Safeway, Cerberus Talks Continue; Earnings Decline In Fourth Quarter

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Safeway Stores, Inc. late last month acknowledged that it is in exploratory talks to potentially sell the company. And while the nation’s second largest pure play supermarket chain did not disclose the party(ies) it was in discussions with, multiple sources have indicated that Cerberus Capital Management is the private equity firm that’s hotly pursuing the entirety of Safeway (Food World first reported Cerberus’ interest in Safeway late last year).

A number of industry analysts, including two senior Wall Street executives, noted that a deal could be completed within 90 days, with one analyst predicting that Cerberus is prepared to pay “in the $50 per share range” for the retailer, which produced annual sales of $36.1 billion in 2013 and earned $246.3 million at its 1,335 stores in the U.S. On February 28, Safeway shares were trading at $37.70, a jump of nearly 25 percent over the past 30 days. Safeway’s market value is approximately $8.9 billion.

“Of all the deals that Cerberus has done in the past 18 months (Supervalu, Albertsons, United Family Markets), the Safeway deal is potentially the cleanest,” said one of our analyst sources. “While there is significant overlap in Southern California and Seattle-Portland, which would likely bring another partner or partners into a prospective deal, the other remaining Safeway divisions – Eastern/Baltimore-Washington, Denver, Phoenix and Texas  – have little or no geographic conflict, potentially giving Cerberus new and desirable markets to complement its presence in Philadelphia, New England and Chicago.”

Another trade observer opined: “Safeway’s become pretty vanilla in recent years – they’re very well run but very predictable – a perfect scenario for a PE firm. A company like Cerberus can handle Safeway’s debt and would potentially acquire a company that has a tremendous real estate portfolio and strong cash flow.”

Also included in the Safeway portfolio is its 49 percent equity in Mexican grocery chain Casa Ley (which it wants to monetize by exploring a potential sale to the majority owner, according to a recent announcement) and the 37.8 million shares it retains in Blackhawk Network Holdings (which it spun off last year through a successful Initial Public offering). The company plans to distribute those shares to Safeway shareholders if or when the retailer is sold.

Safeway has seemingly been positioning itself to “maximize shareholder value” (translation: potentially sell) since former CFO and president Robert Edward replaced iconic chief executive Steve Burd last May. In the ensuing nine months, Safeway has sold its Canadian operation (213 stores) to Empire Co. LTD, the private equity firm that controls supermarket chain Sobey’s, for $5.7 billion, and sold or closed its 72 Dominick’s units in the Chicago market. Edwards has also restructured staffing at the divisional level and, according to many leading CPG vendors, is playing hardball to secure more vendor funding.

You might think that all of this belt-tightening would lead to a stronger bottom line, but other than identical store sales, Safeway’s recently completed fourth quarter gave little indication of that.

For the period ended December 28, 2013, Safeway reported net earnings from continuing operations of $100.0 million ($0.35 per diluted share) for the fourth quarter of 2013 compared to $170.7 million ($0.71 per diluted share) for the fourth quarter of 2012. The fourth quarter of 2013 includes a $57.4 million loss ($0.14 per diluted share) on foreign currency translation, a $30.0 million loss ($0.08 per diluted share) from the impairment of notes receivable and a $9.7 million gain (net of non-controlling interest of $3.8 million) ($0.04 per diluted share) from the reduction of contingent consideration related to Blackhawk’s 2011acquisition of Cardpool, another gift card provider. The fourth quarter of 2012 includes a $46.5 million gain ($0.12 per diluted share) from legal settlements.

Excluding these items, earnings per diluted share from continuing operations was $0.53 in the fourth quarter of 2013 compared to $0.59 in the fourth quarter of 2012.

Sales and other revenue was $11.3 billion in the fourth quarter of 2013 compared to $11.2 billion in the fourth quarter of 2012. An identical-store sales increase (excluding fuel) of 1.6 percent was largely offset by a decline in fuel sales.

Gross profit increased 20 basis points to 26.52 percent of sales in the fourth quarter of 2013 compared to 26.32 percent of sales in the fourth quarter of 2012. Excluding the eight basis-point impact from fuel sales and fuel partner discounts, gross profit increased 12 basis points due primarily to reduce advertising expense and increased LIFO income, partly offset by increased shrink and increased revenue from Blackhawk gift card sales which have a lower gross profit margin than grocery sales.

Operating and administrative expense increased 58 basis points to 24 percent of sales in the fourth quarter of 2013 from 23.42 percent of sales in the fourth quarter of 2012. Excluding the 29 basis-point impact from fuel sales, operating and administrative expense increased 29 basis points. This increase was primarily the result of the$46.5 million gain from legal settlements in 2012 and impairment of notes receivable totaling $30 million in 2013, partly offset by reduced self-insurance expense, higher gains on sale of property and a $13.5 million reduction in the fair value of contingent consideration related to the Blackhawk acquisition of Cardpool.

Self-insurance expense in the fourth quarter of 2013 declined $42.4 million compared to the fourth quarter of 2012. A 100 basis-point increase in the discount rate used to measure the present value of the self-insurance liability accounted for approximately $24 million of the decline in expense. The remaining decline was due primarily to company programs to reduce workers’ compensation expense.

Interest expense for Safeway was $81.3 million in the fourth quarter of 2013 compared to $86.4 million in the fourth quarter of 2012. Lower average borrowings were partly offset by higher average interest rates.

Other income was $2.6 million in the fourth quarter of 2013 compared to $8.2 million in the fourth quarter of 2012. Other income in the fourth quarter of 2013 consisted primarily of $9.2 million of interest income and$3.4 million of equity in the earnings of Casa Ley, partly offset by $10.1 million of expense on the early redemption of debt. Other income in the fourth quarter of 2012 consisted of interest income of $4.0 million and equity in the earnings of Casa Ley of $4.3 million.

Income from discontinued operations, net of tax was $3,228.2 million ($13.11 per diluted share) in the fourth quarter of 2013, which consisted primarily of the gain on the disposal of our Canadian operations. This compares to income from discontinued operations of $74.7 million ($0.31 per diluted share) in the fourth quarter of 2012. For the fiscal year 2013, income from discontinued operations, net of tax, was $3,275.9 million ($13.43 per diluted share) compared to $303.5 million ($1.22 per diluted share) in 2012.

Income from continuing operations, net of tax for the fiscal year 2013 was $246.3 million ($0.95 per diluted share) compared to $294.6 million ($1.18 per diluted share) in 2012. Diluted earnings per share after unusual items were $1.10 in 2013 compared to $1.06 in 2012. Annual sales were $36.1 billion in 2013, essentially flat compared to $36.1 billion in 2012. Identical-store sales increases (excluding fuel) of 1.7 percent and higher other revenue were offset by lower fuel sales and the disposition of Safeway’s Genuardi’s stores. Identical-store sales increases (excluding fuel) were 0.8 percent in 2012.

Net cash flow provided by operating activities was $1,045.8 million in 2013 compared to $1,288.9 million in 2012. This decrease was due primarily to income taxes paid.

Net cash flow used by investing activities was $621.3 million in 2013 compared to $614.3 million in 2012. Cash used in 2013 for business acquisitions by Blackhawk was partly offset by lower capital expenditures.