U.S. Markets closed

Safeway To Spin Off Shares Of Successful Gift-Card Business

THE BUZZ Some people have a knack for picking out gifts, but for a lot of Americans it's a real challenge. When in doubt, there's always an easy option: Buy a gift card that lets them pick their own.

Apparently, more and more Americans are taking this option. Safeway (SWY) formed a separate division to manage its own gift-card business 12 years ago, and that's proved so successful that revenue has nearly tripled just since 2008. Now it's spinning off the unit as a separate company, Blackhawk Network, though it will retain majority ownership.

Blackhawk is essentially a payment processor, much like the companies that handle prepaid phone cards — which is, in fact, one of its businesses. So it's perhaps not surprising that a grocery chain considers it a noncore business. But its incubation within Safeway has helped give it an enormous presence in its niche, and also come to market without the hunger for capital that has pushed many recent IPOs out to market with shaky balance sheets.

"HAWK is a premier company in its market segment and should be bought on the IPO," wrote IPO Desktop's Francis Gaskins in a report Monday. "Its future is bright.

THE COMPANY Safeway formed Blackhawk in 2001, but by now the parent only provides about 12% of Blackhawk's revenue. It now provides gift cards to other grocery chains such as Kroger (KR) and Supervalu (SVU), and a variety of other retailers, including Bed Bath & Beyond (BBBY), J.C. Penney (JCP) and Staples (SPLS). These constitute Blackhawk's distribution partners.

"Closed loop" gift cards can be spent only on particular brands, such as Amazon (AMZN), Apple 's (AAPL) iTunes, Macy's (M) and Starbucks (SBUX). Blackhawk makes money by charging commissions pegged to the load value on the card, which it then shares with its distribution partners. It draws about 70% of its revenue this way.

The company also offers "open loop" gift cards branded by American Express (AXP), Visa (V) and MasterCard (MA). These can be spent almost anywhere, though they do usually have time limits. Blackhawk is paid management fees by the issuing bank, and also takes a cut of the user activation fee and the merchant interchange fees. This provides 14% of revenue.

About 8% of revenue comes from prepaid phone cards, through relationships with AT&T (T), Sprint (S) and Verizon (VZ) among others. Here Blackhawk also charges a commission based on load value, plus it resells handsets at a markup to its distribution partners.

The rest of the company's money comes from reloadable prepaid cards from GreenDot (GDOT) and NetSpend (NTSP), as well as resale of secondhand gift cards it buys from consumers.

RISKS/CHALLENGES The end of Blackhawk's union with Safeway will mean a short-term hit to its bottom line. At the beginning of this year, Safeway is taking a larger cut of commissions, more in line with what other distribution partners take, which delivered a tangible hit to preliminary Q1 income. Also cutting into Q1 income was an increase in sales and marketing spending, which its prospectus did not really explain.

Blackhawk's relationships are everything, and it's especially vulnerable on the distribution end since the top four distribution partners account for more than a third of its business. Any disruption in these contracts would have a considerable impact on Blackhawk, as we have already seen with Safeway.

The company faces competition from Interactive Communications International (InComm) and Euronet Worldwide (EEFT).

Quarterly results are highly seasonal, with most of the money coming in the December shopping season. That makes it vulnerable to events at that time of year, such as bad weather or a financial downturn.

Recent financial regulations such as the Dodd-Frank Act have heightened scrutiny on products like the open-loop and prepaid financial cards.

THE RESULTS Last year's revenue rose 27.6% to $959.1 million, while profit climbed 33% to 93 cents a share. In the fourth quarter, sales gained 27.4% to $453 million, while profit rose 29% to $36.2 million.

Preliminary Q1 numbers show a 22.1% sales increase to $151.5 million, but a 50% drop in adjusted net income, for reasons described above.

USE OF PROCEEDS Blackhawk expects to raise $210 million from its offering of 10 million shares, but it won't see any of the money, which will end up with Safeway and other stockholders.

THE MANAGEMENT William Tauscher Chief executive and chairman Became chairman in 2009 and CEO the next year after serving on Safeway's board of directors since 1998. From 2004 to 2010, he headed Vertical Communications. Since 1986, he's been a managing member of investment-management firm the Tauscher Group. He holds a B.S. in administrative sciences from Yale University.

Talbott Roche President Joined in 2001 and attained her current position in 2010. Before that, she spent a year as a branding consultant at Landor Associates and four years in various positions at News Corp. (NWSA) . She holds a B.A. in economics from Stanford University.

Daniel Dmochowski President, International Joined in 2001 and attained his current position in 2010. He holds a B.S. in agricultural economics from Cornell University.

Blackhawk Network Holdings Pleasanton, Calif.

(925) 226-9990 blackhawknetwork.com Lead underwriters: Goldman Sachs, BofA Merrill Lynch, Citigroup, Deutsche Bank Offering price: $20-$22 Expected date: week of April 15 Ticker: HAWK