Safeway Faces Labor Strife Beyond California

Already hurt by one strike, contracts affecting 39% of its stores expire this year.
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The strike in Southern California subtracted $102.9 million from

Safeway's

(SWY)

bottom line in the fourth quarter. But things could get a lot worse for the grocery chain if it doesn't settle the dispute soon.

The company is already

running the risk of losing customers permanently to rivals such as

Whole Foods

(WFMI)

and

Costco

(COST) - Get Report

. But with labor contracts expiring in coming months in a number of important markets, Safeway faces the prospect of the strife spreading and affecting operations around the country.

The ongoing strike in California affects 320 Safeway stores, or about 17% of its base. Stores representing another 39% of its base will see their contracts expire later this year. Included among those are stores in San Francisco, Sacramento, Seattle and Denver. Meanwhile, labor contracts at Safeway stores in the Washington D.C. area expire next month, and stores representing another 7% of Safeway's base, including those in Chicago and Arizona, are currently operating under expired contracts.

"In the next month, it's critical for Safeway to end this

strike," said Lou Mellet, a grocery analyst with retail consultancy Strategic Resource Group. "It could really mess up the company for the foreseeable future if they don't get it resolved now."

On a conference call with investors and analysts Thursday, Safeway CEO Steven Burd sought to downplay such concerns. Labor issues differ from market to market, Burd said. Just because Safeway workers are on strike in Southern California, doesn't mean that workers in other areas will follow suit, he argued. "I don't think the dots connect in exactly that way."

Still, that doesn't mean that all negotiations outside of Southern California will be easy, he acknowledged. "I believe it will be more difficult to accomplish in some markets than others."

In Chicago, for example, the company operates Dominicks, which it put on the block in 2002. Safeway decided to keep the unit after a bidder and the labor union couldn't come to terms on a contract, according to the company.

Those negotiations could prove difficult depending on the outcome of the Southern California strike, analysts say.

"This strike is important to how the rest of the negotiations will be conducted," said Mark Hugh Sam, an analyst who covers Safeway for Morningstar. (Hugh Sam does not hold Safeway shares and Morningstar doesn't do investment banking.)

In addition to its problems in Southern California and Chicago, Safeway is facing challenges in its markets in Texas. The company wrote down the value of its Randall's chain in Texas by $447.7 million after taxes in the fourth quarter due to a reduction in its expected cash flow from operating that chain, Burd said. The company also wrote down the value of its Dominick's chain by $141.3 million in the quarter.

The company's myriad struggles put it in something of a no-win scenario for the near term, said Mellet. Safeway needs to cut costs to compete with

Wal-Mart

(WMT) - Get Report

, but the company is losing its financial wherewithal to deal with protracted labor strife.

Over the next five years, Wal-Mart plans to open dozens of its Supercenters in California.In other places where Wal-Mart has opened such stores, which add fresh produce and other grocery items to the general merchandise found in the company's traditional discount stores, the Supercenters have been able to undersell and quickly steal market share from competitors such as Safeway.

Trying to cut cost to compete with Wal-Mart is "the right thing in the long haul," said Mellet, "but you're going to see

Safeway's balance sheet continue to deteriorate" because of the other internal issues.

Safeway is taking a hard line with workers in the Southern California strike, because it has little choice, Burd said. Not confronting labor about the costs of health benefits would mean the company would essentially be conceding business to nonunionized, lower-cost competitors, he said.

In other markets, Safeway has already worked to lower its cost structure, meaning those negotiations may not be as difficult, Burd said. But the company continues to face an overall cost-disadvantage compared to nonunion competitors.

"We're conscious of doing what's right for the business and getting people back to work," Burd said. But "we're essentially trying to prepare our business for the long pull," he added.

Investors and analysts may not be willing to wait too long for the company to turn things around. Although Safeway's stock rose 70 cents, or 3.2%, to $22.49 Thursday following its report, the company fielded a number of questions on its call from analysts about its ongoing labor problems. At least some shareholders feel that the company's value is being eroded as the strike goes on.

"This is the broadening of a war going on between unions and management," said Mellet. "If we don't see it resolved in the next couple of days, you're going to see shareholders become really, really upset."

A Costly Walkout

Grocery workers have been on strike in Southern California since mid-October. One of the longest disputes in recent memory in the grocery industry, the strike is targeting stores operated by

Kroger

(KR) - Get Report

and

Albertson's

(ABS)

, in addition to Safeway's Von's stores.

The grocery chains want existing workers to pay a greater portion of their health care costs and want to provide new workers with less generous benefits. The United Food and Commercial Workers, which represents the 70,000 striking workers, has rejected the proposals.

Formal negotiations under the auspices of a federal mediator resumed this week for the first time since December.

The strike has proved costly to the grocers thus far. In the fourth quarter, the strike took 23 cents a share off Safeway's bottom line, the company estimated

Thursday morning. Burd declined to estimate how much the company's sales have been affected by the labor strife.

Safeway's rivals are also hurting. In December, Kroger

said that the strike cut its third-quarter earnings in half. Meanwhile, Albertson's

blamed the strike for a 47% decline in its third-quarter profits.

In contrast, Safeway's nontraditional competitors are benefiting from the strike. Earlier this week, Whole Foods

reported that its overall same-stores sales grew by 14.7% in its fiscal first quarter. In stores outside of Southern California, the company's comparable-store sales increased by just 12.8%.

Costco and

Longs Drugs

(LDG)

have also reported seeing sales increases due to the strike.