Safeway Inc.'s shares dropped Monday after a Credit Suisse analyst downgraded his rating on the grocery chain, saying it may have a larger-than-expected underfunded liability tied to its pension plans that could cause its costs to rise over time.
THE SPARK: Credit Suisse analyst Edward Kelly said that his firm's analysis of Safeway's multi-employer pension plans found a $7 billion pre-tax underfunded liability.
While this doesn't pose a drain on the company's cash flow in the short-term, he said it could also cause labor costs to rise over time. Given the potential rise in costs, Kelly said Safeway's shares are not as cheap as they appear.
Safeway has failed to improve its sales volume since 2006 and the analyst expressed concern the company may not be able to make a notable recovery soon. The tough economy, particularly in California where it has the bulk of its business, and intense competition pose a major threat to its ability to improve sales.
Kelly downgraded Safeway to "Neutral" from "Outperform" and lowered his target price on its shares to $20 from $26.
THE BIG PICTURE: Safeway and its peers have major financial obligations to multi-employer pension plans, which are typically provided to union workers and are funded by numerous employers.
Until recently, investors have been unable to quantify any one company's full stake or risk in them due to lack of information. But regulators recently changed the rules and now require companies to disclose more information about their plans.
THE ANALYSIS: The disclosure is not perfect but Kelly said it is possible to quantify each company's share of the pension risk. Safeway is the first grocery to provide the added disclosure and his firm's tax and accounting team estimates the grocery store operator's obligation is $7 billion pre-tax and $4.5 billion after tax, which he says is too high an exposure for a company of its size.
Safeway's exposure could improve if financial markets improve, interest rates rise, employee benefits shrink or companies increase their contributions to the pension. But Kelly said it was prudent to assume the underfunding is a real liability for the chain.
Safeway did not immediately respond to a request for comment.
SHARE ACTION: Shares of Safeway fell 83 cents, or 3.9 percent, to $20.30 in midday trading. Its shares have traded between $15.93 and $25.43 in the past 52 weeks.