Credit Suisse downgraded Safeway Inc to neutral from outperform saying the second-biggest U.S. supermarket operator has a larger-than-expected underfunded pension liability.

The brokerage said its proprietary analysis revealed that Safeway's multi-employer pension plans (MEPP) underfunding stood at a surprising $7 billion, before tax.

While it's unlikely that Safeway will be responsible for this entire underfunding, the current fair value picture of the underfunding is troubling, Credit Suisse analysts said in a client note.

The rising pension costs could make it difficult for Safeway to grow or stabilize earnings, the analysts said.

While this issue should not result in any material drain on cash flow in the near-term and could improve, it does suggest that the stock is not as cheap as it appears and labor costs could rise over time, said the analysts, who cut their price target on the stock to $20 from $26.

Safeway and most other U.S. grocers are struggling with sales volume declines as a tepid economic recovery has forced many consumers to spend cautiously.

Safeway shares closed at $21.13 on Friday on the New York Stock Exchange.

(Reporting by Juhi Arora in Bangalore; Editing by Gopakumar Warrier)