A City memo to Morrisons: you're not a little firm up North now

The supermarket chain is buckling under the strain of converting 450 Safeway stores, but as Abigail Townsend and Tim Webb find, a profit warning is not its only problem. The Square Mile wants it to behave like a FTSE 100 firm and start communicating

Eighteen months ago, Northern supermarket chain Wm Morrison sparked the longest takeover wrangle the City had seen for years. Its decision to buy larger rival Safeway prompted a flood of potential buyers to join the fray, from legendary US buyout firm Kolhberg Kravis Roberts to fellow British grocers Tesco and J Sainsbury. Even Top Shop billionaire Philip Green got in on the act at one point.

Eighteen months ago, Northern supermarket chain Wm Morrison sparked the longest takeover wrangle the City had seen for years. Its decision to buy larger rival Safeway prompted a flood of potential buyers to join the fray, from legendary US buyout firm Kolhberg Kravis Roberts to fellow British grocers Tesco and J Sainsbury. Even Top Shop billionaire Philip Green got in on the act at one point.

But Morrisons clung on. The £3bn deal was completed in March and the chain is now focused on converting the newly acquired estate to stores bearing its own name - with the traditionally strong level of sales seen at Morrisons.

Yet the task is not proving easy. Safeway is dragging down the previously impregnable Morrisons, forcing a profit warning in July - the first in its 37 years as a public company - and the expectation of yet more bad news at next month's interim results.

One of the reasons is that Morrisons slashed product ranges in Safeway stores, prompting shoppers to take their business elsewhere. Last month, figures from research group Taylor Nelson Sofres showed sales at Safeway stores were down 12 per cent in the 12 weeks to 15 August. Despite a strong performance from Morrisons, the drag left the group's overall sales flat.

Costs are also mounting. The bill for converting the 450-strong estate was underestimated: it is now expected to come in at around £375m, around 50 per cent more than was originally expected.

And the number of people willing to move from Safeway's Middlesex headquarters to Morrisons' Bradford hub was overestimated, meaning the amount of job losses will be higher than expected. Originally, around 1,200 redundancies were predicted from the 1,600-strong HQ, but so far "less than 200 people" have opted to relocate to the North.

Joint managing director Bob Stott's explanation for this to The Independent on Sunday appears ingenuous: "We thought people would have welcomed moving up North. But maybe the pay rates in the South are higher."

"They were naive about the ease with which the businesses could be integrated," says Paul Smiddy, retail analyst at stockbroker Robert W Baird. "Maybe they didn't do as much due diligence as they could have. But it was clear to outsiders like me that the Safeway business was going backwards. They were overestimating the strength of the business they were inheriting."

On a corporate level, much appears to have taken Morrisons by surprise, such as quite how bad sales were, despite lengthy periods of due diligence. And it has yet to make a decision about whether to sell the 120 smaller stores, a sale which would raise about £400m.

To top it all, the group's reputation in the Square Mile is being marred, with management accused of arrogance in their refusal to open meaningful and regular dialogue.

One analyst, at one of the world's biggest and most influential investment banks, complains of poor communication, of requests to meet with management left unanswered and of face-to-face meetings that are few and far between.

"The honest answer is that it's very difficult to assess the performance of the business," he says. "The monthly Taylor Nelson Sofres figures are going to be increasingly distorted by conversions, and the last data point we had was a profit warning, where no suitable explanation was given about how profits and costs may evolve. There's been an extended blackout.

"I would never suggest that we're owed an explanation, but if the company wants a balanced market in its shares, the market needs more information. If you look at the value of [chairman] Sir Ken Morrison's investment and how much he has lost, being crude, that's the price you pay." Morrisons' shares have fallen from a high in March of 256p, when it completed the Safeway deal, to a low last month of just 171.25p.

The problem is that Morrisons used to get away with it.

Led by Sir Ken, the son of the founder, it cultivated a reputation as a no-nonsense Northern retailer, more akin to a family business than a blue chip public company. And while sales and profits remained strong, most in the City where happy to go long with the no-nonsense allusion and accept traditionally poor standards of corporate governance (the first non-executive directors were only appointed this year).

Says Richard Hyman, chairman of retail consultancy Verdict: "Historically they have allowed people to think they were a little company from Yorkshire that didn't know what it was doing. It was uncomplicated and unsophisticated and, through a bit of luck, made a bit of money. But they were actually very, very sharp.

"The thing that makes Morrisons stand out is its execution in the stores: in all my 25 years in retailing, I have never been in a Morrisons store that's not firing on all cylinders."

However, this contradiction will not wash now that it has become the company with a £5.1bn market value.

As Mr Smiddy comments: "Prior to the Safeway deal, the story was a simple one of high quality. But the deal has transformed that." The City wants more access to the company, and detailed answers when things go wrong.

Yet Morrisons is starting to fight back. Joint managing director Marie Melnyk is quick to dismiss the Taylor Nelson Sofres figures, saying they do not take account of the important point that, with stores being converted at the rate of three a week (19 have been changed over so far), Safeway sales are bound to be down on last year.

She also concedes that Morrisons was too quick to slash product ranges from the 30,000 Safeway carried to 20,000. "We drilled down to store level to find out what customers wanted and maybe in some areas we cut back too much."

Most of the old Safeway stores will now carry 2,000 more product ranges than traditional Morrisons outlets.

The group felt it had no choice but to slash prices, however - the main contributing factor to the July profit warning. "Safeway was always going to get found out and we wanted to protect customer numbers. It was why we decided to invest in stores and cut prices," comments Mr Stott.

Under the old regime, Mr Stott says that Safeway store managers were responsible for the bottom line, rather than being allowed to concentrate on running their shops.

"You would go into a Safeway store and ask why a light bulb had not been changed. The answer would be: 'Because it would affect my profitability.' I'm exaggerating only slightly.

"Now we have trading teams to do the buying, the margins are set and the managers can get on and manage."

Both Mr Stott and Ms Melnyk are confident that despite a tough slog ahead in converting the stores - the programme will continue until November 2006, meaning two years of weak Safeway sales - the first few months of full ownership are not indicative of wider problems.

Ms Melnyk has hinted that the figures will be better next month, while Mr Stott has gone on record as saying that the profit warning was just a "short-term blip".

Some investors have been selling out, however, and analyst concerns are not allayed. Last week the chain organised a rare trip for business journalists down to its flagship Milton Keynes store, the first Safeway outlet to convert to a Morrisons fascia. Analysts, however, have not been so fortunate, with not a single site trip so far set up for them.

This lack of in-depth dialogue with the City means that while forecasts vary immensely, most are bearish about short-term prospects.

Mr Smiddy at Robert W Baird comments: "On the three- to four-year view, it will prove to be a transforming deal, but it could be a rough ride for another 12 months. Christmas will be tricky. There's pressure on any business then but when you've got two businesses that are still separate, it's going to be really tricky."

Yet for all the concerns, you would be hard pushed to find someone prepared to write off Morrisons. It may generate ill will, but the City still has faith in the company. It has a tough job ahead - but people believe, for the time being at least, that it will get the job done. What Morrisons needs to do now, however, is to strike a balance between its roots as a family-run retailer and its new status as a leviathan of the supermarket sector.

Mr Hyman at Verdict sums it up: "Morrisons was one of the small players in the food market and that - and the fact it has historically outperformed - allowed it to break City conventions. While it was outperforming and relatively small, it wasn't on the radar. Now it is. It has to play by different rules now."

'Who are these guys?' The burning question of Sir Ken's successor

Sir Ken Morrison turns 73 next month. The oldest FTSE 100 boss, he quips to friends that he is practically retired, as he has cut his working hours down to just five days a week.

But even Sir Ken, the second- longest-serving FTSE 100 chief (after British Land's John Ritblat), knows he cannot go on for ever. The question is, who will replace him - and when?

"When" is easier to answer: it won't be soon. Sir Ken only completed the Safeway deal in March (the company's biggest purchase before then had been eight stores in 1978). And given the mammoth two-year task to convert the Safeway stores and integrate the business, he is unlikely to stand down in the next 12 months, when the job is less than half done.

Before his departure, institutional shareholders want the company to set up a nominations committee to find a replacement, preferably with more than the two newly appointed non-executive directors on board. Morrisons has indicated it is looking for a third non-executive director. The appointment is likely to be in place before the annual general meeting next summer.

Richard Singleton, director of corporate governance at Isis Asset Management, a Morrisons shareholder, says: "A third appointment is very desirable. I would expect the non-executive directors to have a valuable input in succession planning."

Another institutional shareholder adds: "Most large fund managers look for a good smattering of non-executive directors on the board. Traditionally Morrisons did not have any, which caused some concern among clients. It's not a guarantee that bad practice won't happen, but it can help."

Who might replace Sir Ken is harder to answer. The board has discussed it, as joint managing director Bob Stott admits: "We have a succession policy based on certain conditions. But we have not told our shareholders."

Yet shareholders want the issue to be sorted out sooner rather than later. "Succession is always an issue if you are investing in the company," says the institutional shareholder, adding that some of the more junior executives deserve a chance. "We think some of the middle management are better than the City and the press understand. If you cut some of these people in half, they bleed yellow and black. There is an incredible culture at the company."

The obvious candidates are the joint managing directors, Mr Stott and Marie Melnyk. The affable Mr Stott joined the company in 1973 and worked his way up, becoming deputy managing director a decade later. In 1987 he left, but returned nine years on, joining the main board in 1997 as buying director and becoming joint managing director in March 2002. But shareholders may want to see a younger replacement than the 61-year-old and he has hinted that he may retire soon anyway.

Ms Melnyk joined in 1975, straight from school, and became trading director in 1988. Her route to the top has been seamless: main board in 1993, deputy managing director in 1997, joint managing director March 2002. Yet neither she nor Mr Stott are candidates the City and other observers will warm to instantly. They are simply unknown quantities.

As Richard Hyman of Verdict says: "I just don't know them. There isn't a retailer as big as this that we have such a low-level relationship with. But it's clear that the succession, or lack of it, is a major issue that they have got to address."

Another candidate is the well-regarded finance director Martin Ackroyd, another "Morrisons lifer" having joined in 1974. He was appointed to the main board in 1987 and, with Mr Stott, is responsible for overseeing the integration of the Safeway business; his reward for doing it well could be the top job.

Sir Ken's son, William, in his late-20s, is also touted as a candidate. Mr Stott calls him a "smart lad". But he is relatively junior, appearing overwhelmed when wheeled out in front of journalists at recent results, and shareholders may worry that Sir Ken's approach will live on. "It's like investing in BSkyB," says the institutional shareholder. "If you invest, you accept you are in a vehicle which is being influenced by Murdoch senior."

For a City already twitchy about corporate governance and transparency, that is unlikely to sit well.

For the moment, however, debate about who will land the top job is academic. Sir Ken remains entrenched, and as for any potential successors, simply not enough is known about them. As one industry insider puts it: "If something, God forbid, happens to Sir Ken, where is the strength in management behind him? No one has any idea who these people are. Retail is a very small village but these guys just don't have any profile at all."