Grocery giant Safeway reported what appeared to be some pretty good numbers the other day: sales that exceeded analysts' estimates by $400 million and a strong earnings forecast for the year.

But Safeway's shares fell nearly 10 percent on the news, as investors focused on slightly lower same-store sales.

Investors have been punishing the big supermarket chains. Share prices of the Big Three—Kroger, Safeway, and Supervalu—have all slumped in recent months.

At first glance, that would seem to make sense. The food and beverage industry is struggling with climbing commodity prices at the same time that consumer spending is slowing. Wal-Mart, the retailing behemoth, has made successful inroads into the grocery business.

Yet some argue that the selloff has been grossly overdone.

"U.S. grocers have been unfairly punished as investors have doubted their ability to manage food-cost inflation, a changing consumer, and a more promotional pricing strategy at Wal-Mart," said Perry Caicco, an analyst with CIBC World Markets, in a note last fall.

Indeed the latest results from Safeway, which operates 1,743 supermarkets in the United States and Canada, underscore why grocers are better positioned than most to weather the recession.

"We've seen a very modest impact on identical-store sales in the first seven weeks of the year; nothing that gets in the way of producing earnings," Steve Burd, the company's chief executive, said on a conference call. "The worst thing that happens to a good supermarket operating during a recession is that earnings slow. They never go negative. Safeway doesn't expect any slump."

High commodity prices may squeeze grocers in the short term, but unlike casual dining and fast-food chains, they have the ability to pass on the price increases to the consumer and retain healthy margins.

"Although the grocers have raised prices to catch up with inflation, it has yet to deter the consumer from making a trip to the local grocery store," says independent credit research CreditSights, which raised its recommendation on the grocery sector to "overweight" from "marketweight" earlier this week.

Those higher prices, meanwhile, raise revenue overall for the supermarkets.

Most of grocers' gains come about as consumers, worried about the economy, exhibit "trading down" behavior.

As a result, spending on food at home is outpacing food away from home for the first time in six years, according to the U.S. Agriculture Department. Big grocers are taking advantage of that trend by investing in prepared-food offerings.

Safeway has been moving toward prepared offerings since 2000, when the chain first introduced frozen soups, and is currently in the midst of a major experiment with selling prepared entrees.

At the end of 2007, Safeway began piloting new prepared meals in 10 stores, and Burd says consumer interest "has beat internal expectations by a factor of three."

While no details have been provided,  Deborah Weinswig, an analyst with Citigroup, says that Safeway plans to further invest in prepared offerings by opening small-format stores based around the category—imitating a strategy recently tried by the British supermarket chain Tesco on the West Coast with great successes.

Burd noted that some of the "softness" observed in the first seven weeks of 2008 involved trading down in highly discretionary categories like the ultra-premium wine market, and general growth in the sale of private-label products over name brands.

Safeway has positioned itself to capture its portion of that high-margin business by expanding its own offering of private-label products in its own store and elsewhere. New brands include O Organics (organic-food line), Eating Right (health-food line), Basic Red (paper-product line), and Priority (dog-food line).

Aside from the general economic forces shaping the retail industry, there is still the competitive threat from Wal-Mart.

But rather than compete with Wal-Mart on price, Safeway has chosen to diverge from the value categories with its own unique branding.

Over the past four years, Safeway has rapidly remodeled stores in what they call a "lifestyle" format, a renovation that focuses attention on fresh produce and creates a more upmarket, fresh, and modern feel.  

"Safeway's focus on a differentiated shopping experience has allowed it to retain and gain market share in the increasingly competitive food-retail industry," says Deborah Weinswig.

This more premium feel (if not pricing), combined with Safeway's O Organics, also positions the grocer to catch consumers trading down from Whole Foods, which itself is hoping to benefit from brisk prepared-food sales.

"Regardless of what happens in 2008, there's nothing that shakes our confidence of being able to deliver our guidance," Burd says.


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