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Tickers in this Article: SWY, SVU, KR, WMT, COST, AA
With the S&P 500 down more than 15% in the past seven trading sessions, investors' focus has broadened from housing, banking and derivative issues to include the stark reality that the U.S. economy is, right now, in a recession. We are all waiting and bracing for the worst, and the stock markets reflect our pessimism. (Speaking of recession, a good read right now is Recession-Proof Your Portfolio.)

Alcoa (NYSE:AA) started the most influential earnings season in recent memory by reporting a 50% drop in net earnings, and more importantly, a dour forecast that includes a steep fall in the spot price of aluminum amidst stubbornly high input (chemical and energy) costs.

But What About The Consumer?
The U.S. consumer needs to quickly take center stage – we are the fuel for greater than 70% of GDP, and we are under fire. Non-farm payrolls fell dramatically in September, with the actual result 50,000 lower than the consensus of economists. Any and all stocks related to discretionary income should be watched like a hawk, or better yet avoided; downward revisions, earnings shortfalls and poor guidance are likely to dominate the news about the U.S. consumer.

Companies That Provide Basic Consumer Goods
I believe the best places to hide in the consumer sector are companies that provide our basic and "last resort" goods. Grocer and retailer Safeway (NYSE:SWY) is an excellent harbinger of these basic consumer businesses. Safeway reported a very modest 4% rise in net earnings (47 cents EPS) October 7 on top of a similar 4% rise in sales.

Management confirmed the full-year 2008 forecast of between $2.25 and $2.35 EPS, a true achievement considering how severely the economy has deteriorated since July (when the guidance was first issued). Comparable sales (excluding fuel sales) were a scant 0.5% in the third quarter, but I think we'll find that by the end of earnings season, flat results year-over-year will be applauded by investors.

Other safe havens for consumer dollars include discount retailer Wal-Mart (NYSE:WMT) and warehouse retailer Costco (Nasdaq:COST). Costco this week reported what will likely be rare - positive EPS gains, registering 7% earnings growth in Q3.

Safeway Well-Prepared For Financial Winter
Safeway shares were up nearly 10% in the two days following the release against a 6% drop in the S&P 500, a possible sign that investors are comfortable with earnings guidance and looking at the fundamentals - for a change. Interest coverage, a vital metric for companies as we move forward, is a strong eight times interest.

Gross and operating margins remain higher than grocery rivals Kroger (NYSE:KR) and SUPERVALU (NYSE:SVU) due to the net benefits of consistent cost-cutting and renovation efforts. Safeway has spent millions of dollars in the past four years remodeling stores into a more organic-feeling "lifestyle" format, and by the end of 2008 about 75% of all stores will be renovated. It's a good thing for shareholders that most of the renovations have already been paid for, because it would be impossible to justify increased capital expenditures (capex) in today's market. But now Safeway can lower capex, preserve cash flows and take advantage of opportunities when the economy stabilizes.

As a result of cost controls and reduced capex levels, free cash flow (FCF) for the quarter rose to $261 million, up from $139 million. Through three quarters, Safeway has generated roughly $500 million in FCF, and it is on pace to surpass targets of $500 million to $700 million. This will give management further options to reduce debt, repurchase shares or increase the 1.4% dividend yield. (Interested in dividends? Be sure to check out Is Your Dividend At Risk?)

A Case To Go Long?
With a forward P/E of less than 10 times earnings, strong cash flows and a defensive stance in the consumer space, Safeway seems like a fantastic value on a fundamental basis. Consumers of all wealth levels are likely going to have to cut back on their normal spending levels. That means less eating out, less extravagance and more meals at home - more cans of corn and pot roasts.

Safeway also offers an intriguing growth kicker - a gift card business named Blackhawk that has seen sales rise more than 50% so far this year. We won't get a feel for the true earnings power of this segment until later in the year, but many analysts, including myself, feel that it could be a secret weapon to drive earnings growth in future quarters.

Parting Thoughts
The stock market has been utterly unforgiving in recent weeks. The focus is now on the depth of the current recession, not whether or not it exists. Stocks that cater to U.S. consumers are in for a rough earnings season, so investors should seek shelter in companies trading at P/Es below market levels (currently about 12 times) and catering to "bare needs" spending only.

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