Even in Recessions, People Gotta Eat

12/16/2009 11:07 am EST

Focus: STOCKS

Benjamin Shepherd

Analyst, Breakthrough Tech Profits, Global Income Edge and Personal Finance

Benjamin Shepherd, associate editor of Personal Finance, says food retailers should hold up well even in a weak economy, and he finds two well-managed grocery chains.

As the unemployment rate hovers above 10% and many companies prop up revenues by slashing margins, 42% of American consumers report that they expect to spend significantly less [this Christmas] than in years past.

That’s bad news for [many] retailers [that] rely on holiday spending to generate the bulk of annual profits. But some retailers will win big as consumers try to do more with less. Grocery chains will be one major beneficiary, as more folks will entertain at home. And more families will gather at the dining room table after holiday meals rather than the neighborhood eatery.

Safeway (NYSE: SWY) operates almost 1,800 grocery stores, primarily concentrated in the West and the Mid-Atlantic. It also owns a 49% stake in Casa Ley, which operates about 150 food and general merchandise stores in Western Mexico and Canada.

Safeway has faced some short-term head winds: Some consumers have shifted to lower-priced competitors, and falling gasoline prices have put pressure on the company’s fuel operations. Revenues are off about 7% from a year ago, but rose sequentially.

And Safeway has a dark horse in its Blackhawk Network subsidiary. Almost every store now offers a card kiosk from which shoppers can select a variety of prepaid gift cards ranging from store-specific cards to prepaid debit and credit cards.

Blackhawk provides those cards to more than 80,000 stores in North America and Europe. Sales have increased almost 25% this year, and the operation has grown exponentially with the increasing popularity of gift cards.

Plus, Safeway has generated about $1 billion of free cash flow in recent years, some of which it’s used to repurchase shares. That trend should continue. Trading at just over book value and 0.2x trailing-12-month sales, Safeway is a buy up to $28. (It closed above $21 Tuesday—Editor.)

Kroger (NYSE: KR) operates 2,500 supermarkets and 771 convenience stores throughout the US. Its portfolio also includes 385 jewelry stores, as well as Fred Meyer stores in the Northwest.

Price wars have raged in the grocery business for years, particularly among higher-end retailers that have struggled to retain market share. That battle has only intensified over the past two years.

Kroger thrived by recognizing the threat posed by discounters and aggressively reducing prices before its competitors. Although these price reductions have squeezed earnings growth, Kroger enjoys an advantage: Roughly a quarter of its sales come from its own brands, about 40% of which is produced in 40 company-owned production facilities.

Sales of Kroger’s Private Selection branded products reached $1 billion last year, a statistic few other grocery outfits can match. Strong consumer acceptance of the company’s private label brands has provided substantial support to earnings because these items offer higher margins.

Enjoying a clear price advantage in most of its major markets, Kroger is a buy under $29. (It closed around $20 Tuesday—Editor.)

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