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Safeway 10-K 2008
Form 10-K
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

X  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 29, 2007

OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from          to         

Commission file number 1-00041

LOGO

SAFEWAY INC.

(Exact name of registrant as specified in its charter)

 

Delaware   94-3019135

(State or other jurisdiction of

incorporation or organization)

  (I.R.S. Employer Identification No.)
5918 Stoneridge Mall Road  
Pleasanton, California   94588-3229
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including

area code:

  (925) 467-3000

 

Securities registered pursuant to Section 12(b) of the Act:

 

   Title of each class    Name of each exchange on which registered
   Common Stock, $0.01 par value per share    New York Stock Exchange
7.45%    Senior Debentures due 2027    New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

(Title of class)

NONE

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes  X  No     .

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SAFEWAY INC. AND SUBSIDIARIES

 

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Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes      No X.

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X  No   .

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K X.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer X   Accelerated filer      Non-accelerated filer   

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes     No X.

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter. The aggregate market value of the voting stock held by non-affiliates of the registrant as of June 16, 2007 was approximately $15.0 billion.

As of February 21, 2008, there were outstanding 440.2 million shares of the registrant’s common stock.

DOCUMENTS INCORPORATED BY REFERENCE

The following document is incorporated by reference to the extent specified herein:

 

Document Description

  10-K Part

Portions of the definitive proxy statement for

use in connection with the Annual Meeting of

Stockholders (to be held May 14, 2008) to be

filed within 120 days after the end of the fiscal

year ended December 29, 2007

  III

 

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Table of Contents

 

          Page

FORWARD-LOOKING STATEMENTS

   4

PART I

     

Item 1.

   Business    5

Item 1A.

   Risk Factors    10

Item 1B.

   Unresolved Staff Comments    13

Item 2.

   Properties    13

Item 3.

   Legal Proceedings    13

Item 4.

   Submission of Matters to a Vote of Security Holders    13

Executive Officers of the Registrant

   14

PART II

     

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   16

Item 6.

   Selected Financial Data    19

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    21

Item 7A.

   Quantitative and Qualitative Disclosures About Market Risk    31

Item 8.

   Financial Statements and Supplementary Data    32

Item 9.

   Changes In and Disagreements With Accountants on Accounting and Financial Disclosure    66

Item 9A.

   Controls and Procedures    66

Item 9B.

   Other Information    66

PART III

     

Item 10.

   Directors, Executive Officers and Corporate Governance    67

Item 11.

   Executive Compensation    67

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   67

Item 13.

   Certain Relationships and Related Transactions, and Director Independence    67

Item 14.

   Principal Accounting Fees and Services    67

PART IV

     

Item 15.

   Exhibits, Financial Statement Schedules    68

SIGNATURES

   73

 

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FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K for Safeway Inc. (“Safeway” or the “Company”) contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company also provides forward-looking statements in other materials which are released to the public, as well as oral forward-looking statements. Forward-looking statements contain information about our future operating or financial performance. Forward-looking statements are based on our current expectations and involve risks and uncertainties, which may be beyond our control, as well as assumptions. If assumptions prove to be incorrect or if known or unknown risks and uncertainties materialize into actual events or circumstances, actual results could differ materially from those included in or contemplated or implied by these statements. Forward-looking statements do not strictly relate to historic or current facts. Forward-looking statements are indicated by words or phrases such as “continuing,” “ongoing,” “expects,” “estimates,” “anticipates,” “believes,” “guidance” and similar words or phrases and the negative of such words or phrases.

This Annual Report on Form 10-K includes forward-looking statements relating to, among other things: dividend payments on common stock; expansion of product lines; cash capital expenditures; efforts to revitalize operations in certain markets; outcomes of legal proceedings; the effect of new accounting standards; compliance with laws and regulations; pension plan contributions; obligations and payments under benefit plans; total unrecognized tax benefits; amount of indebtedness and Lifestyle stores. The following are among the principal factors that could cause actual results to differ materially from those included in or contemplated or implied by the forward-looking statements:

 

 

General business and economic conditions in our operating regions, including the rate of inflation, consumer spending levels, currency valuations, population, employment and job growth in our markets;

 

Pricing pressures and competitive factors, which could include pricing strategies, store openings, remodels or acquisitions by our competitors;

 

Results of our programs to control or reduce costs, improve buying practices and control shrink;

 

Results of our programs to increase sales;

 

Results of our continuing efforts to improve corporate brands;

 

Results of our programs to improve our perishables departments;

 

Results of our promotional programs;

 

Results of our capital program;

 

Results of our efforts to improve working capital;

 

Results of any ongoing litigation in which we are involved or any litigation in which we may become involved;

 

The resolution of uncertain tax positions;

 

The ability to achieve satisfactory operating results in all geographic areas where we operate;

 

Changes in the financial performance of our equity investments;

 

Labor costs, including benefit plan costs and severance payments, or labor disputes that may arise from time to time and work stoppages that could occur in areas where certain collective bargaining agreements have expired or are on indefinite extensions or are scheduled to expire in the near future;

 

Failure to fully realize or delay in realizing growth prospects for new business ventures, including Blackhawk Network Holdings, Inc. (“Blackhawk”);

 

Legislative, regulatory, tax or judicial developments, including with respect to Blackhawk;

 

The cost and stability of fuel, energy and other power sources;

 

Unanticipated events or changes in real estate matters, including acquisitions, dispositions and impairments;

 

Adverse weather conditions;

 

Performance in new business ventures or other opportunities that we pursue, including Blackhawk;

 

The capital investment in and financial results from our Lifestyle stores;

 

The rate of return on our pension assets; and

 

The availability and terms of financing.

We undertake no obligation to update forward-looking statements to reflect new information, events or developments after the date hereof. For additional information regarding these risks and uncertainties, see “Item 1A. Risk Factors.” These are not intended to be a discussion of all potential risks or uncertainties, as it is not possible to predict or identify all risk factors.

 

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PART I

 

Item 1. Business

General    Safeway was incorporated in the state of Delaware in July 1986 as SSI Holdings Corporation and, thereafter, its name was changed to Safeway Stores, Incorporated. In February 1990, the Company changed its name to Safeway Inc.

Safeway Inc. is one of the largest food and drug retailers in North America, with 1,743 stores at year-end 2007. The Company’s U.S. retail operations are located principally in California, Oregon, Washington, Alaska, Colorado, Arizona, Texas, the Chicago metropolitan area and the Mid-Atlantic region. The Company’s Canadian retail operations are located principally in British Columbia, Alberta and Manitoba/Saskatchewan. In support of its retail operations, the Company has an extensive network of distribution, manufacturing and food-processing facilities.

In 2006 a subsidiary of Safeway purchased the remaining minority interests in GroceryWorks Holdings, LLC, the parent company of Safeway’s online grocery channel, GroceryWorks.com Operating Company, LLC (“GroceryWorks”). GroceryWorks operates under the names Safeway.com, Vons.com and Genuardis.com (collectively “Safeway.com”).

Safeway also has a 49% ownership interest in Casa Ley, S.A. de C.V. (“Casa Ley”) which operates 137 food and general merchandise stores in Western Mexico.

Blackhawk, a subsidiary of Safeway, provides third-party gift cards, prepaid cards, telecom cards and sports and entertainment cards to a broad group of top North American retailers for sale to retail customers. Blackhawk also has gift card businesses in the United Kingdom and Australia.

Stores    Safeway’s average store size is approximately 46,000 square feet. The Company determines the size of a new store based on a number of considerations, including the needs of the community the store serves, the location and site plan, and the estimated return on capital invested. Safeway’s primary new store format, called the “Lifestyle” store, is typically 55,000 square feet but can vary depending on the factors stated above. Lifestyle stores showcase the Company’s commitment to quality with an expanded perishables offering. They feature an earth-toned décor package that is warm and inviting with special lighting to highlight products and departments, custom flooring and unique display features. The Company believes this warm ambience significantly enhances the shopping experience.

Safeway’s stores provide a full array of dry grocery items tailored to local preferences. Most stores offer a wide selection of food and general merchandise and feature a variety of specialty departments such as bakery, delicatessen, floral and pharmacy. In addition, many stores now offer Starbucks coffee shops and adjacent fuel centers.

Safeway continues to operate a number of smaller stores that also offer an extensive selection of food and general merchandise and that generally include one or more specialty departments. These stores remain an important part of the Company’s store network in smaller communities and certain other locations where larger stores may not be feasible because of space limitations and/or community needs or restrictions.

 

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The following table summarizes Safeway’s stores by size at year-end 2007:

 

Square footage   

Number

of stores

         Percent
of total
 

Less than 30,000

   242       14 %

30,000 to 50,000

   742       43  

More than 50,000

   759         43  

Total stores

   1,743         100 %

Store Ownership    At year-end 2007, Safeway owned approximately 41% of its stores and leased its remaining stores. The Company prefers ownership because it provides control and flexibility with respect to remodeling, expansions, closures and financing terms.

Merchandising    Safeway’s operating strategy is to provide value to its customers by maintaining high store standards and a wide selection of high-quality products at competitive prices. To provide one-stop shopping for today’s busy shoppers, the Company emphasizes high-quality produce and meat and offers many specialty items through its various specialty departments.

Safeway is focused on differentiating its offering with high-quality perishables. The Company believes it has developed a reputation for having the best produce in the market, through high-quality specifications and precise handling procedures, and the most tender and flavorful meat, through the Company’s Rancher’s Reserve Tender Beef offering. In addition, Safeway has developed a variety of new items in the deli/food service department, including Signature Cafe sandwiches, soups and salads that provide meal solutions to today’s busy shoppers.

Safeway has continued to develop its premium line of Consumer Brand products. Hundreds of items have been developed since 1993 under the “Safeway SELECT” banner. The award-winning Safeway SELECT line is designed to offer premium quality products that the Company believes are equal or superior in quality to comparable best-selling, nationally advertised brands, or are unique to the category and not available from national brand manufacturers. The Safeway SELECT line of products includes: unique salsas, bagged salads, whole bean coffees, cookies, frozen pizzas, fresh and frozen pastas and an extensive array of ice creams and hors d’oeuvres.

In late 2005, Safeway unveiled the line of O ORGANICS food and beverage products. Everything in the O ORGANICS line, which includes more than 300 items, comes from certified organic growers or processors and is USDA-certified organic. The O ORGANICS line includes, among other products: milk, chicken, salads, juices and entrees. Further expansion of the line is expected in 2008.

Safeway launched Eating Right, a line of great-tasting, better-for-you products, in July 2007. Eating Right products span more than 20 categories, including frozen entrees, soups, produce and salad dressings, with further expansion expected in 2008.

Priority Total Pet Care, a line of pet foods and pet care products, and Basic Red, value-priced paper goods, were introduced in 2006. Other Safeway brands include the Lucerne line of dairy products & the Primo Taglio line of meats and cheeses.

Manufacturing and Wholesale    The principal function of manufacturing operations is to purchase, manufacture and process private-label merchandise sold in stores operated by Safeway. As measured by sales dollars, approximately 22% of Safeway’s private-label merchandise is manufactured in Company-owned plants, and the remainder is purchased from third parties.

Safeway’s Canadian subsidiary has a wholesale operation that distributes both national brands and private-label products to independent grocery stores and institutional customers.

 

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Safeway operated the following manufacturing and processing facilities at year-end 2007:

 

      U.S.          Canada

Milk plants

   6       3

Bakery plants

   6       2

Ice cream plants

   2       2

Cheese and meat packing plants

         2

Soft drink bottling plants

   4      

Fruit and vegetable processing plants

   1       3

Cake commissary

   1        

Total

   20           12  

In addition, the Company operates laboratory facilities for quality assurance and research and development in certain plants and at its corporate offices.

Distribution    Each of Safeway’s 12 retail operating areas is served by a regional distribution center consisting of one or more facilities. Safeway has 17 distribution/warehousing centers (13 in the United States and four in Canada), which collectively provide the majority of all products to Safeway stores. The Company’s distribution centers in Maryland, Alberta and British Columbia are operated by third parties.

 

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Capital Expenditure Program    A key component of the Company’s long-term growth strategy is its capital expenditure program. The Company’s capital expenditure program funds, among other things, new stores, remodels, manufacturing plants, distribution facilities and information technology. Safeway’s management has maintained a rigorous program to select and approve new capital investments.

The table below details changes in the Company’s store base and presents the Company’s cash capital expenditures over the last five years (dollars in millions):

 

      2007     2006     2005     2004     2003  

Total stores at beginning of year

     1,761       1,775       1,802       1,817       1,808  

Stores opened:

          

New

     13       7       11       22       22  

Replacement

     7       10       10       11       18  
     20       17       21       33       40  

Stores closed

     38       31       48       48       31  

Total stores at year end

     1,743       1,761       1,775       1,802       1,817  

Remodels completed (1)
Lifestyle remodels

     253       276       293       92       19  

Other remodels

     15       8       22       23       56  
     268       284       315       115       75  

Number of fuel stations at year end

     361       340       314       311       270  

Total retail square footage at year end
(in millions)

     80 .3     80 .8     81 .0     82 .1     82 .6

Cash capital expenditures

   $   1,768 .7   $   1,674 .2   $   1,383 .5   $   1,212 .5   $ 935 .8

Cash capital expenditures as a
percentage of sales and other revenue

     4.2 %     4.2 %     3.6 %     3.4 %     2.6 %

 

(1) Defined as store remodel projects (other than maintenance) generally requiring expenditures in excess of $0.2 million.

During 2007 Safeway invested $1.77 billion in cash capital expenditures. The Company opened 20 new Lifestyle stores, remodeled 253 stores to the Lifestyle format and closed 38 stores. The Company also completed 15 other remodels. In 2008 the Company expects to spend approximately $1.70 to $1.75 billion in cash capital expenditures and to open approximately 20 to 25 new Lifestyle stores and to remodel approximately 250 to 255 stores into the Lifestyle format. At year-end 2007, 59% of Safeway’s store base was in the Lifestyle format, and the Company expects to have approximately 75% in this format by the end of 2008 and approximately 90% in this format by the end of 2009.

Financial Information about Segments    Note L to the consolidated financial statements set forth in Part II, Item 8 of this report provides financial information about the Company’s segments.

Trade Names and Trademarks    Safeway has invested significantly in the development and protection of “Safeway” both as a trade name and a trademark and considers it to be an important asset. Safeway also owns more than 400 other trademarks registered and/or pending in the United States Patent and Trademark Office and other jurisdictions, including trademarks for its product lines such as Safeway, Safeway SELECT, Rancher’s Reserve, O ORGANICS, Lucerne, Primo Taglio, Eating Right, Basic Red and Priority, and other trademarks such as Pak’N Save Foods, Vons, Pavilions, Dominick’s, Randall’s, Tom Thumb, Genuardi’s and Carrs Quality Centers. Each trademark registration is for an initial period of 10 or 20 years, depending on the registration date, and may be renewed so long as it is in continued use in commerce.

 

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Canada Safeway also has registered numerous trademarks in Canada. Canada Safeway also has invested significantly in “Safeway,” both as a trade name and a trademark, and considers it to be an important asset in Canada. Canada Safeway owns and has registered in Canada more than 200 trademarks, most of which replicate trademarks owned in the United States by Safeway. In addition to those trademarks used in common with Safeway, Canada Safeway owns certain trademarks unique to its business in Canada. For example, Canada Safeway has registered the trademarks, “Macdonalds Consolidated” and “Family Foods” in connection with wholesale distribution of merchandise to independent grocers. In Canada each trademark registration is for an initial period of 15 years, and may be renewed for additional periods of 15 years, as long as the trademark continues to be used in commerce.

Safeway considers its trademarks to be of material importance to its business and actively defends and enforces its rights.

Working Capital    At year-end 2007, working capital consisted of $4.0 billion in current assets and $5.1 billion in current liabilities. Normal operating fluctuations in these substantial balances can result in changes to cash flow from operations presented in the consolidated statements of cash flows that are not necessarily indicative of long-term operating trends. There are no unusual industry practices or requirements relating to working capital items.

Seasonality    Blackhawk receives a significant portion of the cash inflow from the sale of third-party gift cards late in the fourth quarter of the year and generally remits the cash, less commissions, to the card partners early in the first quarter of the following year.

Competition    Food retailing is intensely competitive. The number of competitors and the amount of competition experienced by Safeway’s stores varies by market area. The principal competitive factors that affect the Company’s business are location, quality, service, price and consumer loyalty to other brands and stores.

Local, regional and national food chains, as well as independent food stores, comprise the Company’s principal competition. Safeway also faces substantial competition from dollar stores, convenience stores, liquor retailers, restaurants, membership warehouse clubs, specialty retailers, supercenters, and large-scale drug and pharmaceutical chains. Safeway and its competitors engage in price competition which, from time to time, has adversely affected operating margins in the Company’s markets.

Raw Materials    Various agricultural commodities constitute the principal raw materials used by the Company in the manufacture of its food products. Management believes that raw materials for its products are not in short supply, and all are readily available from a wide variety of independent suppliers.

Compliance with Environmental Laws    The Company’s compliance with the federal, state, local and foreign laws and regulations, which have been enacted or adopted regulating the discharge of materials into the environment or otherwise related to the protection of the environment, has not had and is not expected to have a material adverse effect upon the Company’s financial position or results of operations.

Employees    At year-end 2007, Safeway had approximately 201,000 full- and part-time employees. Approximately 80% of Safeway’s employees in the United States and Canada are covered by collective bargaining agreements negotiated with union locals affiliated with one of 10 different international unions. There are approximately 400 such agreements, typically having three-year terms, with some agreements having terms of up to five years. Accordingly, Safeway renegotiates a significant number of these agreements every year.

During 2007 contracts covering approximately 65,000 employees were ratified. The United Food and Commercial Workers International Union (“UFCW”) collective bargaining agreements, which covered approximately 62,000 employees, primarily in the Company’s Northern California, Vons and Seattle divisions’ stores, were ratified.

Financial Information about Geographic Areas    Note L to the consolidated financial statements set forth in Part II, Item 8 of this report provides financial information by geographic area.

Available Information    Safeway’s corporate Web site is located at www.safeway.com. You may access our Securities and Exchange Commission (“SEC”) filings free of charge at our corporate Web site promptly after such material is electronically filed with, or furnished to, the SEC. We also maintain certain corporate governance documents on our Web

 

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site, including the Company’s Corporate Governance Guidelines, our Director Independence Standards, the Code of Business Conduct and Ethics for the Company’s corporate directors, officers and employees, and the charters for our Audit, Nominating and Corporate Governance, and Executive Compensation committees. We will provide a copy of any such documents to any stockholder who requests it. We do not intend for information found on the Company’s Web site to be part of this document.

 

Item 1A. Risk Factors

We wish to caution you that there are risks and uncertainties that could affect our business. These risks and uncertainties include, but are not limited to, the risks described below and elsewhere in this report, particularly in “Forward-Looking Statements.” The following is not intended to be a complete discussion of all potential risks or uncertainties, as it is not possible to predict or identify all risk factors.

Competitive Industry Conditions    We face intense competition from traditional grocery retailers, non-traditional competitors such as supercenters and membership warehouse clubs, as well as from specialty supermarkets, drug stores, dollar stores, liquor stores, convenience stores and restaurants. Increased competition may have an adverse effect on profitability as the result of lower sales, lower gross profits and/or greater operating costs.

Our ability to attract customers is dependent, in large part, upon a combination of price, quality, product mix, brand recognition, store location, in-store marketing and design and promotional strategies. In each of these areas, traditional and non-traditional competitors compete with us and may successfully attract our customers to their stores by aggressively matching or exceeding what we offer. In recent years many of our competitors have increased their presence in our markets. Our responses to competitive pressure, such as additional promotions and increased advertising, could adversely affect our profitability. We cannot assure that our actions will succeed in gaining or maintaining market share. Additionally, we cannot predict how our customers will react to the entrance of certain non-traditional competitors into the grocery retailing business.

Because we face intense competition, we must anticipate and respond to changing consumer demands more effectively than our competitors. We must achieve and maintain favorable recognition of our unique and exclusive private-label brands, effectively market our products to consumers in several diverse market segments, competitively price our products, and maintain and enhance a perception of value for consumers. Finally, we must source and market our merchandise efficiently and creatively. Failure to accomplish these objectives could impair our ability to compete successfully and adversely affect our growth and profitability.

Labor Relations    A significant majority of our employees are unionized, and our relationship with unions, including labor disputes or work stoppages, could have an adverse impact on our financial results.

We are a party to approximately 400 collective bargaining agreements, of which 102 are scheduled to expire in 2008. These expiring agreements cover approximately 32% of our union-affiliated employees. In future negotiations with labor unions, we expect that rising health care, pension and employee benefit costs, among other issues, will be important topics for negotiation. If, upon the expiration of such collective bargaining agreements, we are unable to negotiate acceptable contracts with labor unions, it could result in strikes by the affected workers and thereby significantly disrupt our operations. Further, if we are unable to control health care and pension costs provided for in the collective bargaining agreements, we may experience increased operating costs and an adverse impact on future results of operations.

Profit Margins    Profit margins in the grocery retail industry are very narrow. In order to increase or maintain our profit margins, we develop strategies to reduce costs, such as productivity improvements, shrink reduction, distribution center efficiencies and other similar strategies. Our failure to achieve forecasted cost reductions might have a material adverse effect on our business. Changes in our product mix also may negatively affect certain financial measures. For example, we continue to add supermarket fuel centers, which generate low profit margins but significant sales. Although this negatively affects our gross profit margin, fuel sales provide a positive effect on operating and administrative expense as a percent of sales.

 

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Opening and Remodeling Stores    Our inability to open and remodel stores as planned could have a material adverse effect on our results. In 2008 we plan to open approximately 20 to 25 new Lifestyle stores and to remodel approximately 250 to 255 stores into the Lifestyle format. If, as a result of labor relations issues, supply issues or environmental and real estate delays, these capital projects do not stay within the time and financial budgets we have forecasted, our future financial performance could be materially adversely affected. Furthermore, we cannot ensure that the new or remodeled stores will achieve anticipated same-store sales or profit levels.

Future Growth of Blackhawk    Blackhawk’s business, financial condition, results of operations and prospects are subject to certain risks and uncertainties. Consequently, actual results could differ materially from Blackhawk’s targeted earnings growth. There is no assurance that Blackhawk will continue to grow at the same rate as it has in the past. Some of the specific risks and uncertainties include, but are not limited to, the following:

 

   

Blackhawk faces competition from other companies, that may introduce new products that compete with products offered by Blackhawk. This could limit Blackhawk’s future growth;

   

Blackhawk is substantially dependent on the continuous operation and security of its information technology applications and infrastructure;

   

A significant portion of Blackhawk’s revenues and net earnings is realized during the last several weeks of the calendar year and is related to consumer gift purchases. A reduction in consumer spending for gifts, operational issues that result in limitations on gift cards available for sale in Blackhawk’s distribution channels or other factors that contribute to a shortfall in sales during this period could have an adverse effect on the Company’s consolidated results of operations and financial condition;

   

Blackhawk’s business depends on its ability to negotiate contract renewals with its key partners;

   

Blackhawk has begun to expand internationally, and it may find a different business or competitive environment in markets outside the U.S. that could adversely affect its profitability; and

   

Blackhawk’s prospects could be adversely affected as a result of regulatory changes affecting the sale of gift cards or other products that Blackhawk sells or plans to sell in the future.

Food Safety, Quality and Health Concerns    We could be adversely affected if consumers lose confidence in the safety and quality of certain food products. Adverse publicity about these types of concerns, whether valid or not, may discourage consumers from buying our products or cause production and delivery disruptions. The real or perceived sale of contaminated food products by us could result in product liability claims, a loss of consumer confidence and product recalls, which could have a material adverse effect on our sales and operations.

Economic Conditions that Impact Consumer Spending    Our results of operations are sensitive to changes in overall economic conditions that impact consumer spending, including discretionary spending. Future economic conditions such as employment levels, business conditions, interest rates, energy and fuel costs and tax rates could reduce consumer spending or change consumer purchasing habits. A general reduction in the level of consumer spending or our inability to respond to shifting consumer attitudes regarding products, store location and other factors could adversely affect our growth and profitability.

Unfavorable Changes in Government Regulation    Our stores are subject to various federal, state, local and foreign laws, regulations and administrative practices that affect our business. We must comply with numerous provisions regulating health and sanitation standards, food labeling, equal employment opportunity, minimum wages, and licensing for the sale of food, drugs and alcoholic beverages. We cannot predict the nature of future laws, regulations, interpretations or applications, nor can we determine what effect either additional government regulations or administrative orders, when and if promulgated, or disparate federal, state, local and foreign regulatory schemes would have on our future business. They could, however, require the reformulation of certain products to meet new standards, the recall or discontinuance of certain products not able to be reformulated, additional record keeping, expanded documentation of the properties of certain products, expanded or different labeling, and/or scientific substantiation. Any or all of such requirements could have an adverse effect on our results of operations and financial condition.

Substantial Indebtedness    We currently have, and expect to continue to have, a significant amount of debt, which could adversely affect our financial health. As of December 29, 2007, we had approximately $5.7 billion in total

 

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consolidated debt outstanding, including capital lease obligations. This substantial indebtedness could increase our vulnerability to general adverse economic and industry conditions. If debt markets do not permit us to refinance certain maturing debt, we may be required to: dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital, capital expenditures, acquisitions, development efforts and other general corporate purposes; limit our flexibility in planning for, or reacting to, changes in our business; place ourselves at a competitive disadvantage relative to our competitors that have less debt; and limit, along with the financial and other restrictive covenants in the documents governing our indebtedness, among other things, our ability to borrow additional funds. Changes in our credit ratings may have an adverse impact on our financing costs and structure in future periods, such as the higher interest costs on future financings and our ability to participate in the commercial paper market. Additionally, interest expense could be materially and adversely affected by changes in the interest rate environment, changes in our credit rating, fluctuations in the amount of outstanding debt, decisions to incur premiums on the early redemption of debt and any other factor that results in an increase in debt.

Retirement Plans    We maintain defined benefit retirement plans for substantially all employees not participating in multi-employer pension plans. Expenses from defined benefit pension plans may be significantly affected by changes in the actual return on plan assets and actuarial assumptions.

In addition, we participate in various multi-employer pension plans for substantially all employees represented by unions. We are required to make contributions to these plans in amounts established under collective bargaining agreements. Pension expense for these plans is recognized as contributions are made. Benefits generally are based on a fixed amount for each year of service. We contributed $270.1 million, $253.8 million and $234.5 million to these plans in 2007, 2006 and 2005, respectively. Based on the most recent information available to us, we believe a number of these multi-employer plans are underfunded. As a result, contributions to these plans may continue to increase. The amount of any increase or decrease in our required contributions to these multi-employer pension plans will depend upon the outcome of collective bargaining, actions taken by trustees who manage the plans, government regulations, the actual return on assets held in the plans, and the potential payment of a withdrawal liability if we choose to exit a market, among other factors. Additionally, the benefit levels and related issues will continue to create collective bargaining challenges. Under current law, an employer that withdraws or partially withdraws from a multi-employer pension plan may incur withdrawal liability to the plan, which represents the portion of the plan’s underfunding that is allocable to the withdrawing employer under very complex actuarial and allocation rules. Multi-employer pension legislation passed in 2006 may impact the funds in which we participate, which may have an impact on future pension contributions.

Legal Proceedings    From time to time, we are a party to legal proceedings, including matters involving personnel and employment issues, personal injury, antitrust claims and other proceedings arising in the ordinary course of business. In addition, there is an increasing number of cases being filed against companies generally, which contain class-action allegations under federal and state wage and hour laws. We estimate our exposure to these legal proceedings and establish reserves for the estimated liabilities. Assessing and predicting the outcome of these matters involves substantial uncertainties. Although not currently anticipated by management, unexpected outcomes in these legal proceedings, or changes in management’s evaluations or predictions, could have a material adverse impact on our financial results.

Dependence on Senior Management    Our future success depends upon the continued services of certain key members of senior management, whose expertise and knowledge of our business would be difficult to replace. If certain key members of senior management leave and we are unable to find qualified replacements, we may be unable to execute our business strategy. This could have a material adverse effect on our financial condition and results of operations.

Insurance Plan Claims    We use a combination of insurance and self-insurance to provide for potential liabilities for workers’ compensation, automobile and general liability, property insurance, director and officers’ liability insurance, and employee health care benefits. We estimate the liabilities associated with the risks retained by us, in part, by considering historical claims experience, demographic and severity factors and other actuarial assumptions which, by their nature, are subject to a high degree of variability. Any actuarial projection of losses concerning workers’ compensation and general liability is subject to a high degree of variability. Among the causes of this variability are unpredictable external factors affecting future inflation rates, discount rates, litigation trends, legal interpretations, benefit level changes and claim settlement patterns.

 

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The majority of the Company’s workers’ compensation liability is from claims occurring in California. California workers’ compensation has received intense scrutiny from the state’s politicians, insurers, employers and providers, as well as the public in general. Recent years have seen escalation in the number of legislative reforms, judicial rulings and social phenomena affecting our business. Some of the many sources of uncertainty in the Company’s reserve estimates include changes in benefit levels, medical fee schedules, medical utilization guidelines, vocation rehabilitation and apportionment.

Impairment of Goodwill and Long-Lived Assets    On our balance sheet, we have $2.4 billion of goodwill subject to periodic testing for impairment. Our long-lived assets, primarily stores, also are subject to periodic testing for impairment. Failure to achieve sufficient levels of cash flow at specific stores or divisions could result in impairment charges on goodwill and/or long-lived assets. We have incurred significant impairment charges to earnings in the past for goodwill and long-lived assets.

Information Technology Risks    The Company has large, complex information technology systems that are important to business operations. The Company could encounter difficulties developing new systems or maintaining and upgrading existing systems. Such difficulties could lead to significant expenses or losses due to disruption in business operations.

Despite the Company’s considerable efforts and technology to secure our computer network, security could be compromised, confidential information could be misappropriated, or system disruptions could occur. This could lead to loss of sales or profits or cause the Company to incur significant costs to reimburse third parties for damages.

Changes in Accounting Standards    Financial statements are prepared in accordance with accounting principles generally accepted in the United States. They are subject to interpretation by various governing bodies, including the Financial Accounting Standards Board (“FASB”) and the SEC, which create and interpret accounting standards. For many aspects of our business, such as workers’ compensation, store closures, employee benefit plans, stock-based employee compensation, goodwill and income tax contingencies, these standards and their interpretations require management’s most difficult, subjective or complex judgments. A change from current accounting standards could have a significant effect on the Company’s results of operations.

Energy and Fuel    Safeway’s operations are dependent upon the availability of a significant amount of energy and fuel to manufacture, store and transport products. Energy and fuel costs have experienced volatility over time. To reduce the impact of volatile energy costs, the Company has entered into contracts to purchase electricity and natural gas at fixed prices to satisfy a portion of its energy needs. This is discussed further in Part II, Item 7 of this report under the caption “Energy Contracts.”

Safeway also sells fuel. Significant increases in wholesale fuel costs could result in retail price increases and in lower gross profit on fuel sales. Additionally, consumer demand for fuel may decline if retail prices increase. Such volatility and the impact to our operations and financial results are difficult to predict.

 

Item 1B. Unresolved Staff Comments

None.

 

Item 2. Properties

The information required by this item is set forth in Part I, Item 1 of this report.

 

Item 3. Legal Proceedings

Information about legal proceedings appears under the caption “Legal Matters” in Note K to the consolidated financial statements set forth in Part II, Item 8 of this report.

 

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of the stockholders during the fourth quarter of fiscal 2007.

 

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Executive Officers of the Registrant

The names and ages of the current executive officers of the Company and their positions as of February 21, 2008 are set forth below. Unless otherwise indicated, each of the executive officers served in various managerial capacities with the Company over the past five years. None of the executive officers named below is related to any other executive officer or director by blood, marriage or adoption. Officers serve at the discretion of the Board of Directors.

 

Name and all positions with the Company

Held at February 21, 2008

            Year first elected
     Age      Officer      Present office

Steven A. Burd
Chairman, President and Chief Executive Officer

     58      1992      1993

Robert L. Edwards (1)
Executive Vice President and Chief Financial Officer

     52      2004      2004

Bruce L. Everette (2)
Executive Vice President
Retail Operations

     56      1991      2001

Larree M. Renda
Executive Vice President
Chief Strategist and Administrative Officer

     49      1991      1999

David F. Bond (3)
Senior Vice President
Finance and Control

     54      1997      1997

David T. Ching
Senior Vice President and
Chief Information Officer

     55      1994      1994

Robert A. Gordon (4)
Senior Vice President
Secretary and General Counsel
Chief Governance Officer

     56      1999      2000

Russell M. Jackson (5)
Senior Vice President
Human Resources

     50      2007      2007

Melissa C. Plaisance (6)
Senior Vice President
Finance and Investor Relations

     48      2004      2004

Kenneth M. Shachmut
Senior Vice President
Reengineering and Marketing Analysis

     59      1994      1999

David R. Stern (7)
Senior Vice President
Planning and Business Development

     53      1994      2002

 

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Executive Officers of the Registrant (continued)

 

Name and all positions with the Company

Held at February 21, 2008

        Year first elected
   Age    Officer    Present office

Jerry Tidwell (8)
Senior Vice President
Supply Operations

   56    2001    2003

Donald P. Wright
Senior Vice President
Real Estate and Engineering

   55    1991    1991

 

(1) Robert L. Edwards was appointed as Executive Vice President and Chief Financial Officer of the Company in March 2004. Prior to that, he was Executive Vice President and Chief Financial Officer of Maxtor Corporation from September 2003 to March 2004. Prior to joining Maxtor, Mr. Edwards was, from 1998 to August 2003, an officer at Imation Corporation, a developer, manufacturer and supplier of magnetic and optical data storage media, where for most of that period he held the position of Senior Vice President, Chief Financial Officer and Chief Administrative Officer. He is a director of Casa Ley, in which Safeway has a 49% ownership interest. In December 2006, Mr. Edwards was elected to the board of directors of Spansion, a provider of Flash memory solutions, where he serves on the Audit and Finance committees.

 

(2) Bruce L. Everette has been an Executive Vice President of Safeway Inc. since December 2001. While serving in that position, he was also President of Dominick’s Finer Foods, LLC, a subsidiary of Safeway, from October 2004 through November 2005. He held the positions of President and Division Manager, Northern California Division of Safeway Inc. from 1998 to 2001, and President, Phoenix Division, from 1995 to 1998.

 

(3) David F. Bond has been Senior Vice President, Finance and Control, of Safeway since July 1997. In this capacity, he also serves as the Company’s Chief Accounting Officer. Prior to joining Safeway, he was a partner with Deloitte & Touche LLP from June 1988 to July 1997.

 

(4) Robert A. Gordon has been a Senior Vice President since May 1999 and General Counsel since June 2000. In September 2005, he also became Secretary. He was Deputy General Counsel from May 1999 to June 2000.

 

(5) Russell M. Jackson was appointed as Senior Vice President, Human Resources, of the Company in March 2007. Prior to joining Safeway, he was employed with PG&E Corporation for 27 years, where he most recently served as Senior Vice President, Human Resources.

 

(6) Melissa C. Plaisance has been Senior Vice President, Finance and Investor Relations since October 2004. She joined the Company in 1990, and was Senior Vice President, Finance and Public Affairs, of Safeway Inc. from 1995 through 2000, and Senior Vice President, Finance and Investor Relations from 2000 to December 2003. From January 2004 to October 2004, she was at Del Monte Foods Company, where she held the position of Senior Vice President, Finance and Corporate Communications.

 

(7) David R. Stern held the position of Vice President, Financial Planning and Analysis, at Safeway from December 1994 until his election to Senior Vice President in 2002.

 

(8) Jerry Tidwell held the position of Vice President of Milk and Beverage Manufacturing from 2001 to 2003 and director of the grocery business unit from 2000 to 2001. Mr. Tidwell joined Safeway in 1998 after a 24-year career with the Pepsi Cola Company.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The Company’s common stock, $0.01 par value, is listed on the New York Stock Exchange. The following table presents quarterly high and low sales prices, as well as dividends declared per common share, for the Company’s common stock.

 

Fiscal Year 2007:    Low    High    Dividends
declared

Quarter 1 (12 weeks)

   $   32.86    $   37.24    $   0.0575

Quarter 2 (12 weeks)

     33.53      38.31      0.069  

Quarter 3 (12 weeks)

     30.10      37.14      0.069  

Quarter 4 (16 weeks)

     30.34      36.00      0.069  
Fiscal Year 2006:                  

Quarter 1 (12 weeks)

   $ 22.23    $ 25.70    $ 0.05    

Quarter 2 (12 weeks)

     22.85      25.72      0.0575

Quarter 3 (12 weeks)

     24.00      31.42      0.0575

Quarter 4 (16 weeks)

     27.41      35.61      0.0575

There were 18,167 stockholders of record as of February 21, 2008; however, approximately 99% of the Company’s outstanding stock is held in “street name” by depositories or nominees on behalf of beneficial holders. The closing price per share of common stock, as reported on the New York Stock Exchange Composite Tape, was $29.66 at the close of business on February 21, 2008.

Although the Company expects to continue to pay quarterly dividends on its common stock, the payment of future dividends is at the discretion of the Board of Directors and will depend upon the Company’s earnings, capital requirements, financial condition and other factors.

 

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Issuer Purchases of Equity Securities

The following table contains information for shares repurchased during the fourth quarter of 2007.

 

Fiscal period   Total number of
shares
purchased
(1)
 

Average price

paid per share (2)

 

Total number of shares
purchased as part of
publicly announced

plans or programs

  

Approximate dollar value of
shares that may yet be purchased
under the plans or programs

(in millions) (3)

September 9, 2007 –
October 6, 2007
  –       –     –      $   614.7
October 7, 2007 –
November 3, 2007
  1,610,156   $   31.61   1,610,156      563.8
November 4, 2007 –
December 1, 2007
  1,349,400     31.63   1,349,400      521.1
December 2, 2007 –
December 29, 2007
  59,490     34.44   –        521.1
Total   3,019,046   $ 31.67   2,959,556    $ 521.1

 

(1) Includes 59,490 shares withheld, at the election of certain holders of restricted stock, by the Company from the vested portion of restricted stock awards with a market value approximating the amount of the withholding taxes due from such restricted stockholders.

 

(2) Average price per share excludes commissions. Average price per share, excluding the withheld restricted shares referred to in footnote 1 above, was $31.62.

 

(3) In 1999, the Company’s Board of Directors initiated a $2.5 billion stock repurchase program. The Board increased the authorized level of the stock repurchase program to $3.5 billion in 2002 and then to $4.0 billion in 2006. From the initiation of the repurchase program in 1999 through the end of fiscal 2007, the aggregate cost of shares of common stock repurchased by the Company, including commissions, was approximately $3.5 billion, leaving an authorized amount for repurchases of $521.1 million. The timing and volume of future repurchases will depend on several factors, including market conditions. The repurchase program has no expiration date but may be terminated by the Board of Directors.

 

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Stock Performance Graph

The following graph compares the yearly percentage change in the Company’s cumulative total stockholder return on its common stock for the period from the end of its 2002 fiscal year to the end of its 2007 fiscal year to that of the Standard & Poor’s (“S&P”) 500 and a group of peer companies( *) in the retail grocery industry. The stock price performance shown below is not necessarily indicative of future performance.

LOGO

 

(*) The peer group consists of The Great Atlantic & Pacific Tea Company, Inc. and The Kroger Co.

The performance graph above is being furnished solely to accompany this Annual Report on Form 10-K pursuant to Item 201(e) of Regulation S-K, and is not being filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and is not to be incorporated by reference into any filing of the Company, whether made before or after the date hereof, regardless of any general incorporation language in such filing.

 

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Item 6. Selected Financial Data

 

(Dollars in millions, except
    per-share amounts)
   52 Weeks
2007 (1)
     52 Weeks
2006
(1)
     52 Weeks
2005
(1)
     52 Weeks
2004
     53 Weeks
2003
 

Results of Operations

              

Sales and other revenue

   $   42,286.0      $   40,185.0      $   38,416.0      $   35,822.9      $   35,727.2  

Gross profit

     12,152.9        11,581.0        11,112.9        10,595.3        10,724.2  

Operating and
administrative expense

     (10,380.8 )      (9,981.2 )      (9,898.2 )      (9,422.5 )      (9,421.2 )

Goodwill impairment
charges

     –          –          –          –          (729.1 )

Operating profit

     1,772.1        1,599.8        1,214.7        1,172.8        573.9  

Interest expense

     (388.9 )      (396.1 )      (402.6 )      (411.2 )      (442.4 )

Other income, net

     20.4        36.3        36.9        32.3        9.6  

Income before income taxes

     1,403.6        1,240.0        849.0        793.9        141.1  

Income taxes

     (515.2 )      (369.4 )      (287.9 )      (233.7 )      (310.9 )

Net income (loss)

   $ 888.4      $ 870.6      $ 561.1      $ 560.2      $ (169.8 )

Basic earnings (loss) per share

   $ 2.02      $ 1.96      $ 1.25      $ 1.26      $ (0.38 )

Diluted earnings (loss) per share

   $ 1.99      $ 1.94      $ 1.25      $ 1.25      $ (0.38 )

Weighted average shares
outstanding (in millions):

              

Basic

     440.3        444.9        447.9        445.6        441.9  

Diluted

     445.7        447.8        449.8        449.1        441.9  

Cash dividends declared
per common share
(2)

   $ 0.2645      $ 0.2225      $ 0.15      $ –        $ –    

 

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Item 6. Selected Financial Data (continued)

 

(Dollars in millions, except
    per-share amounts)
   52 Weeks
2007 (1)
   52 Weeks
2006
(1)
   52 Weeks
2005
(1)
   52 Weeks
2004
   53 Weeks
2003

Financial Statistics

              

Comparable-store sales
increases (decreases)
(3)

     4.4%      4.4%      5.9%      0.9%      (2.4%)

Identical-store sales increases
(decreases)
(3)

     4.1%      4.1%      5.8%      0.3%      (2.8%)

Identical-store sales increases
(decreases) without fuel
(3)

     3.4%      3.3%      4.3%      (1.3%)      (4.5%)

Gross profit margin

     28.74%      28.82%      28.93%      29.58%      30.02%

Operating & administrative
expense as a percentage of
sales
(4)

     24.55%      24.84%      25.77%      26.30%      26.37%

Operating profit as a
percentage of sales

     4.2%      4.0%      3.2%      3.3%      1.6%

Cash capital expenditures

   $ 1,768.7    $ 1,674.2    $ 1,383.5    $ 1,212.5    $ 935.8

Depreciation & amortization

     1,071.2      991.4      932.7      894.6      863.6

Total assets

       17,651.0        16,273.8        15,756.9        15,377.4        15,096.7

Total debt

     5,655.1      5,868.1      6,358.6      6,763.4      7,822.3

Total stockholders’ equity

     6,701.8      5,666.9      4,919.7      4,306.9      3,644.3

Other Statistics

              

Stores opened during the year

     20      17      21      33      40

Stores closed during the year

     38      31      48      48      31

Total stores at year end

     1,743      1,761      1,775      1,802      1,817

Remodels completed (5)

              

Lifestyle remodels

     253      276      293      92      19

Other remodels

     15      8      22      23      56

Total remodels completed

     268      284      315      115      75

Total retail square footage at
year end (in millions)

     80.3      80.8      81.0      82.1      82.6

 

(1) 2007, 2006 and 2005 include stock-based compensation expense of $48.4 million ($0.07 per diluted share), $51.2 million ($0.07 per diluted share) and $59.7 million ($0.08 per diluted share), respectively. For additional information, see the caption “Stock-Based Employee Compensation” in Note A and the caption “Additional Stock Plan Information” in Note G to the consolidated financial statements set forth in Part II, Item 8 of this report.

 

(2) No common stock dividends were declared prior to the second quarter of 2005.

 

(3) Defined as stores operating the same period in both the current year and the previous year. Comparable stores include replacement stores while identical stores do not. 2005 sales increase includes an estimated 130-basis-point improvement in comparable-store sales and an estimated 140-basis-point improvement in identical-store sales due to the impact of the Southern California strike which ended in the first quarter of 2004. 2004 sales increase includes an estimated reduction of 60 basis points due to the impact of this strike. 2003 sales decrease includes the estimated 240-basis-point impact of the Southern California strike.

 

(4) Management believes this ratio is relevant because it assists investors in evaluating Safeway’s ability to control costs.

 

(5) Defined as store remodel projects (other than maintenance) generally requiring expenditures in excess of $0.2 million. Excludes acquisitions.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Results of Operations

Safeway reported net income of $888.4 million ($1.99 per diluted share) in 2007, $870.6 million ($1.94 per diluted share) in 2006 and net income of $561.1 million ($1.25 per diluted share) in 2005. Results in fiscal 2006 were affected by a $62.6 million reduction of income tax expense which is described in this report under the caption “Income Taxes.”

Sales    Sales increased 5.2% to $42.3 billion in 2007 from $40.2 billion in 2006 primarily because of Safeway’s marketing strategy, Lifestyle store execution, increased fuel sales and an increase in the Canadian dollar exchange rate.

Same-store sales increases for 2007 were as follows:

 

     

Comparable-store

sales (includes
replacement stores)

   

Identical-store sales
(excludes

replacement stores)

 

Including fuel

   4.4 %   4.1 %

Excluding fuel

   3.6 %   3.4 %

Total sales increased 4.6% to $40.2 billion in 2006 from $38.4 billion in 2005 primarily because of Safeway’s marketing strategy, Lifestyle store execution and increased fuel sales.

Same-store sales increases for 2006 were as follows:

 

     

Comparable-store

sales (includes
replacement stores)

   

Identical-store sales
(excludes

replacement stores)

 

Including fuel

   4.4 %   4.1 %

Excluding fuel

   3.5 %   3.3 %

Total sales increased 7.2% to $38.4 billion in 2005 from $35.8 billion in 2004, primarily because of Safeway’s marketing strategy, Lifestyle store execution and increased fuel sales.

Same-store sales increases for 2005 were as follows:

 

     

Comparable-store

sales (includes
replacement stores)

   

Identical-store sales
(excludes

replacement stores)

 

Including fuel:

    

Excluding strike-affected stores

   4.6 %   4.4 %

Including strike-affected stores

   5.9 %   5.8 %

Excluding fuel:

    

Excluding strike-affected stores

   3.0 %   2.9 %

Including strike-affected stores

   4.4 %   4.3 %

Gross Profit    Gross profit represents the portion of sales revenue remaining after deducting the cost of goods sold during the period, including purchase and distribution costs. These costs include inbound freight charges, purchasing and receiving costs, warehouse inspection costs, warehousing costs, and other costs associated with Safeway’s distribution network. Advertising and promotional expenses are also a component of cost of goods sold. Additionally, all vendor allowances are classified as an element of cost of goods sold.

Gross profit margin was 28.74% of sales in 2007, 28.82% in 2006, and 28.93% in 2005.

 

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Gross profit decreased 8 basis points to 28.74% of sales in 2007 from 28.82% of sales in 2006. Higher fuel sales reduced gross profit by 20 basis points. Excluding fuel, gross profit increased 12 basis points primarily because of lower advertising expense, improved shrink, and benefits from supply-chain initiatives, partly offset by investments in price and higher LIFO expense. LIFO expense was $13.9 million in 2007 compared to $1.2 million in 2006.

Gross profit decreased 11 basis points to 28.82% of sales in 2006 from 28.93% of sales in 2005. Higher fuel sales reduced gross profit by 28 basis points. Excluding fuel, gross profit increased 17 basis points, primarily because of improved shrink, benefits from product-sourcing initiatives and improved product mix, partly offset by investments in price and increased advertising expense.

The gross profit margin decreased 65 basis points to 28.93% of sales in 2005 from 29.58% in 2004. Higher fuel sales reduced gross profit by 39 basis points. The remaining decline is due to grand openings of Lifestyle stores, investment in price, increased advertising expense and higher energy costs.

Vendor allowances totaled $2.5 billion in both 2007 and 2006 and $2.4 billion in 2005. Vendor allowances can be grouped into the following broad categories: promotional allowances, slotting allowances and contract allowances. All vendor allowances are classified as an element of cost of goods sold.

Promotional allowances make up approximately three-quarters of all allowances. With promotional allowances, vendors pay Safeway to promote their product. The promotion may be any combination of a temporary price reduction, a feature in print ads, a feature in a Safeway circular, or a preferred location in the store. The promotions are typically one to two weeks long.

Slotting allowances are a small portion of total allowances (typically less than 5% of all allowances). With slotting allowances, the vendor reimburses Safeway for the cost of placing new product on the shelf. Safeway has no obligation or commitment to keep the product on the shelf for a minimum period.

Contract allowances make up the remainder of all allowances. Under the typical contract allowance, a vendor pays Safeway to keep product on the shelf for a minimum period of time or when volume thresholds are achieved.

Operating and Administrative Expense    Operating and administrative expense consists primarily of store occupancy costs and backstage expenses, which, in turn, consist primarily of wages, employee benefits, rent, depreciation and utilities.

Dominick’s.    In February 2007, the Company announced a strategic plan to revitalize its operations at Dominick’s. This plan included remodeling 20 stores to the Lifestyle format, new store development and closing 14 under-performing stores in 2007. In the second quarter of 2007, Safeway incurred a store-lease exit charge of $30.3 million ($0.04 per diluted share) as a result of these closures. While management believes this strategy will improve sales and profitability, there can be no assurance that Dominick’s will achieve satisfactory operating results in the future.

Randall’s.    In the third quarter of 2005, the Company announced a plan to revitalize the Texas market which included the closure of 26 under-performing stores, a focused Lifestyle remodel program and the introduction of proprietary products. This resulted in a pre-tax, long-lived asset impairment charge of $54.7 million ($0.08 per diluted share). In the fourth quarter of 2005, Safeway recorded $55.5 million pre-tax ($0.07 per diluted share) in store exit activities for these stores.

Gain (Loss) on Property Retirements.    Operating and administrative expense included a $42.3 million net gain on property retirements in 2007, a $17.8 million net gain on property retirements in 2006 and a $13.6 million net loss on property retirements in 2005. In 2007 the Company sold a Bellevue, Washington distribution center at a gain of $46.6 million and a warehouse in Chicago, Illinois at a gain of $11.2 million. These gains were partly offset by net losses on other property retirements.

Other Charges.    In 2005 the Company incurred $59.4 million before tax ($0.08 per diluted share) in employee buyout charges, severance and related costs, relating primarily to Dominick’s and Northern California.

Operating and administrative expense was 24.55% of sales in 2007 compared to 24.84% in 2006 and 25.77% in 2005.

 

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Operating and administrative expense decreased 29 basis points to 24.55% of sales in 2007 from 24.84% of sales in 2006. Higher fuel sales in 2007 reduced operating and administrative expense by 16 basis points. The remaining 13 basis point decline is primarily the result of reduced employee costs as a percentage of sales and higher gains on disposal of property, partly offset by higher depreciation expense.

Operating and administrative expense decreased 93 basis points to 24.84% of sales in 2006 from 25.77% of sales in 2005. The store exit activities and employee buyouts in 2005 reduced operating and administrative expense by 44 basis points. Higher fuel sales in 2006 reduced operating and administrative expense by 13 basis points. The remaining decline is primarily the result of increased sales and reduced costs as a percentage of sales from store labor, workers’ compensation and pension expense.

Operating and administrative expense decreased 53 basis points in 2005 to 25.77% of sales from 26.30% in 2004. The significant pre-tax charges previously discussed (impairment of long-lived assets, store exit activities and employee buyouts in 2005) combined with store exit activities, health and welfare contributions and an accrual for rent holidays in 2004 increased operating and administrative expense, as a percentage of sales, by 20 basis points. Stock option expense, labor costs associated with the grand opening of Lifestyle stores and higher energy costs also increased operating and administrative expense, as a percentage of sales. These items were more than offset by restructured labor agreements, increased fuel sales and reduced workers’ compensation costs.

Interest Expense    Interest expense was $388.9 million in 2007, compared to $396.1 million in 2006 and $402.6 million in 2005. Interest expense decreased in 2007, 2006 and 2005 primarily due to lower average borrowings, partially offset by a higher average interest rate.

Other Income    Other income consists of interest income, minority interest in a consolidated affiliate and equity in earnings from Safeway’s unconsolidated affiliates. Interest income was $11.8 million in 2007, $11.1 million in 2006 and $12.7 million in 2005. Equity in earnings of unconsolidated affiliates was $8.7 million in 2007, $21.1 million in 2006 and $15.8 million in 2005.

Income Taxes    The Company’s effective tax rates for 2007, 2006 and 2005 were 36.7%, 29.8% and 33.9%, respectively. The effective tax rate for 2006 included a benefit of $62.6 million related to interest, net of income tax, on federal and state income tax refunds, a benefit of $13.6 million from the utilization of net operating loss carryforwards and various other favorable items. The effective tax rate for 2005 included a tax benefit from the repatriation of foreign earnings under the American Jobs Creation Act of 2004 and a tax benefit from the favorable resolution of certain tax issues.

Critical Accounting Policies and Estimates

Critical accounting policies are those accounting policies that management believes are important to the portrayal of Safeway’s financial condition and results of operations and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

Workers’ Compensation    The Company is primarily self-insured for workers’ compensation, automobile and general liability costs. It is the Company’s policy to record its self-insurance liability, as determined actuarially, based on claims filed and an estimate of claims incurred but not yet reported, discounted at a risk-free interest rate. Any actuarial projection of losses concerning workers’ compensation and general liability is subject to a high degree of variability. Among the causes of this variability are unpredictable external factors affecting future inflation rates, discount rates, litigation trends, legal interpretations, benefit level changes and claim settlement patterns. For example, a 25-basis-point increase in the Company’s discount rate would reduce its liability by approximately $5 million.

The majority of the Company’s workers’ compensation liability is from claims occurring in California. California workers’ compensation has received intense scrutiny from the state’s politicians, insurers, employers and providers, as well as the public in general. Recent years have seen an escalation in the number of legislative reforms, judicial rulings and social phenomena affecting this business. Some of the many sources of uncertainty in the Company’s reserve estimates include changes in benefit levels, medical fee schedules, medical utilization guidelines, vocation rehabilitation and apportionment.

 

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Store Closures    Safeway’s policy is to recognize losses relating to the impairment of long-lived assets when expected net future cash flows are less than the assets’ carrying values. When stores that are under long-term leases close, Safeway records a liability for the future minimum lease payments and related ancillary costs, net of estimated cost recoveries. In both cases, fair value is determined by estimating net future cash flows and discounting them using a risk-adjusted rate of interest. The Company estimates future cash flows based on its experience and knowledge of the market in which the closed store is located and, when necessary, uses real estate brokers. However, these estimates project future cash flows several years into the future and are affected by factors such as inflation, real estate markets and economic conditions.

Employee Benefit Plans    In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and 132(R).” SFAS No. 158 requires an employer to recognize in its statement of financial position an asset for a plan’s overfunded status or a liability for a plan’s underfunded status, measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year, and recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. Additional disclosures are also required. Safeway adopted SFAS No. 158 as of December 30, 2006, as required.

The determination of Safeway’s obligation and expense for pension benefits is dependent, in part, on the Company’s selection of certain assumptions used by its actuaries in calculating these amounts. These assumptions are disclosed in Note I to the consolidated financial statements and include, among other things, the discount rate, the expected long-term rate of return on plan assets and the rate of compensation increases. Actual results in any given year will often differ from actuarial assumptions because of economic and other factors. In accordance with GAAP, actual results that differ from the actuarial assumptions are accumulated and amortized over future periods and, therefore, affect recognized expense and recorded obligation in such future periods. While Safeway believes its assumptions are appropriate, significant differences in actual results or significant changes in the Company’s assumptions may materially affect Safeway’s pension and other postretirement obligations and its future expense.

Safeway bases the discount rate on current investment yields on high quality fixed-income investments. The combined weighted-average discount rate used to determine 2007 pension expense was 5.9%. A lower discount rate increases the present value of benefit obligations and increases pension expense. Expected return on pension plan assets is based on historical experience of the Company’s portfolio and the review of projected returns by asset class on broad, publicly traded equity and fixed-income indices, as well as target asset allocation. Safeway’s target asset allocation mix is designed to meet the Company’s long-term pension requirements. For 2007 the Company’s assumed rate of return was 8.5% on U.S. pension assets and 7.0% on Canadian pension assets. Over the 10-year period ended December 29, 2007, the average rate of return was approximately 9% for U.S. and 8% for Canadian pension assets.

Sensitivity to changes in the major assumptions for Safeway’s pension plans are as follows (dollars in millions):

 

     United States          Canada
     

Percentage
point

change

   Projected benefit
obligation
decrease
(increase)
  

Expense

decrease
(increase)

         Projected benefit
obligation
decrease
(increase)
   Expense
decrease
(increase)

Expected return on assets

   +/-1.0 pt         $  17.3/(17.3)            $  3.2/(3.2)

Discount rate

   +/-1.0 pt    $  96.3/(138.4)    $ (8.9)/(9.6)       $  63.0/(75.3)    $ 6.3/(8.2)

Cash contributions, primarily in Canada, to the Company’s pension plans are expected to total approximately $35.6 million in 2008 and totaled $33.0 million in 2007, $33.1 million in 2006 and $22.4 million in 2005. Safeway expects to fund future contributions to the Company’s pension plans with cash flow from operations.

 

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Stock-Based Employee Compensation    Safeway elected to early adopt SFAS No. 123R in the first quarter of 2005 using the modified prospective method. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements as compensation cost based on the fair value on the date of grant. The Company determines fair value of such awards using the Black-Scholes option pricing model. The Black-Scholes option pricing model incorporates certain assumptions, such as a risk-free interest rate, expected volatility, expected dividend yield and expected life of options, in order to arrive at a fair value estimate.

Goodwill    Safeway accounts for goodwill in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” As required by SFAS No. 142, Safeway tests for goodwill annually using a two-step approach with extensive use of accounting judgments and estimates of future operating results. Changes in estimates or the application of alternative assumptions and definitions could produce significantly different results. The factors that most significantly affect the fair value calculation are market multiples and estimates of future cash flows. Fair value is determined primarily by the discounted cash flow method and the guideline company methods.

Income Tax Contingencies    The Company is subject to periodic audits by the Internal Revenue Service as well as foreign, state and local taxing authorities. These audits may challenge certain of the Company’s tax positions such as the timing and amount of income and deductions and the allocation of taxable income to various tax jurisdictions. Income tax contingencies are accounted for in accordance with FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), and may require significant management judgment in estimating final outcomes. Actual results could materially differ from these estimates and could significantly affect the Company’s effective tax rate and cash flows in future years.

Liquidity and Financial Resources

Net cash flow from operating activities was $2,190.5 million in 2007, $2,175.0 million in 2006 and $1,881.0 million in 2005. Net cash flow from operating activities increased to $2,175.0 million in 2006 compared to $1,881.0 million in 2005 primarily because of higher net income. Net cash flow from operating activities decreased in 2005 primarily because working capital contributed to cash flow at a lower level than in 2004.

Blackhawk receives a significant portion of the cash inflow from the sale of third-party gift cards late in the fourth quarter of the year and remits the majority of the cash, less commissions, to the card partners early in the first quarter of the following year. The sale of gift cards increased cash flow from operating activities by $84.1 million in 2007, $71.1 million in 2006 and $48.2 million in 2005.

Net cash flow used by investing activities, which consists principally of cash paid for property additions, was $1,686.4 million in 2007, $1,734.7 million in 2006 and $1,313.5 million in 2005. Net cash flow used by investing activities declined slightly to $1,686.4 million in 2007 from $1,734.7 million in 2006. Cash paid for property additions was greater in 2007 than in 2006. However, proceeds from the sale of property were also greater in 2007. In addition Safeway spent $83.8 million to acquire businesses in 2006. Net cash flow used by investing activities increased to $1,734.7 million in 2006 from $1,313.5 million in 2005 primarily as a result of higher cash paid for property additions, lower proceeds from the sale of property and the cash used to acquire businesses in 2006.

Capital expenditures increased in 2007, 2006 and 2005 as the Company focused on remodeling its existing stores under its Lifestyle store format. During 2007 Safeway invested $1.77 billion in capital expenditures. The Company opened 20 new Lifestyle stores, completed 253 Lifestyle remodels and closed 38 stores. The Company also completed 15 other remodels. In 2006 Safeway opened 17 new Lifestyle stores and completed 276 Lifestyle store remodels. Safeway also completed eight other remodels. In 2005 the Company opened 21 new Lifestyle stores and completed 293 Lifestyle store remodels. The Company also completed 22 other remodels. In 2008 the Company expects to spend approximately $1.70 to $1.75 billion in cash capital expenditures and to open approximately 20 to 25 new Lifestyle stores and to remodel approximately 250 to 255 stores into the Lifestyle format.

Net cash flow used by financing activities was $454.0 million in 2007, $596.3 million in 2006 and $466.9 million in 2005. In 2007 Safeway paid down $261.3 million of debt, repurchased $226.1 million of common stock, and paid $111.5

 

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million of dividends. In 2006 Safeway paid down $493.1 million of debt, repurchased $318.0 million of common stock and paid dividends of $96.0 million. Also in 2006 Safeway received a $262.3 million tax refund related to prior years’ financing. In 2005 Safeway paid down $444.9 million of debt and paid $44.9 million of dividends.

Based upon the current level of operations, Safeway believes that net cash flow from operating activities and other sources of liquidity, including potential borrowing under Safeway’s commercial paper program and its credit agreement, referred to below, will be adequate to meet anticipated requirements for working capital, capital expenditures, interest payments, dividend payments, stock repurchases, if any, and scheduled principal payments for the foreseeable future. There can be no assurance, however, that Safeway’s business will continue to generate cash flow at or above current levels or that the Company will maintain its ability to borrow under its commercial paper program and credit agreement.

Bank Credit Agreement    On June 1, 2005, the Company entered into a $1,600.0 million credit agreement with a syndicate of banks. On June 15, 2006, the Company amended the credit agreement to extend the termination date for an additional year to June 1, 2011. On June 1, 2007, the Company amended the credit agreement again for purposes of (i) extending the termination date of the credit agreement for an additional year to June 1, 2012, (ii) providing for two additional one-year extensions of the termination date on the terms set forth in the amendment, and (iii) amending the pricing levels (which are based on Safeway’s debt ratings or interest coverage ratio), pricing margins and facility fee percentages for the loans and commitments under the revolving credit facility. The credit agreement, as amended (the “Credit Agreement”), provides (i) to Safeway a $1,350.0 million, five-year, revolving credit facility (the “Domestic Facility”), (ii) to Safeway and Canada Safeway Limited, a Canadian facility of up to $250.0 million for U.S. Dollar and Canadian Dollar advances and (iii) to Safeway a $400.0 million sub-facility of the Domestic Facility for issuance of standby and commercial letters of credit. The Credit Agreement also provides for an increase in the credit facility commitments up to an additional $500.0 million, subject to the satisfaction of certain conditions. The restrictive covenants of the Credit Agreement limit Safeway and its subsidiaries with respect to, among other things, creating liens upon its assets and disposing of material amounts of assets other than in the ordinary course of business. Additionally, the Company is required to maintain a minimum Adjusted EBITDA, as defined in the Credit Agreement, to interest expense ratio of 2.0 to 1 and not exceed an Adjusted Debt (total consolidated debt less cash and cash equivalents in excess of $75.0 million) to Adjusted EBITDA ratio of 3.5 to 1. As of December 29, 2007, the Company was in compliance with the covenant requirements. As of December 29, 2007, there were no borrowings, and letters of credit totaled $37.1 million under the Credit Agreement. Total unused borrowing capacity under the Credit Agreement was $1,562.9 million as of December 29, 2007. The Credit Agreement is scheduled to expire on June 1, 2012.

 

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The computation of Adjusted EBITDA, as defined by the Credit Agreement, is provided below solely to provide an understanding of the impact that Adjusted EBITDA has on Safeway’s ability to borrow under the Credit Agreement. Adjusted EBITDA should not be considered as an alternative to net income or cash flow from operating activities (which are determined in accordance with GAAP) as an indicator of operating performance or a measure of liquidity. Other companies may define Adjusted EBITDA differently and, as a result, such measures may not be comparable to Safeway’s Adjusted EBITDA (dollars in millions).

 

     

52 weeks

2007

 

Adjusted EBITDA:

  

Net income

   $ 888.4  

Add (subtract):

  

Income taxes

     515.2  

Interest expense

     388.9  

Depreciation

     1,071.2  

LIFO expense

     13.9  

Stock option expense

     48.4  

Property impairment charges

     27.1  

Equity in earnings of unconsolidated affiliates

     (8.7 )

Dividend received from unconsolidated affiliate

     8.9  

Total Adjusted EBITDA

   $   2,953.3  

Adjusted EBITDA as a multiple of interest expense

     7.59x  

Total debt at year-end 2007

   $ 5,655.1  

Less cash and equivalents in excess of $75.0 at December 29, 2007

     (202.8 )

Adjusted Debt

   $ 5,452.3  

Adjusted Debt to Adjusted EBITDA

     1.85x  

Shelf Registration    In 2004 the Company filed a shelf registration statement covering the issuance from time to time of up to $2.3 billion of debt securities and/or common stock. As of December 29, 2007, $825.0 million of securities were available for issuance under the shelf registration. The Company may issue debt or common stock in the future depending on market conditions, the need to refinance existing debt and capital expenditure plans.

Pursuant to the shelf registration, Safeway issued $500.0 million of 6.35% Notes (the “Notes”) on August 17, 2007. The Notes mature on August 15, 2017. The Company will pay interest on the Notes on February 15 and August 15 of each year. Interest payments commenced on February 15, 2008. Safeway used the net proceeds from the Notes to repay borrowings under its U.S. commercial paper program which had been used to repay $480.0 million of Senior Notes which matured in July 2007. At Safeway’s option, the Notes can be redeemed, in whole or in part, at any time at a redemption price equal to the greater of 100% of the principal amount of the Notes to be redeemed, or the sum of the present values of the remaining scheduled payments of principal and interest on the Notes to be redeemed. Additionally, Safeway will be required to offer payment in cash equal to 101% of the aggregate principal amount of the Notes, plus accrued and unpaid interest, upon change of control as described in the terms of the Notes.

 

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Dividends Declared on Common Stock    The following table presents information regarding dividends declared on Safeway’s common stock during fiscal 2007, 2006 and 2005.

 

(in millions, except per-share amounts)    Date
Declared
     Record
Date
     Per-Share
Amounts
     Total      Year-to-date
Total

2007

                      

Quarter 4

   12/05/07      12/27/07      $   0.0690      $   30.4      $   116.6

Quarter 3

   08/29/07      09/27/07        0.0690        30.5        86.2

Quarter 2

   05/16/07      06/29/07        0.0690        30.3        55.7

Quarter 1

   03/09/07      03/30/07        0.0575        25.4        25.4

2006

                      

Quarter 4

   12/08/06      12/29/06      $ 0.0575      $ 25.3      $ 98.8

Quarter 3

   08/28/06      09/13/06        0.0575        25.4        73.5

Quarter 2

   05/25/06      06/16/06        0.0575        25.6        48.1

Quarter 1

   03/10/06      03/31/06        0.0500        22.5        22.5

2005

                      

Quarter 4

   12/09/05      12/30/05      $ 0.0500      $ 22.5      $ 67.4

Quarter 3

   08/18/05      09/07/05        0.0500        22.5        44.9

Quarter 2

   05/25/05      06/16/05        0.0500        22.4        22.4

Quarter 1

   N/A      N/A        N/A        N/A        N/A

Dividends Paid on Common Stock    The following table presents information regarding dividends paid on Safeway’s common stock during fiscal 2007, 2006 and 2005.

 

(in millions, except per-share amounts)    Date Paid      Record
Date
     Per-Share
Amounts
     Total      Year-to-date
Total

2007

                      

Quarter 4

   10/18/07      09/27/07      $   0.0690      $   30.5      $   111.5

Quarter 3

   07/19/07      06/29/07        0.0690        30.3        81.0

Quarter 2

   04/20/07      03/30/07        0.0575        25.4        50.7

Quarter 1

   01/19/07      12/29/06        0.0575        25.3        25.3

2006

                      

Quarter 4

   10/05/06      09/13/06      $ 0.0575      $ 25.4      $ 96.0

Quarter 3

   07/07/06      06/16/06        0.0575        25.6        70.6

Quarter 2

   04/21/06      03/31/06        0.0500        22.5        45.0

Quarter 1

   01/20/06      12/30/05        0.0500        22.5        22.5

2005

                      

Quarter 4

   09/28/05      09/07/05      $ 0.0500      $ 22.5      $ 44.9

Quarter 3

   07/07/05      06/16/05        0.0500        22.4        22.4

Quarter 2

   N/A      N/A        N/A        N/A        N/A

Quarter 1

   N/A      N/A        N/A        N/A        N/A

 

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Stock Repurchase Program    In December 2006, the Board of Directors increased the total authorized level of the Company’s stock repurchase program to $4.0 billion from the previously announced level of $3.5 billion. From the initiation of the repurchase program in 1999 through the end of fiscal 2007, the aggregate cost of shares of common stock repurchased by the Company, including commissions, was approximately $3.5 billion, leaving an authorized amount for repurchases of $521.1 million. During 2007, Safeway repurchased approximately 6.7 million shares of its common stock under the repurchase program at an aggregate price, including commissions, of $226.1 million. The average price per share, excluding commissions, was $33.57. The timing and volume of future repurchases will depend on several factors, including market conditions.

Credit Ratings    On October 24, 2006, Fitch affirmed Safeway’s BBB rating and revised its outlook to stable from negative. On July 23, 2007, S&P affirmed the Company’s BBB-credit rating and revised its outlook to positive from stable. On August 1, 2007, Moody’s Investors Service affirmed Safeway’s Baa2 rating and revised its outlook to stable from negative. Safeway’s ability to borrow under the Credit Agreement is unaffected by Safeway’s credit ratings. Also, the Company maintains no debt which requires accelerated repayment based on the lowering of credit ratings. Pricing under the Credit Agreement is generally determined by the better of Safeway’s interest coverage ratio or credit ratings. Safeway’s pricing was unaffected by S&P’s lowered rating. However, changes in the Company’s credit ratings may have an adverse impact on financing costs and structure in future periods, such as the ability to participate in the commercial paper market and higher interest costs on future financings. Additionally, if Safeway does not maintain the financial covenants in its Credit Agreement, its ability to borrow under the Credit Agreement would be impaired. Investors should note that a credit rating is not a recommendation to buy, sell or hold securities and may be subject to withdrawal by the rating agency. Each credit rating should be evaluated independently.

Contractual Obligations    The table below presents significant contractual obligations of the Company at year-end 2007 (in millions) (1):

 

     2008   2009   2010   2011   2012   Thereafter   Total

Long-term debt (2)

  $   954.9   $   752.5   $   505.5   $   502.1   $   825.6   $   1,507.8   $   5,048.4

Estimated interest on long-term debt (3)

    298.2     246.3     205.3     163.8     147.5     1,162.1     2,223.2

Capital lease obligations (2),(4)

    42.5     42.9     37.3     32.5     31.3     420.2     606.7

Interest on capital leases

    59.7     54.5     50.6     47.0     43.8     287.0     542.6

Self-insurance liability

    130.2     91.2     61.8     42.7     30.0     121.7     477.6

Interest on self-insurance liability

    2.3     4.8     5.6     5.6     5.0     63.6     86.9

Operating leases (4)

    451.8     410.4     380.8     346.3     317.8     3,089.1     4,996.2

Contracts for purchase of property, equipment and construction of
buildings

    307.9     –       –       –       –       –       307.9

Contracts for purchase of inventory

    171.4     –       –       –       –       –       171.4

Fixed-price energy contracts

    52.9     30.6     18.6     18.9     3.2     –       124.2

 

(1) Excludes funding of pension and other postretirement benefit obligations, which totaled approximately $41.9 million in 2007. Also excludes contributions under various multi-employer pension plans, which totaled $270.1 million in 2007.

 

(2) Required principal payments only.

 

(3) Excludes payments received or made relating to interest rate swap as discussed below.

 

(4) Operating and capital lease obligations do not include common area maintenance, insurance or tax payments for which the Company is also obligated. In fiscal 2007, these charges totaled approximately $218.4 million.

The Company adopted FIN 48 on the first day of its 2007 fiscal year. The amount of unrecognized tax benefits at December 29, 2007 was $123.1 million. This amount has been excluded from the contractual obligations table because a reasonably reliable estimate of the timing of future tax settlements cannot be determined.

 

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Off-Balance Sheet Arrangements

Guarantees    The Company is party to a variety of contractual agreements under which it may be obligated to indemnify the other party for certain matters. These contracts primarily relate to the Company’s commercial contracts, operating leases and other real estate contracts, trademarks, intellectual property, financial agreements and various other agreements. Under these agreements, the Company may provide certain routine indemnifications relating to representations and warranties (for example, ownership of assets, environmental or tax indemnifications) or personal injury matters. The terms of these indemnifications range in duration and may not be explicitly defined. Historically, Safeway has not made significant payments for these indemnifications. The Company believes that if it were to incur a loss in any of these matters, the loss would not have a material effect on the Company’s financial statements.

Letters of Credit    The Company had letters of credit of $58.9 million outstanding at year-end 2007. The letters of credit are maintained primarily to support performance, payment, deposit or surety obligations of the Company. The Company pays commissions ranging from 0.15% to 1.00% on the face amount of the letters of credit.

Interest Rate Swap Agreements    The Company has, from time to time, entered into interest rate swap agreements to change its portfolio mix of fixed - and floating-rate debt to more desirable levels. Interest rate swap agreements involve the exchange with a counterparty of fixed - and floating-rate interest payments periodically over the life of the agreements without exchange of the underlying notional principal amounts. The differential to be paid or received is recognized over the life of the agreements as an adjustment to interest expense. The Company’s counterparties have been major financial institutions. As of year-end 2007, the Company effectively converted $500 million of its 4.95% fixed-rate debt due in 2010 and $300 million of its 4.125% fixed-rate debt due in 2008 to floating-rate debt through interest rate swap agreements. In January 2008, Safeway terminated its interest rate swap agreements on its $500 million debt at a gain of approximately $7.5 million. This gain will be included in debt and will be amortized as an offset to interest expense over the remaining term of the debt.

Energy Contracts    The Company has entered into contracts to purchase electricity and natural gas at fixed prices for a portion of its energy needs. Safeway expects to take delivery of the electricity and natural gas in the normal course of business, and these contracts are not net settled. Since these contracts qualify for the normal purchase exception of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” they are not marked to market. Energy purchased under these contracts is expensed as delivered.

New Accounting Standards

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measurement.” SFAS No. 157 defines and establishes a framework for measuring fair value in generally accepted accounting principles, and expands related disclosures. This Statement does not require any new fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. SFAS No. 157 is not expected to have a material effect on the Company’s financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities–Including an amendment of FASB Statement No. 115.” SFAS No. 159 permits companies to measure many financial instruments and certain other items at fair value at specified election dates. Unrealized gains and losses on these items will be reported in earnings at each subsequent reporting date. The fair value option may be applied instrument by instrument (with a few exceptions), is irrevocable and is applied only to entire instruments and not to portions of instruments. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company is currently assessing the potential impact of SFAS No. 159 on its financial statements.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (SFAS No. 141R”). SFAS No. 141R established principles and requirements for how an entity which obtains control of one or more businesses (1) recognizes and measures the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree, (2) recognizes and measures the goodwill acquired in the business combination and (3) determines what

 

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SAFEWAY INC. AND SUBSIDIARIES

 

information to disclose regarding business combinations. SFAS No. 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual report period beginning on or after December 15, 2008. The Company is currently assessing the potential impact of SFAS No. 141R on its financial statements.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements – an amendment of ARB No. 51.” SFAS No. 160 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. Additionally, SFAS No. 160 requires expanded disclosures in the consolidated financial statements. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company is currently assessing the potential impact of SFAS No. 160 on its financial statements.

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Safeway manages interest rate risk through the strategic use of fixed and variable interest rate debt and, from time to time, interest rate swaps. As of year-end 2007, the Company effectively converted $500 million of its 4.95% fixed-rate debt and $300 million of its 4.125% fixed-rate debt to floating-rate debt through interest rate swap agreements. During 2007 the weighted-average pay rate on the $500 million debt was 6.22%, and the weighted-average pay rate on the $300 million debt was 5.97%. At year-end 2007, the fair value of the interest rate swap on the $300 million debt was a liability of $2.4 million, and the fair value of the interest rate swap on the $500 million debt was an asset of $3.8 million. As a result of a decline in interest rates in early 2008, the fair value of these swaps increased. In January 2008, Safeway terminated its interest rate swap agreements on its $500 million debt due in 2010 at a gain of approximately $7.5 million. This gain will be included in debt and will be amortized as an offset to interest expense over the remaining term of the debt.

The Company does not utilize financial instruments for trading or other speculative purposes, nor does it utilize leveraged financial instruments. The Company does not consider the potential declines in future earnings, fair values and cash flows from reasonably possible near-term changes in interest rates and exchange rates to be material.

The table below presents principal amounts and related weighted-average rates by year of maturity for the Company’s debt obligations at year-end 2007 (dollars in millions):

 

     2008   2009   2010   2011   2012   Thereafter   Total   Fair value

Long-term debt: (1)

               

Principal

  $ 954.9   $ 752.5   $ 505.5   $ 502.1   $ 825.6   $   1,507.8   $   5,048.4   $   5,203.3

Weighted average interest rate

      4.97%       6.73%       4.98%       6.51%       5.79%     6.70%     6.04%  

 

(1) Primarily fixed-rate debt

 

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Item 8. Financial Statements and Supplementary Data

 

     Page

Management’s Annual Report on Internal Control over Financial Reporting

   33

Report of Independent Registered Public Accounting Firm

   34

Consolidated Statements of Operations for fiscal 2007, 2006 and 2005

   36

Consolidated Balance Sheets as of the end of fiscal 2007 and 2006

   37

Consolidated Statements of Cash Flows for fiscal 2007, 2006 and 2005

   39

Consolidated Statements of Stockholders’ Equity for fiscal 2007, 2006 and 2005

   41

Notes to Consolidated Financial Statements

   42

 

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SAFEWAY INC. AND SUBSIDIARIES

Management’s Annual Report on Internal Control over Financial Reporting

Management of the Company, including the Chief Executive Officer and the Chief Financial Officer, is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) of the Securities Exchange Act of 1934, as amended. The Company’s internal controls were designed to provide reasonable assurance as to the reliability of its financial reporting and the preparation and presentation of the consolidated financial statements for external purposes in accordance with accounting principles generally accepted in the United States and includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.

The Company conducted an evaluation of the effectiveness of its internal control over financial reporting based on the criteria in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. This evaluation included review of the documentation of controls, evaluation of the design effectiveness of controls, testing of the operating effectiveness of controls and a conclusion on this evaluation. Through this evaluation, management did not identify any material weakness in the Company’s internal control over financial reporting. There are inherent limitations in the effectiveness of any system of internal control over financial reporting; however, based on the evaluation, management has concluded the Company’s internal control over financial reporting was effective as of December 29, 2007.

The Company’s independent registered public accounting firm has audited the accompanying consolidated financial statements and the Company’s internal control over financial reporting. The report of the independent registered public accounting firm is included in this Annual Report on Form 10-K and begins on the following page.

 

/s/ Steven A. Burd     /s/ Robert L. Edwards
STEVEN A. BURD     ROBERT L. EDWARDS

Chairman, President and

Chief Executive Officer

   

Executive Vice President

and Chief Financial Officer

February 26, 2008     February 26, 2008

 

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Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of Safeway Inc.:

We have audited the accompanying consolidated balance sheets of Safeway Inc. and subsidiaries (the “Company”) as of December 29, 2007 and December 30, 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 29, 2007. We also have audited the Company’s internal control over financial reporting as of December 29, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying “Management’s Annual Report on Internal Control over Financial Reporting.” Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Safeway Inc. and subsidiaries as of December 29, 2007 and December 30, 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 29, 2007, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 29, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

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Report of Independent Registered Public Accounting Firm

As discussed in Note A to the consolidated financial statements, on December 30, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 158, “Employers’ Accounting for Defined Benefit Pension and other Postretirement Plans.” As discussed in Note A to the consolidated financial statements, on December 31, 2006, the Company adopted Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes.”

/s/ DELOITTE & TOUCHE LLP

San Francisco, California

February 26, 2008

 

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SAFEWAY INC. AND SUBSIDIARIES

Consolidated Statements of Operations

(In millions, except per-share amounts)

 

     

52 Weeks

2007

   

52 Weeks

2006

     52 Weeks
2005
 

Sales and other revenue

   $   42,286.0     $   40,185.0      $   38,416.0  

Cost of goods sold

     (30,133.1 )     (28,604.0 )      (27,303.1 )

Gross profit

     12,152.9       11,581.0        11,112.9  

Operating and administrative expense

     (10,380.8 )     (9,981.2 )      (9,898.2 )

Operating profit

     1,772.1       1,599.8        1,214.7  

Interest expense

     (388.9 )     (396.1 )      (402.6 )

Other income, net

     20.4       36.3        36.9  

Income before income taxes

     1,403.6       1,240.0        849.0  

Income taxes

     (515.2 )     (369.4 )      (287.9 )

Net income

   $ 888.4     $ 870.6      $ 561.1  

Basic earnings per share

   $ 2.02     $ 1.96      $ 1.25  

Diluted earnings per share

   $ 1.99     $ 1.94      $ 1.25  

Weighted average shares outstanding – basic

     440.3       444.9        447.9  

Weighted average shares outstanding – diluted

     445.7       447.8        449.8  

See accompanying notes to consolidated financial statements.

 

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SAFEWAY INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(In millions, except per-share amounts)

 

      Year-end
2007
    Year-end
2006
 

Assets

    

Current assets:

    

Cash and equivalents

   $ 277.8     $ 216.6  

Receivables

     577.9       461.2  

Merchandise inventories, net of LIFO reserve of $63.4 and $49.5

     2,797.8       2,642.5  

Prepaid expenses and other current assets

     354.0       245.4  

Total current assets

     4,007.5       3,565.7  

Property:

    

Land

     1,597.1       1,497.9  

Buildings

     5,461.9       4,829.3  

Leasehold improvements

     3,700.0       3,336.9  

Fixtures and equipment

     7,898.2       7,199.0  

Property under capital leases

     767.0       777.4  
     19,424.2       17,640.5  

Less accumulated depreciation and amortization

     (8,802.2 )     (7,867.2 )

Total property, net

     10,622.0       9,773.3  

Goodwill

     2,406.3       2,393.5  

Prepaid pension costs

     73.2       137.3  

Investments in unconsolidated affiliates

     216.0       219.6  

Other assets

     326.0       184.4  

Total assets

   $   17,651.0     $   16,273.8  

 

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SAFEWAY INC. AND SUBSIDIARIES

Consolidated Balance Sheets (continued)

(In millions, except per-share amounts)

 

      Year-end
2007
    Year-end
2006
 

Liabilities and Stockholders’ Equity

    

Current liabilities:

    

Current maturities of notes and debentures

   $ 954.9     $ 790.7  

Current obligations under capital leases

     42.5       40.8  

Accounts payable

     2,825.4       2,464.4  

Accrued salaries and wages

     506.7       485.8  

Income taxes

     88.0       100.6  

Other accrued liabilities

     718.9       719.1  

Total current liabilities

     5,136.4       4,601.4  

Long-term debt:

    

Notes and debentures

     4,093.5       4,428.7  

Obligations under capital leases

     564.2       607.9  

Total long-term debt

     4,657.7       5,036.6  

Deferred income taxes

     254.7       117.4  

Pension and postretirement benefit obligations

     236.7       204.0  

Accrued claims and other liabilities

     663.7       647.5  

Total liabilities

     10,949.2       10,606.9  

Commitments and contingencies

    

Stockholders’ equity:

    

Common stock: par value $0.01 per share; 1,500 shares authorized; 589.3 and
582.5 shares outstanding

     5.9       5.8  

Additional paid-in capital

     4,038.2       3,811.5  

Treasury stock at cost: 149.2 and 142.4 shares

     (4,418.0 )     (4,188.7 )

Accumulated other comprehensive income

     246.2       94.8  

Retained earnings

     6,829.5       5,943.5  

Total stockholders’ equity

     6,701.8       5,666.9  

Total liabilities and stockholders’ equity

   $   17,651.0     $   16,273.8  

See accompanying notes to consolidated financial statements.

 

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SAFEWAY INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(In millions)

 

      52 Weeks
2007
    52 Weeks
2006
    52 Weeks
2005
 

Operating Activities:

      

Net income

   $ 888.4     $ 870.6     $ 561.1  

Reconciliation to net cash flow from operating activities:

      

Depreciation and amortization

     1,071.2       991.4       932.7  

Property impairment charges

     27.1       39.2       78.9  

Stock-based employee compensation

     48.4       51.2       59.7  

Excess tax benefit from exercise of stock options

     (38.3 )     (6.3 )     (8.0 )

LIFO expense (income)

     13.9       1.2       (0.2 )

Equity in earnings of unconsolidated affiliates

     (8.7 )     (21.1 )     (15.8 )

Net pension expense

     72.1       83.1       115.6  

Contributions to pension plans

     (33.0 )     (29.2 )     (18.1 )

(Gain) loss on property retirements and lease exit costs, net

     (42.3 )     (17.8 )     13.6  

(Decrease) increase in accrued claims and other liabilities

     (5.8 )     10.8       44.1  

Deferred income taxes

     130.8       1.1       (215.9 )

Amortization of deferred finance costs

     5.3       5.8       7.5  

Other

     15.8       7.3       6.9  

Changes in working capital items:

      

Receivables

     (3.0 )     (45.1 )     (1.0 )

Inventories at FIFO cost

     (102.1 )     96.9       (7.7 )

Prepaid expenses and other current assets

     (22.7 )     (9.3 )     37.1  

Income taxes

     (8.7 )     (14.9 )     (120.8 )

Payables and accruals

     98.0       89.0       363.1  

Payables related to third-party gift cards, net of receivables

     84.1       71.1       48.2  

Net cash flow from operating activities

       2,190.5         2,175.0         1,881.0  

Investing Activities:

      

Cash paid for property additions

     (1,768.7 )     (1,674.2 )     (1,383.5 )

Proceeds from sale of property

     140.0       80.1       105.1  

Cash used to acquire businesses

     –         (83.8 )     –    

Other

     (57.7 )     (56.8 )     (35.1 )

Net cash used by investing activities

     (1,686.4 )     (1,734.7 )     (1,313.5 )

 

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SAFEWAY INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows (continued)

(In millions)

 

      52 Weeks
2007
    52 Weeks
2006
    52 Weeks
2005
 

Financing Activities:

      

Additions to short-term borrowings

   $   285.0     $            –       $         13.0  

Payments on short-term borrowings

     (190.0 )     –         (23.8 )

Additions to long-term borrowings

        1,864.6          1,418.9       754.5  

Payments on long-term borrowings

     (2,220.9 )     (1,912.0 )     (1,188.6 )

Purchase of treasury stock

     (226.1 )     (318.0 )     –    

Dividends paid

     (111.5 )     (96.0 )     (44.9 )

Net proceeds from exercise of stock options

     106.8       45.4       18.9  

Excess tax benefit from exercise of stock options

     38.3       6.3       8.0  

Income tax refund related to prior years’ debt financing

     7.0       262.3       –    

Payment of debt issuance costs

     (4.0 )     (1.2 )     (2.7 )

Other

     (3.2 )     (2.0 )     (1.3 )

Net cash flow used by financing activities

     (454.0 )     (596.3 )     (466.9 )

Effect of changes in exchange rates on cash

     11.1       (0.7 )     5.9  

Increase (decrease) in cash and equivalents

     61.2       (156.7 )     106.5  

Cash and Equivalents:

      

Beginning of year

     216.6       373.3       266.8  

End of year

   $ 277.8     $ 216.6     $ 373.3  

Other Cash Information:

      

Cash payments during the year for:

      

Interest

   $ 406.3     $ 418.1     $ 412.1  

Income taxes, net of refunds (excluding income tax refund related to prior years’ debt financing)

     393.0       383.2       624.4  

Non-cash Investing and Financing Activities:

      

Capital lease obligations entered into

   $ 1.6     $ 5.2     $ 27.1  

Mortgage notes assumed in property additions

     4.2       –         3.2  

See accompanying notes to consolidated financial statements.

 

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SAFEWAY INC. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity

(In millions, except per-share amounts)

 

    Common stock  

Additional

paid-in

capital

  Treasury stock    

Retained

earnings

   

Accumulated

other

comprehensive

income

   

Total

stock-

holders’

equity

   

Compre-

hensive

Income

 
  Shares   Amount     Shares     Cost          

Balance, year-end 2004

  578.5   $ 5.8   $ 3,357.9   (130.8 )   $ (3,879.7 )   $ 4,678.0     $ 144.9     $ 4,306.9    

Net income

  –       –       –     –         –         561.1       –         561.1     $ 561.1  

Stock-based compensation

  –       –       59.7   –         –         –         –         59.7       –    

Cash dividends declared ($0.15 per share)

  –       –       –     –         –         (67.4 )     –         (67.4 )     –    

Translation adjustments (net of income tax benefit of $16.4)

  –       –       –     –         –         –         59.5       59.5       59.5  

Minimum pension liability (net of income tax benefit of $15.6)

  –       –       –     –         –         –         (28.4 )     (28.4 )     (28.4 )

Other (net of income tax benefit of $1.5)

  –       –       –     (0.1 )     (1.5 )     –         (3.2 )     (4.7 )     (3.2 )

Amortization of restricted stock

  –       –       5.5   –         –         –         –         5.5       –    

Options exercised

  1.6     –       22.0   0.2       5.5       –         –         27.5       –    

Balance, year-end 2005

  580.1     5.8     3,445.1   (130.7 )     (3,875.7 )     5,171.7       172.8       4,919.7     $ 589.0  

Net income

  –       –       –     –         –         870.6       –         870.6     $ 870.6  

Stock-based employee compensation

  –       –       51.2   –         –         –         –         51.2       –    

Cash dividends declared ($0.2225 per share)

  –       –       –     –         –         (98.8 )     –         (98.8 )     –    

Translation adjustments

  –       –       –     –         –         –         (6.0 )     (6.0 )     (6.0 )

Federal income tax refund

  –       –       262.3   –         –         –           262.3       –    

Minimum pension liability (net of income tax expense of $10.4)

  –       –       –     –         –         –         23.8       23.8       23.8  

Pension adjustment to funded status (net of income tax benefit of $47.9)

  –       –       –     –         –         –         (96.7 )     (96.7 )     –    

Other (net of income tax expense of $0.8)

  –       –       1.0   –         (2.2 )     –         0.9       (0.3 )     0.9  

Amortization of restricted stock

  –       –       5.0   –         –         –         –         5.0       –    

Treasury stock purchased

  –       –       –     (12.0 )     (318.0 )     –         –         (318.0 )     –    

Options exercised

  2.4     –       46.9   0.3                 7.2       –         –         54.1       –    

Balance, year-end 2006

  582.5     5.8     3,811.5   (142.4 )     (4,188.7 )     5,943.5       94.8       5,666.9     $ 889.3  

Net income

  –       –       –     –         –         888.4       –         888.4     $ 888.4  

FIN 48 adjustment

  –       –       25.5   –         –         114.2       –         139.7       –    

Stock-based employee compensation

  –       –       48.4   –         –         –         –         48.4       –    

Cash dividends declared ($0.2645 per share)

  –       –       –     –         –         (116.6 )     –         (116.6 )     –    

Translation adjustments

  –       –       –     –         –         –         172.1       172.1       172.1  

Income tax refund

  –       –       0.7   –         –         –         –         0.7       –    

Pension adjustment to funded status (net of income tax benefit of $25.7)

  –       –       –     –         –         –         (44.0 )     (44.0 )     (44.0 )

Recognition of pension actuarial loss, net (net of tax expense of $9.9)

  –       –       –     –         –         –         21.5       21.5       21.5  

Other (net of income tax expense of $0.2)

  –       –       0.8   (0.1 )     (3.2 )     –         1.8       (0.6 )     1.8  

Amortization of restricted stock

  0.1     –       5.2   –         –         –         –         5.2       –    

Treasury stock purchased

  –       –       –     (6.7 )     (226.1 )     –         –         (226.1 )     –    

Options exercised

  6.7     0.1     146.1   –         –         –         –         146.2       –    

Balance, year-end 2007

  589.3   $   5.9   $   4,038.2   (149.2 )   $ (4,418.0 )   $   6,829.5     $   246.2     $   6,701.8     $   1,039.8  

See accompanying notes to consolidated financial statements.

 

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SAFEWAY INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements

Note A:  The Company and Significant Accounting Policies

The Company    Safeway Inc. (“Safeway” or the “Company”) is one of the largest food and drug retailers in North America, with 1,743 stores as of year-end 2007. Safeway’s U.S. retail operations are located principally in California, Oregon, Washington, Alaska, Colorado, Arizona, Texas, the Chicago metropolitan area and the Mid-Atlantic region. The Company’s Canadian retail operations are located principally in British Columbia, Alberta and Manitoba/Saskatchewan. In support of its retail operations, the Company has an extensive network of distribution, manufacturing and food processing facilities. The Company also owns and operates GroceryWorks.com Operating Company, LLC, an online grocery channel, doing business under the names Safeway.com, Vons.com and Genuardis.com (collectively “Safeway.com”).

Blackhawk Network Holdings, Inc. (“Blackhawk”), a subsidiary of Safeway, provides third-party gift cards, prepaid cards, telecom cards and sports and entertainment cards to a broad group of top North American retailers for sale to retail customers. Blackhawk also has gift card businesses in the United Kingdom and Australia.

The Company also has a 49% ownership interest in Casa Ley, S.A. de C.V. (“Casa Ley”), which operates 137 food and general merchandise stores in Western Mexico.

Basis of Presentation    The consolidated financial statements include Safeway Inc., a Delaware corporation, and all majority-owned subsidiaries and have been prepared in accordance with accounting principles generally accepted in the United States of America. All intercompany transactions and balances have been eliminated in consolidation. The Company’s investment in Casa Ley is reported using the equity method and is recorded on a one-month delay basis because financial information for the latest month is not available from Casa Ley in time to be included in Safeway’s consolidated results until the following reporting period.

Fiscal Year    The Company’s fiscal year ends on the Saturday nearest December 31. The last three fiscal years consist of the 52-week period ended December 29, 2007 (“fiscal 2007”), the 52-week period ended December 30, 2006 (“fiscal 2006”) and the 52-week period ended December 31, 2005 (“fiscal 2005”).

Revenue Recognition    Retail store sales are recognized at the point of sale. Sales tax is excluded from revenue. Internet sales are recognized when the merchandise is delivered to the customer. Discounts provided to customers in connection with loyalty cards are accounted for as a reduction of sales.

Safeway records a deferred revenue liability when it sells Safeway gift cards. Safeway records a sale when a customer redeems the gift card. Safeway gift cards do not expire. During 2007 Safeway completed an analysis of the historical redemption patterns of gift cards. As a result of this analysis, the Company has determined that the likelihood of redemption after two years is remote. Therefore, the Company reduces the liability and increases other revenue for the unused portion of gift cards (“breakage”) after two years. In prior years, breakage was recognized after three years. Breakage amounts were $9.5 million, $3.0 million and $4.4 million in 2007, 2006 and 2005, respectively.

The Company, through its Blackhawk subsidiary, also sells third-party gift cards through Safeway retail operations and through other grocery, drug and convenience store retailers. Safeway records a commission as other revenue when the third-party gift card is sold. The liability for redemption and potential income for breakage remain with the third-party merchant; therefore, Safeway records no entries for redemption or breakage of these gift cards.

Cost of Goods Sold    Cost of goods sold includes cost of inventory sold during the period, including purchase and distribution costs. These costs include inbound freight charges, purchasing and receiving costs, warehouse inspection costs, warehousing costs and other costs of Safeway’s distribution network. Advertising and promotional expenses are also included as a component of cost of goods sold. Such costs are expensed in the period the advertisement occurs. Advertising and promotional expenses totaled $551.8 million in 2007, $587.1 million in 2006 and $523.7 million in 2005.

Vendor allowances totaled $2.5 billion in both 2007 and 2006 and $2.4 billion in 2005. Vendor allowances can be grouped into the following broad categories: promotional allowances, slotting allowances, and contract allowances. All vendor allowances are classified as an element of cost of goods sold.

 

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Promotional allowances make up approximately three-quarters of all allowances. With promotional allowances, vendors pay Safeway to promote their product. The promotion may be any combination of a temporary price reduction, a feature in print ads, a feature in a Safeway circular, or a preferred location in the store. The promotions are typically one to two weeks long.

Slotting allowances are a small portion of total allowances (typically less than 5% of all allowances). With slotting allowances, the vendor reimburses Safeway for the cost of placing new product on the shelf. Safeway has no obligation or commitment to keep the product on the shelf for a minimum period.

Contract allowances make up the remainder of all allowances. Under a typical contract allowance, a vendor pays Safeway to keep product on the shelf for a minimum period of time or when volume thresholds are achieved.

Slotting and promotional allowances are accounted for as a reduction in the cost of purchased inventory and recognized when the related inventory is sold. Contract allowances are recognized as a reduction in the cost of goods sold as volume thresholds are achieved or through the passage of time.

Use of Estimates    The preparation of financial statements, in conformity with accounting principles generally accepted in the United States of America, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Translation of Foreign Currencies    Assets and liabilities of the Company’s Canadian subsidiaries and Casa Ley are translated into U.S. dollars at year-end rates of exchange, and income and expenses are translated at average rates during the year. Adjustments resulting from translating financial statements into U.S. dollars are reported, net of applicable income taxes, as a separate component of comprehensive income in the consolidated statements of stockholders’ equity.

Cash and Cash Equivalents    Short-term investments with original maturities of less than three months are considered to be cash equivalents. Book overdrafts at year-end 2007 and 2006 of $313.2 million and $243.8 million, respectively, are included in accounts payable.

Merchandise Inventories    Merchandise inventory of $1,886 million at year-end 2007 and $1,843 million at year-end 2006 is valued at the lower of cost on a last-in, first-out (“LIFO”) basis or market value. Such LIFO inventory had a replacement or current cost of $1,949 million at year-end 2007 and $1,892 million at year-end 2006. Liquidations of LIFO layers during the three years reported did not have a material effect on the results of operations. All remaining inventory is valued at the lower of cost on a first-in, first-out (“FIFO”) basis or market value. The FIFO cost of inventory approximates replacement or current cost. The Company takes a physical count of perishable inventory in stores every four weeks and nonperishable inventory in stores and all distribution centers twice a year. The Company records an inventory shrink adjustment upon physical counts and also provides for estimated inventory shrink adjustments for the period between the last physical inventory and each balance sheet date.

Property and Depreciation    Property is stated at cost. Depreciation expense on buildings and equipment is computed on the straight-line method using the following lives:

 

Stores and other buildings

   7 to 40 years

Fixtures and equipment

   3 to 15 years

Property under capital leases and leasehold improvements are amortized on a straight-line basis over the shorter of the remaining terms of the leases or the estimated useful lives of the assets. Accounts payable include $336.4 million, $319.1 million and $272.5 million at year-end 2007, 2006 and 2005, respectively, related to the property additions.

Employee Benefit Plans    In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and 132(R).” SFAS No. 158 requires an employer to recognize in its statement of financial position an asset for a plan’s overfunded status or a liability for a plan’s underfunded status, measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year, and recognize changes in the

 

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Notes to Consolidated Financial Statements

 

funded status of a defined benefit postretirement plan in the year in which the changes occur. Additional disclosures are also required. Safeway adopted SFAS No. 158 as of December 30, 2006, as required. See Note I.

Self-Insurance    The Company is primarily self-insured for workers’ compensation, automobile and general liability costs. The self-insurance liability is determined actuarially, based on claims filed and an estimate of claims incurred but not yet reported, and is discounted using a risk-free rate of interest. The present value of such claims was calculated using a discount rate of 3.5% in 2007, 4.5% in 2006 and 4.35% in 2005.

A summary of changes in Safeway’s self-insurance liability is as follows (in millions):

 

      2007     2006      2005  

Beginning balance

   $ 512.7     $ 532.4      $ 496.5  

Expense

     117.1       133.2        193.7  

Claim payments

     (153.2 )     (152.9 )      (157.8 )

Currency translation loss

     1.0       –          –    

Ending balance

     477.6       512.7        532.4  

Less current portion

     (130.2 )     (138.7 )      (144.2 )

Long-term portion

   $ 347.4     $ 374.0      $ 388.2  

The current portion of the self-insurance liability is included in other accrued liabilities, and the long-term portion is included in accrued claims and other liabilities in the consolidated balance sheets. The total undiscounted liability was $564.5 million at year-end 2007 and $618.5 million at year-end 2006.

Deferred Rent

Rent Escalations.    The Company recognizes escalating rent provisions on a straight-line basis over the lease term.

Rent Holidays.    Certain of the Company’s operating leases contain rent holidays. For these leases, Safeway recognizes the related rent expense on a straight-line basis at the earlier of the first rent payment or the date of possession of the leased property. The difference between the amounts charged to expense and the rent paid is recorded as deferred lease incentives and amortized over the lease term.

Construction Allowances.    As part of certain lease agreements, the Company receives construction allowances from landlords. The construction allowances are deferred and amortized on a straight-line basis over the life of the lease as a reduction to rent expense.

Income Taxes    The Company provides income tax expense or benefit in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes.” Deferred income taxes represent future net tax effects resulting from temporary differences between the financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse. Accrued interest on tax deficiencies and refunds is included in the income tax expense or benefit.

In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”) which was effective for Safeway in the first quarter of 2007. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in tax returns. For benefits to be realized, a tax position must be more likely than not to be sustained upon examination. The amount recognized is measured as the largest amount of benefit that is more likely than not of being realized upon settlement.

Income Tax Contingencies    The Company is subject to periodic audits by the Internal Revenue Service and other foreign, state and local taxing authorities. These audits may challenge certain of the Company’s tax positions such as the timing and amount of income and deductions and the allocation of taxable income to various tax jurisdictions. Income tax contingencies are accounted for in accordance with FIN 48, and may require significant management judgment in

 

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Notes to Consolidated Financial Statements

 

estimating final outcomes. Actual results could materially differ from these estimates and could significantly affect the Company’s effective tax rate and cash flows in future years.

Off-Balance Sheet Financial Instruments    The Company has, from time to time, entered into interest rate swap agreements to change its portfolio mix of fixed - and floating-rate debt to more desirable levels. Interest rate swap agreements involve the exchange with a counterparty of fixed - and floating-rate interest payments periodically over the life of the agreements without exchange of the underlying notional principal amounts. The differential to be paid or received is recognized over the life of the agreements as an adjustment to interest expense. The Company’s counterparties have been major financial institutions.

Energy Contracts    The Company has entered into contracts to purchase electricity and natural gas at fixed prices for a portion of its energy needs. Safeway expects to take delivery of the electricity and natural gas in the normal course of business, and these contracts are not net settled. Since these contracts qualify for the normal purchase exception of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” they are not marked to market. Energy purchased under these contracts is expensed as delivered.

Fair Value of Financial Instruments    Generally accepted accounting principles require the disclosure of the fair value of certain financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate fair value. The Company estimated the fair values presented below using appropriate valuation methodologies and market information available as of year end. Considerable judgment is required to develop estimates of fair value, and the estimates presented are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions or estimation methodologies could have a material effect on the estimated fair values. Additionally, the fair values were estimated at year end, and current estimates of fair value may differ significantly from the amounts presented.

The following methods and assumptions were used to estimate the fair value of each class of financial instruments:

Cash and equivalents, accounts receivable, accounts payable and short-term debt.    The carrying amount of these items approximates fair value.

Long-term debt.    Market values quoted on the New York Stock Exchange are used to estimate the fair value of publicly traded debt. To estimate the fair value of debt issues that are not quoted on an exchange, the Company uses those interest rates that are currently available to it for issuance of debt with similar terms and remaining maturities. At year-end 2007, the estimated fair value of debt was $5.2 billion compared to a carrying value of $5.0 billion. At year-end 2006, the estimated fair value of debt was $5.3 billion compared to a carrying value of $5.2 billion.

Interest rate swaps.    Interest rate swaps, under which the Company agrees to pay variable rates of interest, are designated as fair value hedges of fixed-rate debt. For these fair value hedges that qualify for hedge accounting treatment, Safeway uses the short-cut method, and thus, there are no gains or losses recognized due to hedge ineffectiveness. Unrealized gains or losses from changes in the value of fair value hedges are offset by changes in the fair value of the hedged underlying debt. At year-end 2007, the fair value of the interest rate swap on the $300 million debt was a liability of $2.4 million, and the fair value of the interest rate swap on the $500 million debt was an asset of $3.8 million.

Store Closing and Impairment Charges    Safeway regularly reviews its stores’ operating performance and assesses the Company’s plans for certain store and plant closures. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” losses related to the impairment of long-lived assets are recognized when expected future cash flows are less than the asset’s carrying value. At the time a store is closed or because of changes in circumstances that indicate the carrying value of an asset may not be recoverable, the Company evaluates the carrying value of the assets in relation to its expected future cash flows. If the carrying value is greater than the future cash flows, a provision is made for the impairment of the assets to write the assets down to estimated fair value. Fair value is determined by estimating net future cash flows, discounted using a risk-adjusted rate of return. The Company calculates impairment on a store-by-store basis. These provisions are recorded as a component of operating and administrative expense and are disclosed in Note C.

 

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Notes to Consolidated Financial Statements

 

When stores that are under long-term leases close, the Company records a liability for the future minimum lease payments and related ancillary costs, net of estimated cost recoveries that may be achieved through subletting properties or through favorable lease terminations, discounted using a risk-adjusted rate of interest. This liability is recorded at the time the store is closed. Activity included in the reserve for store lease exit costs is disclosed in Note C.

Accumulated Other Comprehensive Income    Accumulated other comprehensive income, net of applicable taxes, consisted of the following at year-end 2007, year-end 2006 and year-end 2005 (in millions):

 

      2007     2006      2005  

Translation adjustments

   $    367.2     $   195.1      $   201.1  

Minimum pension liability

     (4.6 )     (4.6 )      (28.4 )

Pension adjustment to funded status

     (140.7 )     (96.7 )      –    

Recognition of pension actuarial loss, net

     21.5       –          –    

Other

     2.8       1.0        0.1  

Ending balance

   $ 246.2     $ 94.8      $ 172.8  

Stock-Based Employee Compensation    Safeway elected to early adopt SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”), in the first quarter of 2005 using the modified prospective method. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements as compensation cost based on the fair value on the date of grant. The Company determines fair value of such awards using the Black-Scholes option pricing model. The Black-Scholes option pricing model incorporates certain assumptions, such as risk-free interest rate, expected volatility, expected dividend yield and expected life of options, in order to arrive at a fair value estimate.

New Accounting Standards

In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measurement.” SFAS No. 157 defines and establishes a framework for measuring fair value in generally accepted accounting principles, and expands related disclosures. This Statement does not require any new fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. SFAS No. 157 is not expected to have a material effect on the Company’s financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities–Including an amendment of FASB Statement No. 115.” SFAS No. 159 permits companies to measure many financial instruments and certain other items at fair value at specified election dates. Unrealized gains and losses on these items will be reported in earnings at each subsequent reporting date. The fair value option may be applied instrument by instrument (with a few exceptions), is irrevocable and is applied only to entire instruments and not to portions of instruments. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company is currently assessing the potential impact of SFAS No. 159 on its financial statements.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (SFAS No. 141R”). SFAS No. 141R established principles and requirements for how an entity which obtains control of one or more businesses (1) recognizes and measures the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree, (2) recognizes and measures the goodwill acquired in the business combination and (3) determines what information to disclose regarding business combinations. SFAS No. 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual report period beginning on or after December 15, 2008. The Company is currently assessing the potential impact of SFAS No. 141R on its financial statements.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51.” SFAS No. 160 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements.

 

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Additionally, SFAS No. 160 requires expanded disclosures in the consolidated financial statements. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The Company is currently assessing the potential impact of SFAS No. 160 on its financial statements.

Note B:  Goodwill

A summary of changes in Safeway’s goodwill during 2007 and 2006 by geographic area is as follows (in millions):

 

      2007    2006  
      U.S.     Canada     Total    U.S.     Canada     Total  

Balance – beginning of year

   $     2,309.5     $     84.0     $     2,393.5    $     2,317.8     $     84.6     $     2,402.4  

Acquisition of businesses

     –         –           –        (7.7 (1)     –         (7.7 )

Other adjustments

     (0.7 (2)       13.5  (3)     12.8      (0.6 (2)     (0.6 (3)     (1.2 )

Balance – end of year

   $ 2,308.8     $ 97.5     $ 2,406.3    $ 2,309.5     $ 84.0     $ 2,393.5  

 

(1) Net reduction in goodwill results from the expected utilization of net operating loss carryforwards. See Note H.

 

(2) Primarily represents revised estimate of pre-acquisition tax accrual.

 

(3) Represents foreign currency translation adjustments in Canada.

Safeway completed its annual impairment tests in the fourth quarters of 2007, 2006 and 2005. Fair value was determined based primarily on the discounted cash flow and guideline company methods. As a result of these annual reviews, Safeway concluded that no impairment charge was required.

Note C:  Store Closing and Impairment Charges

Impairment Write-Downs    Safeway recognized impairment charges on the write-down of long-lived assets of $27.1 million in 2007, $39.2 million in 2006 and $78.9 million in 2005. This includes Randall’s impairment charges of $54.7 million in 2005. These charges are included as a component of operating and administrative expense.

Store Lease Exit Costs    The reserve for store lease exit costs includes the following activity for 2007, 2006 and 2005 (in millions):

 

      2007     2006     2005  

Beginning balance

   $   164.2     $   197.7     $   167.1  

Provision for estimated net future cash flows of additional closed stores (1)

     31.5       0.1       67.3  

Net cash flows, interest accretion, changes in estimates of net future cash flows

     (35.3 )     (33.6 )     (36.7 )

Ending balance

   $ 160.4     $ 164.2     $ 197.7  

 

(1) Estimated net future cash flows represents future minimum lease payments and related ancillary costs from the date of closure to the end of the remaining lease term, net of estimated cost recoveries that may be achieved through subletting properties or through favorable lease terminations.

Store lease exit costs are included as a component of operating and administrative expense, and the liability is included in accrued claims and other liabilities.

 

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Note D: Financing

Notes and debentures were composed of the following at year end (in millions):

 

      2007      2006  

Commercial paper

   $ 25.0      $ –    

Bank credit agreement, unsecured

     –          52.3  

Other bank borrowings, unsecured

     99.7        5.3  

Mortgage notes payable, secured

     20.1        18.1  

9.30% Senior Secured Debentures due 2007

     –          24.3  

4.80% Senior Notes due 2007, unsecured

     –          480.0  

7.00% Senior Notes due 2007, unsecured

     –          250.0  

4.125% Senior Notes due 2008, unsecured

     300.0        300.0  

4.45% Senior Notes due 2008, unsecured

     301.1        257.8  

6.50% Senior Notes due 2008, unsecured

     250.0        250.0  

7.50% Senior Notes due 2009, unsecured

     500.0        500.0  

Floating Rate Notes due 2009, unsecured (interest at 5.19% as of December 29, 2007)

     250.0        250.0  

4.95% Senior Notes due 2010, unsecured

     500.0        500.0  

6.50% Senior Notes due 2011, unsecured

     500.0        500.0  

5.80% Senior Notes due 2012, unsecured

     800.0        800.0  

5.625% Senior Notes due 2014, unsecured

     250.0        250.0  

6.35% Senior Notes due 2017, unsecured

     500.0        –    

7.45% Senior Debentures due 2027, unsecured

     150.0        150.0  

7.25% Senior Debentures due 2031, unsecured

     600.0        600.0  

9.875% Senior Subordinated Debentures due 2007, unsecured

     –          24.2  

Other notes payable, unsecured

     2.5        7.4  
     5,048.4        5,219.4  

Less current maturities

     (954.9 )      (790.7 )

Long-term portion

   $   4,093.5      $   4,428.7  

Commercial Paper    The amount of commercial paper borrowings is limited to the unused borrowing capacity under the bank credit agreement. Commercial paper is classified as long term because the Company intends to and has the ability to refinance these borrowings on a long-term basis through either continued commercial paper borrowings or utilization of the bank credit agreement, which matures in 2012. The weighted-average interest rate on commercial paper borrowings was 5.48% during 2007 and 5.56% at year-end 2007. There was $25.0 million of commercial paper outstanding at year-end 2007 and none at year-end 2006.

Bank Credit Agreement    On June 1, 2005, the Company entered into a $1,600.0 million credit agreement with a syndicate of banks. On June 15, 2006, the Company amended the credit agreement to extend the termination date for an additional year to June 1, 2011. On June 1, 2007, the Company amended the credit agreement again for purposes of (i) extending the termination date of the credit agreement for an additional year to June 1, 2012, (ii) providing for two additional one-year extensions of the termination date on the terms set forth in the amendment, and (iii) amending the pricing levels (which are based on Safeway’s debt ratings or interest coverage ratio), pricing margins and facility fee percentages for the loans and commitments under the revolving credit facility. The credit agreement, as amended (the “Credit Agreement”), provides (i) to Safeway a $1,350.0 million, five-year, revolving credit facility (the “Domestic Facility”), (ii) to Safeway and Canada Safeway Limited, a Canadian facility of up to $250.0 million for U.S. Dollar and Canadian Dollar advances and (iii) to Safeway a $400.0 million sub-facility of the Domestic Facility for issuance of standby and commercial letters of credit. The Credit Agreement also provides for an increase in the credit facility commitments up to an additional $500.0 million, subject to the satisfaction of certain conditions. The restrictive covenants of the Credit Agreement limit Safeway and its subsidiaries with respect to, among other things, creating liens upon its assets and disposing of material amounts of assets other than in the ordinary course of business. Additionally, the Company is required to maintain a minimum Adjusted EBITDA, as defined in the Credit Agreement, to interest expense ratio of 2.0 to

 

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1 and not exceed an Adjusted Debt (total consolidated debt less cash and cash equivalents in excess of $75.0 million) to Adjusted EBITDA ratio of 3.5 to 1. As of December 29, 2007, the Company was in compliance with the covenant requirements. As of December 29, 2007, there were no borrowings, and letters of credit totaled $37.1 million under the Credit Agreement. Total unused borrowing capacity under the Credit Agreement was $1,562.9 million as of December 29, 2007. The Credit Agreement is scheduled to expire on June 1, 2012.

U.S. borrowings under the Credit Agreement carry interest at one of the following rates selected by the Company: (1) the prime rate; (2) a rate based on rates at which Eurodollar deposits are offered to first-class banks by the lenders in the bank credit agreement plus a pricing margin based on the Company’s debt rating or interest coverage ratio (the “Pricing Margin”); or (3) rates quoted at the discretion of the lenders. Canadian borrowings denominated in U.S. dollars carry interest at one of the following rates selected by the Company: (a) the Canadian base rate; or (b) the Canadian Eurodollar rate plus the Pricing Margin. Canadian borrowings denominated in Canadian dollars carry interest at one of the following rates selected by the Company: (1) the Canadian prime rate or (2) the rate for Canadian bankers acceptances plus the Pricing Margin.

During 2007 the Company paid facility fees of 0.06% on the total amount of the credit facility.

Shelf Registration    In 2004 the Company filed a shelf registration statement covering the issuance from time to time of up to $2.3 billion of debt securities and/or common stock. As of December 29, 2007, $825.0 million of securities were available for issuance under the shelf registration. The Company may issue debt or common stock in the future depending on market conditions, the need to refinance existing debt and capital expenditure plans.

Other Bank Borrowings    Other bank borrowings had a weighted average interest rate of 5.08% during 2007 and 4.79% at year-end 2007.

Mortgage Notes Payable    Mortgage notes payable at year-end 2007 have remaining terms ranging from less than one year to 16 years, had a weighted-average interest rate during 2007 of 8.06% and are secured by properties with a net book value of approximately $129.6 million.

Senior Unsecured Indebtedness    Pursuant to the shelf registration described above, in August 2007, Safeway issued $500.0 million of 6.35% Notes due 2017.

In March 2006, the Company issued senior unsecured debt consisting of $250.0 million of Floating Rate Notes due 2009 under the shelf registration. The interest rate was 5.19% as of December 29, 2007.

In November 2005, the Company issued senior unsecured debt in Canada consisting of CAD300 million (USD301.1 million at December 29, 2007) of 4.45% Notes due 2008.

Other Notes Payable    Other notes payable at year-end 2007 have remaining terms ranging from less than one year to 15 years and a weighted average interest rate of 4.07% during 2007.

Fair Value Hedges    In 2004 the Company effectively converted $500 million of its 4.95% fixed-rate debt due in 2010 to floating-rate debt through an interest swap agreement. In 2003 the Company effectively converted $300.0 million of its 4.125% fixed-rate debt to floating-rate debt through an interest rate swap agreement. These swaps are designated as fair value hedges of fixed-rate debt. For these fair value hedges that qualify for hedge accounting treatment, Safeway uses the short-cut method, and thus, there are no gains or losses recognized due to hedge ineffectiveness. Unrealized gains or losses from changes in the value of fair value hedges are offset by changes in the fair value of the hedged underlying debt. In January 2008, Safeway terminated its interest rate swap agreements on its $500 million debt at a gain of approximately $7.5 million. This gain will be included in debt and will be amortized as an offset to interest expense over the remaining term of the debt.

 

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Notes to Consolidated Financial Statements

 

Annual Debt Maturities    As of year-end 2007, annual debt maturities were as follows (in millions):

 

2008

   $ 954.9

2009

     752.5

2010

     505.5

2011

     502.1

2012

     825.6

Thereafter

     1,507.8
     $   5,048.4

Letters of Credit    The Company had letters of credit of $58.9 million outstanding at year-end 2007, of which $37.1 million were issued under the Credit Agreement. The letters of credit are maintained primarily to support performance, payment, deposit or surety obligations of the Company. The Company pays commissions ranging from 0.15% to 1.00% on the face amount of the letters of credit.

Note E:  Lease Obligations

Approximately 59% of the premises that the Company occupies are leased. The Company had approximately 1,570 leases at year-end 2007, including approximately 210 that are capitalized for financial reporting purposes. Most leases have renewal options, typically with increased rental rates during the option period. Certain of these leases contain options to purchase the property at amounts that approximate fair market value.

As of year-end 2007, future minimum rental payments applicable to non-cancelable capital and operating leases with remaining terms in excess of one year were as follows (in millions):

 

      Capital
leases
     Operating
leases

2008

   $ 102.2      $ 451.8

2009

     97.4        410.4

2010

     87.9        380.8

2011

     79.5        346.3

2012

     75.1        317.8

Thereafter

     707.2        3,089.1

Total minimum lease payments

       1,149.3      $   4,996.2

Less amounts representing interest

     (542.6 )   

Present value of net minimum lease payments

     606.7     

Less current obligations

     (42.5 )   

Long-term obligations

   $ 564.2     

Future minimum lease payments under non-cancelable capital and operating lease agreements have not been reduced by minimum sublease rental income of $142.5 million.

Amortization expense for property under capital leases was $41.7 million in 2007, $42.7 million in 2006 and $43.0 million in 2005. Accumulated amortization of property under capital leases was $320.2 million at year-end 2007 and $291.4 million at year-end 2006.

 

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Notes to Consolidated Financial Statements

 

The following schedule shows the composition of total rental expense for all operating leases (in millions):

 

      2007      2006      2005  

Property leases:

        

Minimum rentals

   $ 436.5      $   423.7      $   422.4  

Contingent rentals (1)

     12.7        10.5        10.8  

Less rentals from subleases

     (10.4 )      (6.9 )      (6.0 )
     438.8        427.3        427.2  

Equipment leases

     26.2        25.4        25.7  
     $   465.0      $ 452.7      $ 452.9  

 

(1) In general, contingent rentals are based on individual store sales.

Note F:  Interest Expense

Interest expense consisted of the following (in millions):

 

      2007      2006      2005  

Commercial paper

   $ 15.8      $ 10.9      $ 1.5  

Bank credit agreement

     1.6        5.6        3.3  

Other bank borrowings

     1.8        0.5        0.2  

Mortgage notes payable

     1.5        1.8        2.1  

9.30% Senior Secured Debentures

     –          2.3        2.3  

2.50% Senior Notes

     –          –          4.1  

Floating Rate Senior Notes

     14.3        10.9        4.5  

3.80% Senior Notes

     –          –          5.3  

6.15% Senior Notes

     –          7.1        43.1  

4.80% Senior Notes

     12.5        23.0        23.0  

7.00% Senior Notes

     12.5        17.5        17.5  

4.125% Senior Notes

     12.4        12.4        12.4  

4.45% Senior Notes

     12.5        11.7        1.5  

6.50% Senior Notes

     16.3        16.3        16.3  

7.50% Senior Notes

     37.5        37.5        37.5  

4.95% Senior Notes

     24.8        24.8        24.8  

6.50% Senior Notes

     32.5        32.5        32.5  

5.80% Senior Notes

     46.4        46.4        46.4  

5.625% Senior Notes

     14.1        14.1        14.1  

6.35% Senior Notes

     11.8        –          –    

7.45% Senior Debentures

     11.2        11.2        11.2  

7.25% Senior Debentures

     43.5        43.5        43.5  

9.875% Senior Subordinated Debentures

     0.5        2.4        2.4  

Other notes payable

     0.8        0.5        1.1  

Obligations under capital leases

     62.4        63.1        64.8  

Amortization of deferred finance costs

     5.3        5.8        7.5  

Interest rate swap agreements

     12.9        10.1        (4.3 )

Capitalized interest

     (16.0 )      (15.8 )      (16.0 )
     $   388.9      $   396.1      $   402.6  

 

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Notes to Consolidated Financial Statements

 

Note G:  Capital Stock

Shares Authorized and Issued    Authorized preferred stock consists of 25 million shares, of which none was outstanding during 2007, 2006 or 2005. Authorized common stock consists of 1.5 billion shares at $0.01 par value per share. Common stock outstanding at year-end 2007 was 440.1 million shares (net of 149.2 million shares of treasury stock) and 440.1 million shares at year-end 2006 (net of 142.4 million shares of treasury stock).

Stock Option Plans    Under Safeway’s stock option plans, the Company may grant incentive and non-qualified options to purchase common stock at an exercise price equal to or greater than the fair market value at the grant date, as determined by the Executive Compensation Committee of the Board of Directors. Options generally vest over five or seven years. Vested options are exercisable in part or in full at any time prior to the expiration date of six to 15 years from the date of the grant.

1999 Amended and Restated Equity Participation Plan    The 2007 Equity and Incentive Award Plan (the “2007 Plan”), discussed below, succeeds the 1999 Amended and Restated Equity Participation Plan (the “1999 Plan”). Although the 1999 Plan will remain in full force and effect, there will be no more grants under this plan. Options generally vest over five or seven years. Vested options are exercisable in part or in full at any time prior to the expiration date of six to 15 years from the date of the grant. Shares issued, as a result of stock option exercises, will be funded with the issuance of new shares.

2007 Equity and Incentive Award Plan    In May 2007, the stockholders of Safeway approved the 2007 Plan. Under the 2007 Plan, Safeway may grant or issue stock options, stock appreciation rights, restricted stock units, deferred stock, dividend equivalents, performance awards and stock payments, or any combination thereof. Safeway may grant incentive and non-qualified options to purchase common stock at an exercise price equal to or greater than the fair market value at the grant date, as determined by the Executive Compensation Committee of the Safeway Board of Directors. There are 22.4 million shares of common stock authorized for issuance pursuant to grants under the 2007 Plan. As of December 29, 2007, 0.5 million shares have been granted under this plan. Shares issued, as a result of stock option exercises, will be funded with the issuance of new shares.

Voluntary Exchange Program    In September 2004, Safeway initiated a voluntary exchange program for stock options and stock rights having an exercise price greater than $35.00 to eligible employees. The Company’s executive officers, members of the Board of Directors and former employees were not eligible to participate. The voluntary exchange offer ended on October 5, 2004, and approximately 9.7 million stock options and rights were surrendered and cancelled. Replacement stock options and replacement stock rights totaling approximately 4.5 million shares were issued on April 7, 2005 at an exercise price of $20.75. These replacement stock options have a six-year term and vest over five years.

Restricted Stock    The Company awarded 100,000 shares and 21,187 shares of restricted stock in 2007 and 2005, respectively, to certain officers and key employees. Restricted stock was not awarded in 2006. These shares vest over a period of between three to four years and are subject to certain transfer restrictions and forfeiture prior to vesting. Deferred stock compensation, representing the fair value of the stock at the measurement date of the award, is amortized to compensation expense over the vesting period. The amortization of this restricted stock resulted in compensation expense of $5.2 million in 2007, $5.0 million in 2006 and $5.5 million in 2005. As of December 29, 2007, 951,673 restricted shares were vested, 138,876 were unvested and 253,999 shares had been returned to Safeway to satisfy tax-withholding obligations of employees. There were no cancellations of restricted stock during 2007, 2006 or 2005. The weighted-average intrinsic value at grant date of restricted stock outstanding at year-end 2007 was $24.66.

 

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Notes to Consolidated Financial Statements

 

Activity in the Company’s stock option plans for the three-year period ended December 29, 2007 was as follows:

 

      Options     Weighted-
average
exercise price
   Aggregate
intrinsic value
(in millions)

Outstanding, year-end 2004

   26,814,561     $ 26.37   

2005 Activity:

       

Granted

   11,515,944       20.19   

Canceled

   (1,575,189 )     28.55   

Exercised

   (1,889,572 )     8.12   

Outstanding, year-end 2005

   34,865,744     $   25.23    $   139.3

2006 Activity:

       

Granted

   7,223,122       23.51   

Canceled

   (1,388,435 )     26.00   

Exercised

   (2,725,654 )     15.80   

Outstanding, year-end 2006

   37,974,777     $ 25.59    $ 431.2

2007 Activity:

       

Granted

   7,067,078       35.10   

Canceled

   (1,963,124 )     27.04   

Exercised

   (6,673,669 )