Will Supermarkets Take Pre-Emptive Strike Against Deep Discounters?

Aldi is the fastest growing food retailer in America. With a market share of around 0.8 percent of U.S. food sales and, perhaps, 1.0 percent of produce sales, it is not a major market factor, but deep discounters such as Aldi and Lidl have reached double-digit market shares in many markets. The so-called “big four” British multiples scramble to stop a market share increase that has brought the hard or deep discount sector to 10 percent of the market in the United Kingdom, according to the latest Nielsen figures.

Now every market is different, but there is no particular reason to believe deep discounters won’t be able to achieve similar penetration in the U.S. market. So what approach should American retailers take to blunt the growth of deep discounters? It is not an easy task — the deep discount business model is powerful.

Deep discounters offer the consumer a lower cost because the concept works on a lower gross margin, yet because operating costs and overhead are so much lower, the stores actually produce higher earnings than more expensive concepts.

This reveals the power of the concept and why it is sweeping the world. The concept offers both lower prices to consumers and higher returns to investors.

This also points out why no amount of across-the-board “price investment” by supermarket chains can make the supermarkets competitive. The basic economics of the concept are different than those of a supermarket, so supermarkets would have to accept margin reductions on a level that exceeds total profits.

The big supermarkets hope to steal a page from Robert Crandall, former chairman and chief executive of American Airlines during a tumultuous period when discounters such as People’s Express began to fly. His legend in the airline industry came from cracking the discounter’s code.

Things looked grim for American and the other legacy carriers. They were saddled with high union costs and were being undercut by discounters whose cost per mile flown was way below those of the legacy carriers. It looked like the discounters were unstoppable.

Crandall found a different path. He observed that although on average, American Airlines’ costs were far higher than those of People’s Express, American had an ace in the hole. Although the majority of seats were sold to business people at a high fare, a substantial portion of the seats went unsold. Crandall’s epiphany? If American could find a way to offer the unsold seats to discount flyers (vacationers, students, etc.) while keeping its high-priced business passengers paying full fare, that would enable American — whose marginal cost of seating a passenger in a plane flying anyway was almost nothing — to offer a “discount airline” price that had costs far lower than those of People’s Express.

American went on to institute various innovations such as a Saturday night stay requirement and advance-purchase requirements, all designed to create conditions unacceptable to the business flyers and thus keep them in their expensive seats.

It turned out to be a brilliant strategy and in short is why People’s Express is out of business.

So the question is whether there is a way to use the existing box and have supermarkets somehow offer a competitive discount package that would entice the deep discounter’s customers without disturbing the relationship with shoppers who buy at full margin.

The key attempt to do this is with a discount private label range, but it doesn’t seem to be very successful. Some of the problem is inconsistent supermarket execution. Even when multiples in the U.K. developed such ranges, they often executed half-heartedly and pulled the discount ranges from certain stores to keep margins high.

But even when fully executed, the cheap private label line just doesn’t seem to work. Part of the problem is that developing such a range is an odd task. Supermarkets literally sit there trying to design packages sufficiently ugly that only those desperate to save a dime would consider them. Then consumers who select from these ranges have to be aware that everyone who looks at the basket notes they are buying the cheap stuff. This is in contrast to the Aldi experience where everyone in the store is equal, and the discounters try to make each private label item more attractive than the next.

Finally, one key reason the plan worked on the airlines but may not in supermarkets is that with the airlines it was easy for business travelers to decide they were unwilling to stay a Saturday night or take other steps to get a discount fare — in most cases it was not their money. There is no third-party payer in the supermarket aisles.

If the in-store approach won’t work to stop the deep discounters, the other alternative is to adopt an “if I can’t beat ‘em, then join them” philosophy. This has been the approach in France, where many multiples set up their own hard discount divisions.

When Wal-Mart rolled out its supercenter concept, the most important and interesting thing is what didn’t happen. It took a long time for Wal-Mart supercenters to roll out across the country, but we didn’t see Safeway, for example, decide to roll out supercenters. Safeway never decided to protect, say, its California territory by pre-empting Wal-Mart on the supercenter market in California.

This was true everywhere. Now as Aldi ramps up its roll-out and as Lidl prepares to enter America, will the big supermarkets once again simply abandon a chunk of market share as a concept rolls out, or will they act now to pre-empt?