Safeway's (SWY) initial disclosure of its pension obligations was enough for a Credit Suisse analyst to downgrade the stock from outperform to neutral earlier this week. 

 

As an analyst, I look at the new rating as a change from "I don't see any way out of its pricing problems vs. the competition," to "I don't see any way out of its pricing problems vs. the competition, and now it cannot use a significant portion of its balance sheet to help reposition itself, either." Yuck.

A couple of months ago, I wrote a note called Safeway and SuperValu: Why Clinging to Margins Can Hurt. I noted that:

• Safeway's prices are about 18% higher than Walmart’s (WMT), and 11% higher than Kroger (KR). The price differential that consumers notice and act on has typically been 5-8%
  
  
• Safeway has had flat to down EBIT for about three years as sales have not come in this environment, while Kroger has had expanded sales
  
  
• Safeway’s heretofore-strong urban/suburban California has been relatively protected from supercenters because it could not acquire space. But Family Dollar (FDO) will be expanding strongly into California over the next few years. And Walmart has decided to rev up growth of its neighborhood markets as the return on assets on new supercenters has declined
  
  
• A 5% across-the-board price cut to halve the price differential with Kroger would cut   2011 revenue projections by 5%. The result is a reduction of $594 million of gross profit against an operating income estimate of $1,137 million, or a 52% hit before any SG&A offsets
  

Additionally, I can add to that recent note the fact that traditional supermarkets now sell less than 50% of the food in the nation. The trend is not Safeway’s friend.

Now we have FASB coming out, far too late in my opinion, with the requirement that corporations tell shareholders what pension liabilities are for multi-employer pension funds.  Safeway has $3.7 billion of shareholders equity.  The underfunding of Safeway’s liabilities to these funds is, according to management, $1.22 billion.  That is 32% on the low end.  Estimates by Credit-Suisse, made by their analysts in conjunction with their accounting experts with differing assumptions, are substantially higher.

My opinion is that, strategically for an investor, the present earnings quality is suspect.  It should be looked upon as what it would be if prices equaled those of Kroger.  So earnings should be seen as non-existent.  Then, taking a long-term investment view, you have to ask what can be changed.  Within the present operation that would be “not much,” unless you depend on the balance sheet to fund losses, either for much lower prices or for an investment in a new discount priced operation. But the balance sheet is severely compromised for these pension obligations.

So, I see the stock as being overpriced at $21.  I could not recommend shorting it, because the cash flow is no problem now and earnings are not going to be falling off of any imminent cliff.  Nevertheless, unless there is a big recovery in consumer spending to validate the Safeway supermarket’s relatively upscale product positioning, and higher interest rates to lessen the pension liability, the future looks like an inexorable journey to a train wreck.

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