The last three fiscal years consist of the 52-week period ended December 29, 2012 ("fiscal 2012" or "2012"), the 52-week period ended December 31, 2011 ("fiscal 2011" or "2011") and the 52-week period ended January 1, 2011 ("fiscal 2010" or "2010").
Results of Operations
Management Overview The Company's results of operations can be affected by economic conditions such as macroeconomic conditions, credit market conditions and the level of consumer confidence. We believe that consumer confidence remains at low levels, which can lead to reduced spending and to some consumers trading down to discounters for grocery items. We believe that such changes in consumer spending have adversely affected Safeway's results of operations. The Company is responding to this challenging environment with new marketing programs, such as just for U™, a continuing focus on cost control and new business initiatives.
Safeway's income before income taxes declined $53.7 million to $828.4 million in 2012 from $882.1 million in 2011. This decline was primarily the result of higher interest expense, additional marketing expense and higher corporate pension expense. Interest expense in 2012 was impacted by higher average borrowings, partly offset by lower average interest rates. Additional marketing expenses were incurred in 2012 to roll out the just for U digital marketing program, a platform which downloads personalized pricing and digital coupons to the Safeway Club Card.
Total debt increased $163.5 million in 2012 compared to 2011. During the first half of 2012, Safeway increased debt to repurchase approximately 57.6 million shares of its common stock under its stock repurchase program at an aggregate price, including commissions, of $1,240.3 million. In the second half of 2012, the Company utilized free cash flow to reduce debt. In 2013, Safeway intends to continue to reduce debt, which the Company expects will reduce interest expense. Net Income Safeway earned net income of $596.5 million ($2.40 per diluted share) in 2012, net income of $516.7 million ($1.49 per diluted share) in 2011 and net income of $589.8 million ($1.55 per diluted share) in 2010. Fiscal 2012 included a $46.5 million gain from legal settlements (recorded within Operating and Administrative Expense) and a gain on discontinued operations of $31.9 million, net of tax, as discussed below. Repurchases of common stock during 2012, net of incremental interest expense, increased diluted earnings per share by $0.32. Fiscal 2011 included a $98.9 million tax charge resulting from the decision to repatriate $1.1 billion from Safeway's wholly-owned Canadian subsidiary. Discontinued Operations In January 2012, Safeway announced the planned sale or closure of its Genuardi's stores, located in the eastern United States. These transactions were completed during 2012 with cash proceeds of $107.0 million and a pre-tax gain of $52.4 million ($31.9 million after tax).
Sales Identical-store sales increases (decreases) for the past three fiscal years were as follows:

2012 2011 2010
Including fuel 1.2 % 4.4 % (0.7 )%
Excluding fuel 0.5 % 1.0 % (2.0 )%

Sales increased 1.3% to $44.2 billion in 2012 from $43.6 billion in 2011. Fuel sales increased $378 million in 2012, as a result of the average retail price per gallon of fuel increasing 2.2% and gallons sold increasing 5.9%. Other revenue from gift and prepaid card sales increased $204 million. Identical-store sales, excluding fuel, increased 0.5%, or $167 million, primarily due to inflation. New stores, net of store closures, increased sales $154 million. These increases were partly offset by a $64 million decrease in sales from the change

in the Canadian dollar exchange rate and a $254 million decline in sales due to the disposition of Genuardi's stores. Average transaction size increased during fiscal 2012, and transaction counts decreased.
Sales increased 6.3% to $43.6 billion in 2011 from $41.1 billion in 2010. Fuel sales increased $1,408.7 million in 2011, as a result of the average retail price per gallon of fuel increasing 23.8% and gallons sold increasing 16.5%. Additionally, the change in the Canadian dollar exchange rate resulted in a $240.0 million increase in sales. Identical-store sales, excluding fuel, increased 1.0%, or $375 million, primarily due to inflation. Average transaction size increased during 2011, and transaction counts decreased slightly. Prior to 2011, Safeway recorded Blackhawk Network distribution commissions on the sale of certain gift cards, net of commissions shared with other retailers. In the first quarter of 2011, Safeway determined that these commissions should be reported on a gross basis. This change increased both revenue and cost of goods sold in fiscal 2011 by $413.5 million but had no impact on identical-store sales, gross profit dollars or net income. Previously reported results are not adjusted because the impact is immaterial.
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 26.51% of sales in 2012, 27.03% of sales in 2011 and 28.28% in 2010.
The gross profit margin decreased 52 basis points to 26.51% of sales in 2012 from 27.03% of sales in 2011. The impact from fuel sales decreased gross profit margin 30 basis points. The remaining 22 basis-point decline was largely the result of a 13 basis-point decline due to investments in price and a seven basis-point decline from costs incurred to launch just for U, partly offset by a nine basis-point improvement from lower LIFO expense.
The gross profit margin decreased 125 basis points to 27.03% of sales in 2011 from 28.28% of sales in 2010. The impact from fuel sales decreased gross profit margin 80 basis points. The remaining 45 basis-point decline was largely the result of a 53 basis-point decline due to cost increases and investments in price, a 32 basis-point decline from the change in the reporting for gift card commissions and a 16 basis-point decline resulting from LIFO expense, partly offset by a 34 basis-point improvement in shrink and a 13 basis-point improvement from Blackhawk contributions.
Shrink expense was essentially flat, as a percentage of sales, in 2012. Shrink improved gross profit 34 basis points in 2011 and 19 basis points in 2010. Safeway's long-term programs to control shrink expense include improved buying practices to prevent overstocking of inventory and increased security to reduce theft. These programs have been very successful in recent years, and we believe we can continue to further reduce shrink in the future. However, shrink can never be completely eliminated, and consequently, shrink improvement cannot continue indefinitely.
Vendor allowances totaled $3.0 billion in 2012, $2.9 billion in 2011 and $2.9 billion in 2010. Vendor allowances can be grouped into the following broad categories: promotional allowances, slotting allowances and contract allowances. Promotional allowances make up the vast majority 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 very small portion of total 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.
Promotional and slotting allowances are accounted for as a reduction in the cost of purchased inventory and are 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. 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.
Operating and administrative expense was 24.01% of sales in 2012 compared to 24.43% of sales in 2011 and 25.45% in 2010.
Operating and administrative expense margin decreased 42 basis points to 24.01% of sales in 2012 from 24.43% of sales in 2011. Higher fuel sales in 2012 decreased operating and administrative expense margin by 16 basis points. The remaining 26 basis-point decline was due primarily to a 12 basis-point basis-point decline from gains related to legal settlements and a 12 basis-point decline from lower labor costs.
Operating and administrative expense margin decreased 102 basis points to 24.43% of sales in 2011 from 25.45% of sales in 2010. Higher fuel sales in 2011 decreased operating and administrative expense margin by 69 basis points. The impact from the change related to gift card commissions reduced operating and administrative expense 28 basis points, and net gains on property dispositions reduced operating and administrative expense 17 basis points.
Gain (Loss) on Property Dispositions Operating and administrative expense included a net gain on property dispositions of $79.1 million in 2012. Operating and administrative expense included a net gain of $65.6 million in 2011, primarily consisting of a gain of $47.1 million on the sale of a distribution center in Burnaby, British Columbia and a net gain of $27.5 million in 2010. Interest Expense Interest expense was $304.0 million in 2012, compared to $272.2 million in 2011 and $298.5 million in 2010. The increase in 2012 was due to higher average borrowings, partly offset by lower average interest rates. Interest expense decreased in 2011 primarily due to a combination of lower average borrowings and a lower average interest rate. Average borrowings were $6,467.6 million, $5,126.8 million, $5,276.6 million in 2012, 2011 and 2010, respectively. Average interest rates were 4.70%, 5.31% and 5.66% in 2012, 2011 and 2010, respectively.
Other Income Other income consists primarily of interest income and equity in earnings from Safeway's unconsolidated affiliate. Interest income was $10.3 million in 2012, $6.7 million in 2011 and $4.4 million in 2010. Equity in earnings of unconsolidated affiliate was $17.5 million in 2012, $13.0 million in 2011 and $15.3 million in 2010.
Income Taxes Income tax expense was $262.2 million, or 31.7% of pre-tax income, in 2012. In 2011, Safeway had income tax expense of $363.9 million, or 41.3% of pre-tax income. Fiscal 2011 included a $98.9 million tax charge resulting from the decision to repatriate $1.1 billion from Safeway's wholly-owned Canadian subsidiary.

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. Self-insurance reserves are actuarially determined primarily by applying historical paid loss and incurred loss development trends to current cash and incurred expected losses in order to estimate total losses. We then discount total expected losses to their present value using a risk-free rate of return. Any actuarial projection of self-insured losses is subject to a high degree of variability. Litigation trends, legal interpretations, benefit level changes, claim settlement patterns and similar factors influenced historical development trends that were used to determine the current year expense and therefore contributed to the variability in annual expense. However, these factors are not direct inputs into the actuarial projection, and thus their individual impact cannot be quantified.
The discount rate is a significant factor that has led to variability in self-insured expenses. Since the discount rate is a direct input into the estimation process, we are able to quantify its impact. The discount rate, which is based on the United States Treasury Note rates for the estimated average claim life of five years, was 0.75% in 2012, 0.75% in 2011 and 2.00% in 2010. A 25-basis-point change in the discount rate affects the self-insured 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 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.
Store Lease Exit Costs and Impairment Charges Safeway assesses store impairment indicators quarterly. 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. At any one time, Safeway has a portfolio of closed stores which is widely dispersed over several markets. While individual closed store reserves are likely to be adjusted up or down in the future to reflect changes in assumptions, the change to the total closed store reserve has not been nor is expected to be material.
Employee Benefit Plans The Company recognizes in its balance sheet a liability for the underfunded status of its employee benefit plans. The Company measures plan assets and obligations that determine the funded status as of fiscal year end. Additional disclosures are provided in Note K to the consolidated financial statements, set forth in Part II, Item 8 of this report.

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 K 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 generally accepted accounting principles ("GAAP"), the amount by which actual results differ from the actuarial assumptions is accumulated and amortized over future periods and, therefore, affects recognized expense 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 discount rate assumption used to determine the year-end projected benefit obligation is increased or decreased to be consistent with the change in yield rates for high-quality fixed-income investments for the expected period to maturity of the pension benefits. The discount rate used to determine 2012 pension expense was 4.8%. 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 2012, the Company's assumed rate of return was 7.75% on U.S. pension assets and 6.50% on Canadian pension assets. For 2013, the Company's assumed rate of return is 7.50% on U.S pension assets and 6.25% on Canadian pension assets. Over the 10-year period ended December 29, 2012, the average rate of return was approximately 7% for U.S. and 6% for Canadian pension assets, slightly below the Company's assumed rate of return. The deteriorating conditions in the global financial markets during 2008 led to a substantial reduction in the 10-year average rate of return on pension assets. We expect that the markets will eventually recover to our assumed long-term rate of return.
The following table summarizes actual allocations for Safeway's plans at year-end:

                              Plan assets
Asset category   Target     2012      2011
Equity              65 %    64.3 %    65.5 %
Fixed income        35      33.0      33.3
Cash and other       -       2.7       1.2
Total              100 %   100.0 %   100.0 %

The investment policy with regard to Safeway's pension plans also emphasizes the following key objectives: (1) maintain a diversified portfolio among asset classes and investment styles; (2) maintain an acceptable level of risk in pursuit of long-term economic benefit; (3) maximize the opportunity for value-added returns from active investment management while establishing investment guidelines and monitoring procedures for each investment manager to ensure the characteristics of the portfolio are consistent with the original investment mandate; and (4) maintain adequate controls over administrative costs.

                         SAFEWAY INC. AND SUBSIDIARIES


Sensitivity to changes in the major assumptions for Safeway's pension plans are
as follows (in millions):
                                                    United States                            Canada
                                          Projected benefit                     Projected benefit
                            Percentage       obligation           Expense          obligation          Expense
                              point           decrease           decrease           decrease           decrease
                              change         (increase)         (increase)         (increase)         (increase)
Expected return on assets     +1 pt      $               -     $      13.0     $               -     $      3.5
                              -1 pt      $               -     $     (13.0 )   $               -     $     (3.5 )
Discount rate                 +1 pt      $           268.2     $      28.8     $            79.4     $      6.2
                              -1 pt      $          (338.6 )   $     (36.1 )   $           (92.9 )   $     (6.3 )

Cash contributions to the Company's pension and post-retirement benefit plans are expected to total approximately $94 million in 2013 and totaled $159.5 million in 2012, $176.2 million in 2011 and $17.7 million in 2010. 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. The Company evaluates its tax positions and establishes liabilities in accordance with the applicable accounting guidance on uncertainty in income taxes. These tax uncertainties are reviewed as facts and circumstances change and are adjusted accordingly. This requires 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. Note J to the consolidated financial statements set forth in Part II, Item 8 of this report provides additional information on income taxes.

Liquidity and Financial Resources
Net cash flow from operating activities was $1,569.7 million in 2012, $2,023.6 million in 2011 and $1,849.7 million in 2010. Net cash flow from operating activities declined in 2012 compared to 2011 primarily due to a greater use of cash flow for working capital which was largely calender driven. Blackhawk receives significant 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. Changes in payables related to third-party gift cards, net of receivables, was a source of cash of $26.4 million in 2012 compared to a source of cash of $293.6 million in 2011, primarily as a result of the timing of holiday sales and a shift towards payables with shorter payment terms.

The decline in the financial markets during 2008 resulted in a substantial reduction in the fair value of the retirement plan assets. Since 2008, the financial markets have improved. Despite the improvement, the projected benefit obligation exceeds the fair value of the plan assets. As a result, cash contributions to pension and post-retirement plans increased from $17.7 million in 2010 to approximately $176.2 million in 2011 and $159.5 million in 2012. Cash contributions are expected to decline to approximately $94.0 million in 2013 due primarily to the impact of the Pension Funding Stabilization legislation which increased the discount rate used to determine pension funding (but which had no effect on pension expense).
Net cash flow used by investing activities, which consists principally of cash paid for property additions, was $572.0 million in 2012, $1,014.5 million in 2011 and $798.8 million in 2010. Net cash flow used by investing activities declined in 2012 compared to 2011 primarily as a result of higher capital expenditures in 2011, higher proceeds from the sale of property in 2012 and net cash proceeds from discontinued operations in 2012. Net cash flow used by investing activities increased in 2011 compared to 2010 primarily as a result of higher capital expenditures, partly offset by higher proceeds from the sale of property in 2011.

Cash paid for property additions was $0.9 billion in 2012, $1.1 billion in 2011 and $0.8 billion in 2010. The decrease in capital expenditures in 2012 was due to fewer store openings and fewer remodels. The increase in capital expenditures in 2011 compared to 2010 was primarily due to an increase in new store openings and the refurbishment of some in-store pharmacies. In 2012, the Company opened nine new Lifestyle stores and completed four Lifestyle store remodels. In 2011, the Company opened 25 new Lifestyle stores and completed 29 Lifestyle store remodels. In 2010, the Company opened 14 new Lifestyle stores and completed 60 Lifestyle store remodels. In 2013, the Company expects to spend approximately $1.1 billion in cash capital expenditures.
Net cash flow used by financing activities was $1,373.8 million in 2012, $1,077.3 million in 2011 and $768.1 million in 2010. In 2012, net cash additions to debt were $73.0 million. The Company also repurchased $1,274.5 million of common stock and paid $163.9 million in dividends. In 2011, Safeway had net cash additions to debt of $609.1 million, repurchased $1,554.0 million of common stock and paid $188.0 million in dividends. In 2010, net cash payments on debt were $84.8 million. Additionally, the Company repurchased $621.1 million of common stock and paid $168.1 million in dividends.
As previously announced, Safeway's subsidiary, Blackhawk Network Holdings, Inc., plans to file a registration statement in the United States for a potential initial public offering of a minority stake in Blackhawk Network Holdings. Depending on market conditions, the Company anticipates executing a transaction in the first half of 2013. This Annual Report on Form 10-K does not constitute an offer to sell, or a solicitation of an offer to buy, any securities, which will be made only by prospectus.
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, its credit agreement and debt offerings, 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.
Free cash flow Free cash flow is calculated as (1) net cash flow from operating activities adjusted to exclude payables related to third-party gift cards, net of receivables, less (2) net cash flow used by investing activities adjusted to exclude cash used by investments and business acquisitions. Cash from the sale of third-party gift cards is held for a short period of time and then remitted, less our commission, to card partners. Because this cash flow is temporary, it is not available for other uses, and it is therefore excluded from our calculation of free cash flow. We add back cash used by investments and business acquisitions to our calculation of free cash flow in order to provide a more accurate indication of our capacity to apply our available free cash flow to its intended uses.

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