Safeway, Inc (SWY): What The Canadian Exit Means For US Business? – iStockAnalyst (press release)

(By Mani) Safeway, Inc. (NYSE: SWY) announced the sale of its Canadian unit to Empire’s Sobeys division for C$5.8 billion, which translates to C$4.0 billion after expenses and taxes. The acquisition includes 213 grocery stores under the Safeway banner in Western Canada, 199 in-store pharmacies, 62 co-located fuel stations, 10 liquor stores, 4 distribution and 12 manufacturing facilities.

However, the key debates, as they always have been, are can Safeway turn around its profit trajectory. The actual disposal of Canada for C$4 billion net proceeds is equivalent to the value it created for Safeway as an ongoing business.

With the sale, there is increased spotlight and also clarity about Safeway’s US grocery business EBIT is $550 million in 2012, about 1.5 percent EBIT margin. The US grocery EBIT has fallen from $1.4 billion in 2007 to $550 million in 2012, representing a drop of about 17 percent compounded annual growth rate.

“We model Safeway will continue to drop prices, which will hold back its EBIT near term, but help stabilize profits in the long-term at continually lower gross and EBIT margins,” UBS analyst Jason DeRise wrote in a note to clients.

Recently, Safeway has been able to reduce its prices while protecting its margin due to fuel and pharmacy margins rising year-over-year. In its quarterly filing, Safeway clearly stated it reduced gross margin by 59 basis points (bps) to cut prices, but this was partially offset by a 38bps benefit from pharmacy gross margins on generic conversion and a 15bps benefit from fuel sales.

“Rising SG&A at a ~1.5% inflation rate on a per sqft basis implies sharp downward pressure on EBIT,” DeRise said.

Meanwhile, the pharmacy and fuel benefits should fade by the second half of 2013. When this happens, will Safeway continue to reduce its food prices, even if it means showing profit pressure? For Safeway, it would be the key for its long term sustainability.

Safeway, once the darling of investors, is already squeezed from the heavy rivalry with traditional operators like Kroger, Supervalu (NYSE:SVU) and others.

Now, the company is under more pressure as even big box retailers and dollar stores such as Target Corporation (NYSE:TGT), Wal-Mart Stores, Inc. (NYSE:WMT), Dollar Tree, Inc. (NASDAQ:DLTR) and Dollar General Corp. (NYSE:DG) are offering groceries.

Leaving its list prices high would likely drive more traffic away from its stores putting pressure on it to cut staff in store, which reduces service levels and drives revenue down further. This is the classic downward spiral for food retailers. Avoiding it requires significant investments in driving sustainable traffic.

“We still believe SWY needs to reduce prices in the US to stabilize profit long term, even though near term pain could be significant,” DeRise noted.

However, Safeway did well to sell the Canadian business as there are significant challenges ahead for the Canadian food retailer industry, so selling now is well timed from Safeway’s point of view. Canada is seeing increasing competition from US discounters such as Wal-Mart, Target and Costco Wholesale Corporation (NASDAQ:COST).

“We think they sold at its businesses peak profits and at peak multiples,” DeRise noted.

Safeway’s Canadian arm generated sales of about C$6.7 billion and operating profit of C$428 million in the 52-week period ended March 23, 2013.

Safeway needed a double digit EV/EBITDAR takeout price to cover the repatriation taxes that would limit the cash coming back to Safeway shareholders. Sobey’s offer allowed Safeway to execute this deal; although, the net cash proceeds for shareholders are just $4 billion.

As part of the deal, Safeway will continue to be responsible for C$300 million of Canada Safeway’s debt due in March 2014 while Sobeys will retain the rights to the Canada Safeway name and associated trademarks.

Safeway says it plans on using $2 billion of the C$4 billion to pay down debt, with most of the remainder going toward buying back shares. The deal is expected to be closed in the fourth quarter of 2013.

For Sobeys, it would need to deliver the synergies to justify the purchase price. Yet, the pressure will be to reduce prices as Wal-Mart, Target and Costco continue to push for market share at lower prices than Safeway Canada. Attempting to maximize profit to justify this significant investment potentially could help Walmart, Target and Costco win more market share.