Safeway Options Surge Signals Deal as Shorts Pounce: Real M&A

Safeway Options Surge Signals Deal as Shorts Pounce
Safeway, which got its start with a small grocery store in Idaho in 1915, now has 1,678 stores in the U.S. and Canada. Photographer: David Paul Morris/Bloomberg

Options traders betting on Safeway Inc. are growing more convinced the cheapest grocery-store chain in America will be acquired, threatening short sellers that have pushed bearish wagers to an all-time high.

Calls priced 10 percent above Safeway’s stock rose to the highest on record this month versus puts on three-month contracts, according to data compiled by Bloomberg, as traders anticipate a possible takeover, said JonesTrading Institutional Services LLC. Safeway shares climbed 12 percent in the last six days, the most since 2009, after the company spurred deal speculation by adjusting executive pay rules in the event of an acquisition and promoting its chief financial officer.

While short sellers are more bearish on Safeway shares than 99 percent of stocks in the Standard & Poor’s 500 Index, Safeway is also the least expensive relative to earnings among U.S. food retailers greater than $1 billion, the data show. The $5.9 billion company’s valuation and higher-quality stores than some of its competitors may lure potential buyers, said Highmark Capital Management Inc. Kroger Co. could pay $30 a share, about a 37 percent premium, to merge with Pleasanton, California-based Safeway and still boost both stocks, BMO Capital Markets said.

“I wouldn’t be surprised to see vultures circling Safeway to see if the wounded prey has any value to it,” Todd Lowenstein, a Los Angeles-based fund manager for Highmark Capital, which oversees about $17 billion, said in a telephone interview. “They have some good assets and it’s been a tough environment. When good assets get priced as if they’re in the bargain bin like this, for both strategic and financial buyers, it hits their radar.”

KKR’s Leverage Buyout

Today, shares of Safeway were unchanged at $21.92.

Teena Massingill, a spokeswoman for Safeway, said the company doesn’t comment on speculation, when asked whether it has been approached by any potential acquirers or would be open to a sale. Keith Dailey, a spokesman for Cincinnati-based Kroger, also said the company doesn’t comment on speculation.

Safeway, which got its start with a small grocery store in Idaho in 1915, now has 1,678 stores in the U.S. and Canada.

A takeover wouldn’t be the first for the company. KKR & Co. took Safeway private in a 1986 leveraged buyout after Peter Magowan, the grocer’s chief executive officer at the time and grandson of the company’s founder, allied with KKR in a takeover battle against Herbert and Robert Haft. KKR sold its stake by 1999, making more than $7 billion on its original $129 million investment, according to KKR’s records.

‘Tough in Grocery’

Safeway shares had fallen 41 percent in the last five years through yesterday as bargain-hunting shoppers flocked to cheaper competitors such as Wal-Mart Stores Inc. In the same time period, Wal-Mart rose 28 percent, while Kroger, the largest U.S. grocery-store chain, declined 19 percent and Supervalu Inc. lost 84 percent.

“It’s tough in grocery right now,” said Highmark’s Lowenstein. “You look at the history of the grocery business and they have gone in and out of the hands of private equity many times.”

Even after rising for six straight days on takeover speculation, Safeway had a price-to-earnings ratio of 11 yesterday, less than the six other U.S. food retailers with market values of at least $1 billion, data compiled by Bloomberg show. The group trades at a median of almost 17 times earnings.

Safeway was also valued as of yesterday at an 83 percent discount to its $43.6 billion in sales last year, near its 18-year low of an 87 percent discount, which was set in September, the data show.

Bullish Options

Many traders in the options market are growing more optimistic about the possibility of a takeover. Implied volatility, the key gauge of options prices, for calls on three-month contracts that pay off if Safeway shares gain 10 percent jumped 12 percent on April 13, exceeding the cost of puts by 1.76 points, the most ever, data compiled by Bloomberg show.

The number of outstanding call contracts to buy Safeway surged 81 percent last week to 62,445 on April 13, the most since August 2010, according to Bloomberg data. Open interest for calls exceeded put contracts by 54 percent, the most since April 2011.

“The call skews are absolutely telling us that people are afraid of the upside,” Chris Rich, head options strategist at JonesTrading in Chicago, said in a phone interview. “When people are betting with their wallets, you need to listen.”

Takeover speculation was partly initiated when Safeway adopted a “double-trigger vesting acceleration” that may require executives to stay at the company to get their full vested payout if the company is bought, according to a March 28 regulatory filing. In addition to a change of control, awards will only fully vest if an acquirer doesn’t assume the awards or if an executive is fired without cause or quits “for good reason” within one year, the filing said.

Change in Control

“There was a change in their language on the vesting of options in the event of a change in control, basically making Safeway more takeover friendly,” Karen Short, an analyst for BMO Capital in New York, said in a phone interview.

The change, along with share buybacks, the promotion of CFO Robert L. Edwards to president and CEO Steven A. Burd ceding day-to-day duties to focus on innovation and strategic initiatives, may mean Safeway is considering a “corporate action,” Ken Goldman, an analyst at JPMorgan Chase & Co. in New York, wrote in an April 13 note.

Goldman said in a subsequent e-mail the same day that Safeway may be more likely to pursue a Reverse Morris Trust -- a scenario in which a company can divest an asset without paying taxes by spinning it off and merging it with another company -- than a leveraged buyout because of its debt and pension liabilities.

Debt Burden

Michael Keara, an analyst at Morningstar Inc. in Chicago, said in an e-mail that Safeway’s debt burden may be too large for a buyout. The company had $6.3 billion in total long-term liabilities at the end of 2011, data compiled by Bloomberg show.

While the change in vesting policies would make retention of management easier and cheaper in a takeover, it doesn’t signal that Safeway is up for sale or an attractive target, Edward Kelly, a New York-based analyst at Credit Suisse Group AG, said in an April 12 note.

Short sellers are also betting that the company won’t be bought. In a short sale, traders sell borrowed stock on the assumption the price will decline and enable them to profit by buying the shares back at a lower price.

Kroger Merger

About 27 percent of Safeway’s 268 million outstanding shares were sold short as of April 13, higher than 496 stocks in the S&P 500 and a record for Safeway, according to New York-based research firm Data Explorers. Companies in the index have average short interest of 2.8 percent.

Still, an acquisition of Safeway would help Kroger gain scale as increased competition from non-traditional grocery retailers such as Wal-Mart and Target Corp. reduces market share and profitability, according to Short at BMO. Kroger could pay $30 a share for Safeway, financing the deal with debt, and it would still add to the combined company’s earnings and benefit both sets of shareholders, Short said. Kroger would be paying a 37 percent premium to yesterday’s closing price of $21.92.

Private-equity firms may also be lured by Safeway’s real estate and could look to sell off pieces of the company such as its business in Canada to help pay down debt used for the transaction, she said. As of Dec. 31, the grocer owned 42 percent of its stores and leased the rest, according to its year-end regulatory filing.

‘Attractive Valuation’

William Nasgovitz, a Milwaukee-based portfolio manager at Heartland Advisors Inc., which oversees more than $5 billion, also said Safeway may be attractive for a private-equity buyer or Kroger. The firm owned 1.3 million shares of Safeway as of Dec. 31.

“It’s a stable business, it’s at an attractive valuation, they have significant market share, and they own a fair amount of real estate,” Nasgovitz said in a phone interview. “It would be attractive for Kroger perhaps to combat the supercenters of the world and the more specialty areas. As it relates to a private equity firm, maybe they could leverage that real estate portfolio.”

Activity in the options market last week indicates many traders are anticipating a takeover, said Steve Sosnick, equity risk manager at Timber Hill LLC, the market-making unit of Interactive Brokers Group Inc. in Greenwich, Connecticut.

“Safeway’s been a name that has been on the rumor mill for some time,” Sosnick said in a phone interview. “When they talk about change-in-control clauses, that does nothing to diminish a rumor mill. If you believed that something might happen, that kind of news does nothing to dissuade you.”

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