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Safeway, Inc. was facing a hostile takeover. However, the management of the company decided to go private in a $4.3 billion leveraged buyout. This case study analysis discusses the issues and problems faced by the company over the years which led to this unfortunate event.
Karen H. Wruck and Steve-Anna Stephens
Harvard Business Review (294139-PDF-ENG)
June 02, 1994
Case questions answered:
- How did rising hourly employee costs create competitive problems for Safeway, Inc.? How could they have been a problem when labor costs are such a small fraction of total costs?
- By what amount could prices at Safeway's Alpha division be undercut by an aggressive competitor paying competitive wages? (See case Table 7 and assume that, on average, employees work 1800 hours a year.)
- How did the company's performance measurement system change as a result of the LBO? How did this affect management decision-making?
- Was an LBO necessary or could Safeway have resolved its problems and remained an independent publicly-traded company? Why or why not?
- What was management's strategy in dealing with the unions through the asset sale process? Why did Safeway decide to renegotiate divisional union contracts before selling them? Why did the local and international unions disagree over what should happen in Dallas?
- Based on the information provided in the case, and the fallout from the Dallas experience, which divisions do you think management should sell? Why? What are the implications of your decision for the company's future competitiveness and performance?
- What was the human toll of the Safeway buyout? Was it necessary or could it have been avoided?
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Case answers for Safeway, Inc.'s Leveraged Buyout (A)
1. How did rising hourly employee costs create competitive problems for Safeway, Inc.? How could they have been a problem when labor costs are such a small fraction of total costs?
Since Safeway, Inc.’s labor-force primarily comprised of unionized labor, its labor costs amounted to almost two-thirds of its store’s non-merchandise operating expenses. Therefore, any increase in wages directly cut into its profitability. However, the lower labor costs of non-unionized chains were beginning to threaten the survival chances of unionized chains such as Safeway, Kroger, A&P, etc.
Not only were Safeway and alike stores at a labor wage costs disadvantage but were also at a significant problem when it came to purchasing goods for sale in their stores. The Robinson-Patman Act put these stores at a substantial survival risk by prohibiting them from securing product discounts from suppliers above regional players. Hence, higher labor costs and no advantage on procurement rates put Safeway in a tight spot.
In general, labor costs amount to a small fraction of total expenses, Safeway paid an hourly wage premium over and above the industry average, and this premium had been on the rise over the last few years.
2. By what amount could prices at Safeway’s Alpha division be undercut by an aggressive competitor paying competitive wages? (See case Table 7 and assume that, on average, employees work 1800 hours a year.)
Salary Premium. The number of stores in the Alpha division was 120, with 6367 employees. The average number of working hours/ employee was 1800 hours. The wage premium for the division was $4/hr/employee. Thus, the amount gained through wage concessions to bring labor costs in line with local non-union competitors would be $ 45,842,400 ($45.84Mn = 6367*4*1800) of net premium.
Division Valuation. The other metrics include the annual sales of $ 735 Mn. Even though the market share is at the number 1 position, the trend is declining. At no. 1 spot, the market share can be assumed to be 25-30%. This market share translated into annual operating profits of $6Mn.
Further, the Book value of assets of Safeway was $146Mn, appraised asses value was $153Mn, and Projected Cash Flow was $20Mn. $20 Mn in perpetuity at 5% would result in $400 Mn. However, the perpetuity value of the labor and cashflow combine ($65.84 Mn) is $1.30 Bn at a discount rate of 5%, $926 Mn at a discount rate of 7%, and $720 Mn @ disc rate of 9%.
Compensation to Employees. The prices above can be reduced by an amount of compensation paid to the employees who leave. Assuming 10% of the employees go, then the amount of compensation is approximately $2,48 Mn (300 hrs*637 employees*$13; 300 hrs is assumed for two weeks of compensation). Thus, the book value of the firm is considered to be $150 Mn ($153 mn – $3 mn).
Thus, the range of the total value of other metrics becomes $870 Mn to $ 1.42 Bn ($150 + 720 Mn to $150 + $1.3 Bn) within a discount range of 5-9%. Hence, an aggressive competitor paying a competitive price can bid between the high range for the Alpha division.
Comparable Method. Another way to calculate would be using the metrics of the UK division sale. This method may not be a correct multiple since the UK division was much more profitable compared to the Alpha division. However, 132 stores of the UK division and four plants with a book value of $192 and an after-tax earning of $40.81 Mn were sold for $1 Bn.
After-tax earnings of $40.81 at a discount rate of 5% are approximately $810 Mn. The book value of $192 Mn gives a value of $1 Bn. Thus, using the discount rate of 5%, the value of Alpha division is $1.45 Bn (at CF of $65.84 Mn in perpetuity) and $553Mn (at CF of $20Mn).
Final Value. Average from comparable method = 1 Bn
Valuation Method (@5%) for CF of 20 Mn and CF of 65.84 Mn = $926.5 Mn
The value of approximately $925 Mn seems to be practical
3. How did the company’s performance measurement system change as a result of the LBO? How did this affect management decision-making?
Supermarket Industry is very competitive and low margin business — profit margins are typical of around 1% of sales. Before the LBO, the strategy of Safeway was based on its four pillars: superior quality, superior selection, excellent service, and competitive prices.
As the critical performance measures, management focused on sales growth, profitability, and the number of stores. The division performance was assessed through the same standards. The overall performance was measured by comparing Safeway sales and profits with other domestic supermarket chains’ sales and profits.
After the LBO, management preferred not to depend solely on sales profitability or growth for division quality assessment. As the process of the asset sale evolved, a “return on market value” (ROMV) measure had been developed. ROMV was measured as a cash flow pre-tax divided by appraised asset value. ROMV was also used to set bonus targets for the new incentive compensation system, which was decided after the LBO.
The decision-making process of Safeway’s management also improved. Safeway appraised every operation at market value. They would set a target for every business unit, and then they compared what kind of returns they were getting to the objectives that were established. They looked at what had to be done when the gains were not satisfactory. For example, how much capital would the asset need to compete entirely from a simple standpoint?
They knew what kind of performance new stores and remodels would expect. If labor costs were problematic, they analyzed their chances of getting a concession to the purchaser. Finally, they analyzed the operation’s potential sale value. On this basis, they continued the asset analysis.
Before the buyout, they didn’t focus on…
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