3 Challenges to Justify This Valuation

When you combine a stock that is up more than 30% with fundamentals that are getting worse, you have a recipe for a disaster. Safeway shareholders have seen their stock jump from the low twenties to more than $30 a share in just the last few months. While the company's sale of its Canadian operations provides a windfall of cash, the core numbers just don't look good.

A tough business made tougher by the company
Safeway announced its intention to sell its Canadian operations for a net of about $4 billion , and understandably investors got excited. With about $2 billion expected to pay down debt, and $2 billion earmarked for share repurchases, the stock has done very well.

In the short-term this is good news. Once we get past this event, the remaining company has some challenges that are hard to overlook. The first and most obvious is that the company's operating margin is lower than a few of its peers. Considering that the grocery business is extremely cutthroat, a company with a low operating margin is fighting an uphill battle.

In the most recent quarter, Safeway managed an operating margin of less than 1%, which was down from nearly 1.6% last year. By comparison, Kroger and Wal-Mart are two big players in the grocery business, and with margins of better than 2.5 % and 5.8 % respectively, Safeway isn't playing in the same league.

As you might imagine, Safeway's huge disadvantage when it comes to operating margin comes with a price. In fact, the company's lower margin actually sets off several falling dominoes.

Even at half of this cost, this could be a problem
It's possible that investors expect that $2 billion less in long-term debt will make Safeway a much stronger company. While there is no doubt that paying down debt is strategically important, maybe investors don't realize how troubled Safeway's balance sheet is today.

Prior to any debt being retired, Safeway's interest expense used more than 78% of the company's operating income in the most recent quarter. The second challenge facing Safeway is that even if it cuts its interest expense in half, the company would still use nearly 40% of its operating income on interest.

If investors don't think this is a big deal, consider that neither Kroger nor Wal-Mart uses more than 17% of its operating income on interest. With a large percentage of income being used on interest, Safeway has less than its peers to use on dividends, share repurchases, and growth investments.

No surprise that this number is going down
The third challenge facing Safeway is that the company's high interest expense and declining margins are leading to lower operating cash flow. Looking at operating cash flow, the best way to compare companies is to look at the sum of net income plus depreciation. Adding these two figures together helps avoid some of the accounting changes that don't affect bottom line cash flow.

Using this core operating cash flow figure, Safeway reported a decline of more than 13 % last quarter and a decline of almost 2% in the current quarter. If we look again at Kroger and Wal-Mart, both companies reported increases in core operating cash flow in their most recent quarterly reports.

The biggest problem
With a low margin, high interest costs, and declining cash flow you might expect that Safeway's stock would sell at a discount to some of its peers. Kroger and Wal-Mart each sell for around 14 times 2013 projected earnings. Both companies are expected to grow earnings by around 9%. This means that Safeway's competitors carry price-earnings-growth ratios of about 1.5.

Analysts expect Safeway to grow earnings faster than these peers at about 12% over the next few years. However, investors have a right to question this assumption. In the last four quarters, Safeway has missed estimates by more than 40% on average. Even if the company only missed estimates by half this amount in the future, estimates of 12% growth would have to be cut to around 9%.

Given that Safeway sells for over 30 times this year's estimates and nearly 19 times next year's estimates, investors expect a lot from the company. Given the multiple challenges facing the company, this stock looks like less than a safe way to make money on the grocery business.

The article 3 Challenges to Justify This Valuation originally appeared on Fool.com.

Chad Henage has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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