing a premium of

8.75% over the latest closing price of $21.55. However, the FCFF model is
sensitive to assumptions made about expected growth rates as well as
assumptions made about capital expenditures relative to depreciation. If
consistent assumptions are not made relative to growth rates, the free cash
flow to firm can be significantly inflated or deflated which in turn will
significantly impact the ending firm value. For my model I assumed the cost
of equity to be 5.9% and the pre-tax cost of debt to be 4.9%. Based on these
assumptions my wacc comes to 4.97%. This is the value used to discount
future cash flows, if assumptions used to calculate this value are not correct,
ending firm value will be significantly impacted. My terminal growth rate is
simply the historical average growth rate for firms that operate in the same
industry, the terminal growth is 3%. 3% is appropriate for this particular
industry due to oversaturation, high degree of competition and low growth in

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market share. To see just how sensitive the fcff model is to assumptions
made about growth, I conducted a sensitivity analysis using wacc and
terminal growth to see what the price would be if one of the two rates
changes, holding the other constant. I found that if wacc decreases by 0.5%,
holding the terminal growth rate constant at 3.0%, the ending price
increases to $38.7 from $23.4 per share. If we hold wacc constant at 4.97%
and increase the terminal growth rate by .10%, the price per share increases
to $25.7 from $23.4, if we increase the terminal growth rate by 0.5% the
price increases to $37.5. The fcff model is almost equally affected by
changing either growth rate.
The multiples used to compare between comparable firms are
EV/EBITDA and P/E. From my research I found that these multiples are some
of the more commonly used multiples to value grocery stores and similar
firms. For the relative valuation I used a ten year industry average for each
of the applied multiples. The maximum and minimum values reflect the max
and min industry averages over the last ten years. The 10 year average
EV/EBITDA multiple of 6.11x, yields a price target of $22.75 and the 10 year
average P/E multiple of 14.28x, yields a price target of $21.87. Taking the
average of the two multiples, I come up with a relative price target of $22.31
which represents a 3% premium over the current stock price of $21.55.
Summary:

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Supermarket Industry
Although deflation is showing signs of letting up, I expect it will
continue longer than expected adding to the uncertainty in my model and
ending valuation. In addition, although Safeway has shown signs of margin
improvements though price investment, better shrink control, cost cutting
and other strategies, I dont feel Safeway is quite where it needs to be for the
long haul, especially as it has yet to go head to head with Wal-Mart on its
home turf. I fell Safeway needs to take further steps to protect its pricing and
strategic advantages against Wal-Mart, which is a formidable competitor with
access to global economies of scale, something Safeway lacks. Firms such as
Kroger have already strengthened themselves against Wal-Marts low price
strategy that I feel they are better equipped to grow in the long-term. Not to
mention, Kroger has been aggressively pursuing market share through
acquisitions while Safeway has been reducing its store count. This could
come back to haunt them later on down the line when competition between
firms reaches a boiling point, especially in the California and Mid-West
markets. I believe Safeway is a solid company, but, I do not feel that they
are strategically positioned to take advantage of the little growth potential
that exists in the industry. For these reasons I recommend a hold for Safeway
until further clarification is gained as to what Safeways long-term growth
strategies are and further insight into where the economy is headed as we
enter into 2011. If Safeway suprises us in the next year, I may reconsider my
recommendation, so, if you own Safeway stock, hold on to it, it pays a good

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Supermarket Industry
dividend. However, if you are interested in owning stock in a grocery store, I
would look at other firms such as Kroger or Whole Foods.

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Supermarket Industry
Safeway Revenue Forecast:

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Supermarket Industry
Safeway Pro-Forma Financial Statements:
Income Statement

Balance Sheet & Assumptions:

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Safeway Valuation Models:

Safeway Relative and Blended Valuation:

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Safeway Sensitivity Analysis:

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Appendix WFMI A

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Appendix WFMI B

Appendix WFMI C adjusted FCFF

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Appendix WFMI D Scenario analysis

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Sources:
Whole Foods Market Inc:
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Yahoo Finance: WFMI
Factset
Bloomberg
http://www.ota.com/organic/mt/business.html
http://www.wholefoodsmarket.com/company/call-scripts.php#self
http://www.bls.gov/news.release/cpi.nr0.htm
JP Morgan Supermarkets 2009 Outlook
Kroger:
Thompson Research
JP Morgan reports
Morningstar reports
Factset
Kroger 10Q
Kroger 10K
Congressional Budget Office

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