By James Davey
LONDON (Reuters) - While investors have had their sights trained on the biggest names slugging it out in Britain's supermarket price war, one former struggler, Morrisons, may be embarking on a quiet revolution.
Eighteen months after Chief Executive David Potts took over, the retailer is on course to return to profit growth this year after four years of falls caused largely by the rapid advance of German discounters Aldi and Lidl.
That would put Morrisons, the fourth-largest supermarket group, on a par with market leader Tesco (LON:TSCO), which is expected to post a small rise, and ahead of second-biggest player Sainsbury which is set to post another fall.
Analysts forecast Morrisons will report underlying pretax profit of 150 million pounds for the first half of the year on Thursday, up from 141 million in the same period of 2015.
But Potts has yet to win over the doubters. Shares in the firm, which is based in the northern English city of Bradford, have risen 17 percent in the last year but remain a little below 204 pence, where they were when he joined on March 16, 2015. Over 60 percent of analysts rate the stock as "underperform".
Morrisons is still losing market share but this is due to Potts's decision to close about 30 stores and sell a loss-making local convenience chain. On the measure of sales at stores open for over a year, he has made significant progress.
The firm has reported two consecutive quarters of like-for-like sales growth, is expected to report a third on Thursday and given current forecasts is likely to be the strongest of the big four, which also includes Wal-Mart's Asda, on that measure over the first half.
There is also some evidence that the group may be in a stronger position than its peers to cope with the consequences of Britain's vote to leave the European Union. More tangibly, two deals with Amazon (NASDAQ:AMZN) and Ocado (LON:OCDO) to sell Morrisons products online could also boost profit.
PATRIARCH
Ken Morrison, the firm's boss for half a century and still its Life President, gives what by his standards is a ringing endorsement of Potts. "I think he's doing very well, but there's still a lot of room for improvement," the 84-year-old son of the company's founder told Reuters.
By contrast, the patriarch of a family that still owns almost 10 percent of the group once described the strategy pursued by Potts's predecessor Dalton Philips as "bullshit".
Potts, 59, joined Morrisons after 39 years with Tesco where he began by stacking shelves. His initial task was to steady the ship after the group lost ground in its traditional northern market under Philips.
Potts has slashed prices, narrowing the gap with the discounters. He has replenished shelves more rapidly, tailored products to local tastes and improved service with, for example, more self-scan and express checkouts.
Analysts say he has also improved the look and condition of the group's 492 stores and sharpened up marketing, emphasising its army of more than 9,000 trained butchers, bakers, fishmongers and other specialists who prepare more food in-store than in other British supermarkets.
The changes appear popular. Like-for-like transactions were up 3.1 percent in the first quarter, with sales volume growth up 3.3 percent.
Analysts at Jefferies International, who have a 'buy' rating on the stock, say the firm is misunderstood.
"Rarely have we seen such a negative combination of views both from investors and sell siders," they said, noting that about 21 percent of Morrisons' freefloat stock is on loan for short-selling by investors who expect the price to fall.
NAYSAYERS
Naysayers highlight the intensely competitive nature of the British grocery market, saying Potts needs to go even further on price cuts, and fear a fight back by industry laggard Asda, the British arm of U.S. giant Wal-Mart (NYSE:WMT).
Morrisons has invested heavily in food production and packing and now has 14 plants, making it Britain's second biggest food manufacturer and most integrated food retailer.
While data is sparse, Morrisons says it imports less of the food it sells than the 40 percent industry average.
This would make it less exposed than rivals to the pound's fall of 9 percent against the euro and 11 percent against the dollar after Britons opted for Brexit. Potts has cut prices twice since the referendum on June 23.
Morrisons also has a very small non-food offer, shunning the trend of other big supermarkets which sell everything from coffee makers to washing machines and TVs. With many of those goods imported, here too Morrisons is less exposed to the currency swings.
It is also less exposed to the risk of a post-Brexit economic slowdown and a resulting drop in consumer confidence which would particularly damage demand for bigger purchases. Such a slowdown has yet to materialise but remains expected by many economists.
Phoenix Asset Management, which owns nearly 1 percent of Morrisons according to Reuters data, has estimated the firm's food production capacity has grown to about three times the size it was a decade ago. However, it says productivity, or volume growth, has not kept track, meaning it has scope to raise output.
A wholesale supply deal struck by Potts with U.S. online giant Amazon in February gives Morrisons the opportunity to increase volume with little additional capital expenditure, boosting profitability.
Amazon's own assault on the UK grocery market is focused on London, where Morrisons is weak and has little share to lose but where Tesco and Sainsbury's are strong.
Morrisons is also benefiting from its own belated move online through a partnership with Ocado, a deal that Potts re-negotiated, paying less upfront and holding on to more profit.
It also wants to expand the wholesale of its own-label foods through an alliance with Motor Fuel Group (MFG) Britain's second largest independent forecourt operator.
BALANCE SHEET STRENGTH
Morrisons has significantly strengthened its balance sheet, with net debt forecast to be as low as 1.4 billion pounds ($1.86 billion) by the end of its 2016-17 year, down from a peak of 2.82 billion pounds in 2014.
Clive Black, analyst at the group's broker Shore Capital, says Morrisons stands apart with a lease-adjusted net debt/earnings before interest, tax, depreciation, amortisation and rent (EBITDAR) ratio of 2.4 times. This compares with a forecast of 3.9 times for Sainsbury and 4.6 times for Tesco.
Black said that if trading remains sound and debt reduction continues, Morrisons may be able to consider something to please shareholders, such as a share buyback, over the next 18 months.