TSCDY Tesco PLC (PK)

By Saabira Chaudhuri 

LONDON--Janet Wadsworth abandoned U.K. grocery giant Tesco PLC for discounter Aldi after the German chain opened a store near her home in the English village of St. Bees three years ago.

"It used to be that people might have been embarrassed to be seen at Aldi," says the 51-year-old teacher. "But I think that's gone."

Ms. Wadsworth is part of a new wave of British shoppers chasing bargains with little regard to where they find them. The shift--driven here in large part by two, newly aggressive German discounters, Aldi and its archrival Lidl--has shaken the U.K.'s $274 billion grocery industry to its core.

The traditional U.K. grocer "had huge margins," says David Herro, a fund manager at Chicago-based investment firm Harris Associates, which, until recently, was a large Tesco shareholder. In the current environment, "It's like exposing your neck to the discounters, like to a vampire," he says.

Indeed, as the discount-driven German duo expanded offerings, they have stolen away market share from the country's traditional players. Those grocers, in turn, have seen their stock prices plummet, triggering executive ousters, layoffs and billion-dollar write downs.

Such turmoil here is reminiscent of some of the same industry headwinds hitting grocers elsewhere--particularly in the U.S. With discounters on one end, and upscale grocery chains on the other, opposing forces are pressuring profits. The result has been forced consolidation, and, in some cases, more desperate measures.

On Monday, Tesco, the U.K.'s largest retailer, said it had agreed to sell its South Korea business for $6.1 billion in cash--a retrenchment that comes after the grocer has also quit Japan and the U.S. and been forced to strike a joint venture for its Chinese operations as it works to stem the slide in market share back home.

"Our business has not been as competitive in recent years as we would like it to be," acknowledged Tesco Chief Executive Dave Lewis on an April conference call.

Andy Clarke, CEO of Wal-Mart Stores Inc.'s Asda, Britain's second-largest grocery chain, has been more blunt, calling the goings-on "the worst storm in retail history."

Storm spreads to U.S.

Similar challenges are washing up on U.S. shores. A&P, America's first traditional supermarket chain, with roots dating back to 1859, said in July that it would close or sell its remaining stores as part of its bankruptcy filing. The moves come after years of it being squeezed by an array of new competitors, such as Whole Foods Stores Inc. on the high-end to cheaper alternatives like Wal-Mart and Aldi.

Seeking scale in the U.S. and Europe, Dutch grocery giant Royal Ahold NV and Belgian rival Delhaize Group agreed in June to merge in a deal that will create a $29 billion titan--combining American chains like Food Lion and Stop & Shop.

The $1 trillion U.S. grocery market remains largely regional and fragmented, despite a wave of consolidation in recent years. That insulates it somewhat from the sort of carnage ravaging the U.K. market. Here, the country's four biggest grocers are national chains that butt heads everywhere, and on everything from online deliveries to supplier relationships.

But now, the two scrappy German discounters that have wreaked the most havoc in Britain are ratcheting up their U.S. ambitions.

In June, Aldi's U.S. operation said it would pour about $3 billion into opening new stores, including across the large southern California market. It plans to operate 2,000 stores by the end of 2018, up from the 1,400 it runs now across 32 states. Kroger, by comparison, operates about 2,600 stores in 34 states.

A day after Aldi's U.S. announcement, Lidl--owned by Germany's Schwarz Group, Europe's largest retailer--fired back, outlining its own plans to enter the market, likely by 2018.

Analysts and others say the moves threaten to pressure discount chains like Wal-Mart and Supervalu Inc.'s Save-A-Lot, but could also further shake up the wider U.S. market.

"They're on everybody's radar in the U.S. today," says Craig Rosenblum, partner at retail consultancy Willard Bishop, of Aldi and Lidl, adding: "Everybody knows how successful they are in Europe."

Long looked down upon in class-conscious Britain, no-frills Aldi and Lidl gained traction only after the recession here. At the time, the country's biggest grocers kept jacking up prices, even as unemployment jumped and customers tightened their purse strings.

"At a time of slow to declining volumes, they attempted to raise prices and widen margins," says Andy Higginson, chairman of No. 4 British chain Morrison and a former board member at market leader Tesco. "Customers recognized this and voted with their feet."

Aldi and Lidl acted swiftly, ramping up advertising and expanding their product lines to include more fresh produce and baked goods. The two chains together now command 9.7% of the British market as of August 16, according to Kantar, up from 5.9% three years prior. Even their competitors acknowledge the creeping threat.

"I believe the discounters will get to 15% of the U.K. grocery market by 2022," said Sainsbury CEO Mike Coupe at a meeting with journalists in May. Aldi and Lidl, he said, are "formidable competitors."

The chains have kept prices low by prioritizing speedy store deliveries, efficiency and high turnover at the expense of breadth of offerings and customer service. As part of that push, Aldi and Lidl take daily deliveries of a slim range of mainly private-label products, often with the look and feel of popular, branded items.

"By not offering this huge variety we've made the offering and our range efficient." says Lidl's marketing director, Arnd Pickhardt. "We provide just a handful of different mineral waters, about seven, compared with other supermarkets that have a whole aisle full of space" for waters, he says. The stores' smaller footprint also saves on costs.

Some products are sold directly off the delivery pallets, while others arrive in boxes with open fronts, allowing the staff to quickly move them in bulk onto store shelves without being unpacked from the boxes. Lidl drives its trucks through the night to avoid traffic and save fuel.

Both grocers charge for bags, which customers take to packing areas that help keep the register areas moving. Aldi and Lidl cashiers also do double duty, stocking shelves when things are slow.

"We can operate at a far lower margin because of our efficiency," says David Hills, Aldi's U.K. group buying director. "Everyone in our shops needs to do every job from mopping to check outs."

Shoppers have been willing to go with the program in return for better prices. Nick James, a 27-year-old urban planner in London, used to frequent Sainsbury's until he wandered into a Lidl to buy a croissant about 18 months ago.

Lidl has "funny European brands," he allows, and the stores aren't "quite as plush or neatly presented" as those at Tesco or Sainsbury, which competes with Asda for the market's No. 2 position.

He says he also finds it "really frustrating" when he can't find anyone at the cash registers to check out. Still, he has switched to shopping almost entirely at Lidl because "the quality is just the same, but the prices are more affordable."

U.K. grocers adjust

The Germans' success is proving calamitous for Britain's traditional grocers. In the past year, shares of Tesco, Sainsbury and Morrison have fallen more than 13% on average, amid profit warnings, billions in property write-downs, and canceled or slashed dividends. They have axed jobs and closed or shelved plans to open stores. Two of the three have recently ousted their chief executives.

Yet the results have been a boon for consumers. A loaf of whole wheat bread here now costs an average of 98 pence ($1.50), down 15% from a year ago, according to the Office of National Statistics. Shopping has also never been so convenient, with the big grocers expanding their click-and-collect services--allowing customers to order online and pick up from stores, gas stations or other locations.

Morrison has cut prices on 1,665 products by an average of 16% since the start of last year. Wal-Mart's Asda, meanwhile, earlier this year plowed nearly GBP300 million ($458 million) into reducing the prices of 2,500 basic items; Sainsbury dedicated GBP150 million to fund lower prices.

Tesco had weathered the recession of the early 1990s better than rivals by introducing lines with bare-bones packaging that appealed to cash-strapped shoppers. It rolled out a pioneering loyalty card--now copied the world over--that tracked shoppers' habits. Memorable TV ads featured a dedicated but hapless Tesco buyer, played by Dudley Moore.

"In that period, Tesco did a good job of understanding the changing environment and readjusting its overall competitive offer," says Terry Leahy, who took over as chief executive in 1997. Over the next 14 years, he transformed the chain into a global retail powerhouse, competing on the world stage with Wal-Mart and France's Carrefour SA.

Then the latest recession hit Britain in 2008 amid the global economic crisis. Unemployment jumped, leaving increasingly panicky customers hunting for bargains. But grocers raised prices--passing along higher commodity costs to defend margins. Grocery inflation peaked at 9.3% year-over-year in October 2008, according to Kantar.

"They had such a strong grip on the market that obviously they felt they could do it," says Bruno Monteyne, a Sanford C. Bernstein analyst who worked as a Tesco executive for 10 years. Margins at Tesco, Sainsbury and Morrison rose steadily through the downturn, to an average of 8.1% in 2010, from 5.8% in 2005, according to Bernstein.

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September 10, 2015 22:00 ET (02:00 GMT)

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