The hard discount threat

We found the recent news that Aldi has purchased the Bottom Dollar stores in Pennsylvania from Delhaize striking, for several reasons:

For food retailers outside North America, intense competition from hard discount formats is just part of the competitive landscape. But inside North America, hard discount has not been much of a factor. We believe that is likely to change soon. Aldi is reaching an inflection point in its store density and customer acceptance; it is poised for explosive growth. Lidl is likely to enter the United States, though probably not until 2018. These two discounters alone have opened 7,000 stores in the past ten years — and their growth trajectory is up.

We think there are three factors food retail executives should analyze and understand to assess the impact hard discount could have on their businesses. First, the hard discount customer comes from all income brackets, putting more spend at other formats under attack. Yes, low-income customers shop at Aldi. But they are not alone. Middle class customers are increasingly finding that they can enjoy very attractive prices without having to compromise on quality.

In the U.K., the financial crisis helped Aldi and Lidl get traction, but now they have crossed a threshold where it is no longer embarrassing to be seen shopping there. And while they are disproportionately taking customers from supermarkets that over-index on lower income customers, all supermarkets have lost volume as middle- and upper-income shoppers split their baskets between grocery and hard discount. As one grocery CEO told us recently, “You only have to look at where they are putting their stores to know they think they can win with a higher demographic.”

Second, the hard discount economic model is very different to traditional food retail. Low gross margins make it almost impossible for competitors to compete on price; superb efficiency ensures that those low grosses become strong bottom-line profit. Based on our benchmarking, we believe the hard discount P&L compares to a typical supermarket P&L roughly as follows:

Once hard discounters get going in a market they can drive a virtuous cycle of attracting customers with fantastic prices, driving volume and operating leverage, and delivering enough ROIC to reinvest in the customer proposition and fund expansion.

Third, the format’s unique products exploit full-assortment operators’ dependence on assortment architectures. Hard discounters use what we call “Bull’s Eye” lines — a single or very small number of products that are designed to pull in volume from the entire category. They do this by offering fantastic value vs. branded products — not just because they are cheap, but because they offer high quality and attractive packaging. Grocers who try to fight back with “discounter fighter” own brand products find they must make their packaging unappealing to keep their customers from trading down. Hard discounters have no architecture to protect, so they don’t have this problem.

Of course discounters can only offer this extreme value because their business is built on mastery of manufacturing, not just retailing. Aldi, Lidl and the rest have deep expertise on how their products are produced, who can produce them and what trade-offs they need to make. And they have scale: Aldi and Schwarz Group (Lidl’s parent) are the No. 1 and No. 2 sellers of own brand grocery products worldwide. As a result they are able to take a “grind it to powder” approach to costs, driving out every fractional cent of cost without compromising on quality.

What we think this means

In the U.K., with the exception of Walmart-owned Asda, the grocers waited too long to respond. By the time hard discount had established itself the price gaps were so large that closing them was ruinously expensive. But grocers in other countries have fought back much more effectively. We think U.S. grocers could benefit by reviewing the playbooks of the companies that have absorbed the hard discount onslaught. In a nutshell, the successful grocers:

The good news is that taking these steps will help supermarkets win against every class of trade, so a radical change in strategy is not needed. But for many, we believe a radical increase in urgency is needed. Hard discount is going to become more of a factor in U.S.; now is the time to prepare for an even tougher competitive environment.

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