Safeway Inc. (SWY) reported EPS of 67 cents in the fourth quarter of fiscal 2011, surpassing the Zacks Consensus Estimate of 64 cents as well as the year-ago earnings of 62 cents. For the full year, adjusting for a tax charge of 29 cents per share related to the Canadian dividend paid in the first half of 2011, adjusted EPS came in at $1.78, ahead of the Zacks Consensus Estimate of $1.72 and was up 20.6% year over year.

The company reported total sales of $13.6 billion during the reported quarter, exceeding both the Zacks Consensus Estimate of $13.5 billion and the year-ago level of $12.8 billion. The upside in sales was attributable to higher fuel sales, a 1.5% increase in identical-store sales (excluding fuel) along with the impact of reporting Blackhawk commissions on a gross basis. Total sales stood at $43.6 billion for fiscal 2011, up 6.2% year over year and ahead of the Zacks Consensus Estimate of $43.4 billion.

Gross margin in the reported quarter contracted 137 basis points (bps) year over year to 26.7%. However, excluding the 48 basis points (bps) impact from fuel sales and the 48 bps impact pertaining to the accounting change in gift card commissions, gross margin declined 41 bps primarily due to increased LIFO expense.

Operating profit during the quarter decreased 6.4% to $390.1 million leading to a 16-bp drag in operating margin to 3.09%. This drop in operating margin was primarily attributable to higher expenses to drive future growth at Blackhawk and higher IT expenses to support Safeway marketing programs.

In the fourth quarter of 2011, Safeway incurred $412.2 million in capital expenditures. The company opened 11 new stores, completed the remodelling of 10 Lifestyle stores and closed 14 stores during the quarter. For the full year, Safeway’s capital expenditure was $1,09 billion. The company opened 25 new Lifestyle stores, completed 29 Lifestyle remodels and closed 41 stores in fiscal 2011.

Safeway exited fiscal 2011 with $729.4 million in cash and cash equivalents, down from $778.8 million at the end of December 2010. Net cash flow provided by operating activities in the fiscal 2011 was $2.02 billion compared with $1.84 billion in the previous year. This was primarily credited to increased contributions to pension plans and lower net income, partially offset by greater cash flow from working capital.

The company repurchased 43.3 million shares during the quarter for $858.6 million. The company had around $0.9 billion remaining under its existing stock repurchase program at quarter end. For the full year, Safeway repurchased 76.1 million shares for a total cost of $1.6 billion (including commissions).

During the reported quarter, the company increased the authorization for stock repurchases by $1.0 billion. At the end of fiscal 2011, Safeway had $1.1 billion remaining under its current share buyback program.

Safeway expects to further repurchase shares in 2012. From year-end 2011 until February 22, 2012, the company repurchased 28.7 million shares at a total cost of $626.2 million (including commissions).

Outlook

Safeway has not yet declared its guidance for 2012. The company plans to issue a press release announcing its earnings guidance for 2012 on March 6, 2012 along with its annual investor conference.

Recommendation

Safeway reported encouraging fourth quarter results amid the prevailing weak macroeconomic conditions, which are adversely impacting on the company’s Lifestyle strategy. The macro environment of the U.S. and Canada is taking a toll on consumers. Wealth destruction from the equity markets, uncertainties and the decline in the housing market and falling consumer confidence are forcing consumers to opt for cheaper substitutes or cut back on overall spending.

The declining margins still remain one of the key challenges for the company. However, we are to some extent, encouraged by the company’s gradual improvement in non-fuel identical store sales. We also anticipate further shrink improvement in the next quarter, which will complete the company’s 18-month goal to reduce shrink by $350 million.

Additionally, in an attempt to control operating expenses and increase focus on areas with a strong presence, Safeway recently entered into agreements to sell its Genuardi’s stores in Pennsylvania and the greater Philadelphia area. Moreover, the company has closed its distribution centers in British Columbia and Vancouver to lower its operating expenses further. We expect all these strategies to bode well for the company’s cost reduction initiative.

Safeway confronts a wide spectrum of competitive threats, especially from SUPERVALU Inc. (SVU), The Kroger Co. (KR) and Wal-Mart Stores (WMT).

Safeway currently retains a Zacks #3 Rank (short-term Hold rating). Over the long term, we are Neutral on the stock.

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