Introduction

Over the past decade, grocery discounters Aldi and Lidl have taken the UK by storm, stealing market share from major incumbent rivals, and forcing those rivals to take radical measures to slash costs, lower prices and overhaul offerings. This report reviews five measures major UK grocery retailers have taken to fight Aldi and Lidl – and summary verdicts on the success of each. We begin with an outline of the past and potential future growth of Aldi and Lidl in the UK.

Grocery Discounters: The UK Context

Discounters’ Gains In the UK, discounters Aldi and Lidl have reshaped the grocery landscape. Sustained double-digit revenue growth at Aldi and Lidl has eroded the aggregate share captured by the traditional “Big Four” grocery retailers—Tesco, Asda, Sainsbury’s and Morrisons. According to market-measurement service Kantar Worldpanel, for the 12 weeks ended March 24, 2019, Tesco had a grocery market share of 27.4%, Asda 15.4%, Sainsbury’s 15.3% and Morrisons 10.3%. This compared to 8.0% market share for Aldi and 5.6% for Lidl. The chart below shows growth at Aldi and Lidl over the past three years (through February 24, 2019), as recorded by Kantar Worldpanel. We also show period-start and period-end market shares for Aldi and Lidl. Between January 2011 (not included in the chart below) and February 2019, Aldi and Lidl more than doubled their combined UK grocery market share from 6.1% to 12.8%. During that period, Aldi overtook the Co-Operative to become the UK’s fifth-biggest grocery retailer and Lidl overtook Waitrose to capture seventh position. [caption id="attachment_84306" align="aligncenter" width="720"] Data are for overlapping 12-week periods and attributed to the years in which the periods end. Market share data are for the 12 weeks ended Jan. 3, 2016 and Feb. 24, 2019.
Source: Kantar Worldpanel [/caption]   The impact on incumbents has been felt in attrition of margins as well as loss of market share. Established nondiscount retailers were forced to cut prices to compete, just as they saw weakening sales volumes as shoppers turned to low-price rivals. [caption id="attachment_84307" align="aligncenter" width="720"] Source: S&P Capital IQ[/caption] Tesco and Morrisons are among those focusing on volume-led recoveries — and this has generally borne fruit, according to recent management commentary:

• On Tesco’s 3Q19 earnings call in January 2019, CEO Dave Lewis said the retailer “led the market from both a volume and a value perspective in food, general merchandising and clothing.”
• On Sainsbury’s 1H19 earnings call in November 2018 CFO Kevin O’Byrne said: “We've seen one of the most encouraging volume performances that we have for a number of years. Volumes are down slightly, but [represented a] material improvement year on year.” In 3Q19, management pointed to “a broadly similar volume performance” to 1H19.
• On Morrisons earnings call in for fiscal 2019 (ended January 2019), CFO Trevor Strain said: “the volume performance of the group is strong” and that volumes were “stable” in its core supermarkets (excluding online and wholesale).

Aldi and Lidl Could Capture Another £9 Billion in Sales by 2023 Aldi UK and Ireland broke the £10 billion sales barrier in 2017 and, based on growth rates reported by Kantar Worldpanel, we estimate this will have risen to around £11.4 billion in 2018. Lidl does not publish meaningful UK accounts, but based on the company’s occasional prior statements about annual revenues and Kantar growth data, we provide estimates of its 2017 and 2018 revenues below. [caption id="attachment_84308" align="aligncenter" width="720"] 2017 actual; 2018 estimated based on average annual growth recorded by Kantar Worldpanel.
Source: Company reports/Kantar Worldpanel/Coresight Research [/caption]  

• Aldi UK and Ireland grew revenues by a compound annual growth rate (CAGR) of 21.2% between 2012 and 2017 (latest confirmed). In 2017, it grew revenues by 16.4%. Kantar Worldpanel data imply it grew UK-only sales by around 12% in 2018, slowing from Kantar-implied UK-only growth of around 16% in 2017.
• Lidl UK grew revenues by a CAGR of 15.4% between 2013 and 2018, and by 13.0% in 2018, according to Euromonitor International estimates.

Revenue growth rates for Aldi and Lidl therefore appear to be on a slowing trend. If we assume each increases revenue by a CAGR of 9% in the five years from 2018 to 2023, we arrive at the following estimates:

• Combined Aldi UK and Lidl UK estimated sales of just over £25 billion in 2023, up by an aggregate £9 billion from estimated 2018 sales.
• Aldi UK and Ireland sales of around £17.5 billion by 2023, up by around £6 billion in total from estimated 2018 revenues. Within this, we estimate Aldi UK (ex Ireland) would grow sales by around £5 billion to approximately £14.6 billion.
• Lidl UK sales of around £10.5 billion in 2023, up by almost £4 billion from estimated 2018 revenues.

A £9 billion gain by the discounters would be equivalent to the following:

• 20% of Tesco UK and Ireland fiscal 2018 revenue (note, including Ireland).
• 31.5% of Sainsbury’s fiscal 2018 retail revenues (ex financial services).
• 40% of Asda’s 2017 revenues (latest confirmed).
• 50% of Morrisons recently reported fiscal 2019 revenues.

The possibility of meaningful market-share loss therefore remains a significant threat for the UK’s Big Four grocery retailers.

Five Ways UK Grocery Retailers Have Fought Aldi and Lidl

We note five strategies that incumbent retailers have adopted to compete in this environment. 1.     Cutting Out Costs to Lower Prices The Big Four have been forced to invest in price, and at retailers such as Tesco and Sainsbury’s, this has involved a general switch from special offers such as multibuys to more steady everyday lower pricing. At the same time, some retailers have been seeking to rebuild margins after a depletion in recent years. All Big Four have been cutting costs to achieve these aims. This has resulted in thousands of job cuts, in which the general pattern has been to move from head office to stores:

• Tesco is aiming to reduce operating costs by £1.5 billion and grow operating margins to 3.5-4.0% by fiscal 2020. In 2015, Tesco closed its Cheshunt headquarters, shedding 2,000 jobs; reformed its staff pension scheme; and, shuttered stores – including a single tranche of 43 stores. In 2017, the company cut 1,200 jobs at its head office and announced plans to close a call center, shedding 1,100 jobs. In 2018, Tesco cut 1,700 jobs in stores and warehouses (while creating 900 other roles). It is currently planning to shut fresh-food counters in 90 stores with some other stores switching to a reduced counter service, cut store-based staff canteens and make further job cuts at its head office, in total impacting 9,000 staff.
• In 2017, Sainsbury’s cut 2,000 head-office roles and 400 jobs in stores. In 2018, the company cut an unspecified number (widely reported to be in the thousands) of store-level jobs when it axed the roles of deputy manager, department manager, team leader and store supervisor.
• In 2016, Asda cut around 200 head office jobs and around 1,000 store jobs as it closed staff canteens and some in-store services. In 2017, the retailer cut 300 head-office posts, sought to cut an unspecified number of posts at some underperforming stores, according to the Guardian newspaper, and revealed plans to remove the role of 842 section leaders from its store management teams. In October 2018, The Grocer reported Asda plans to cut 2,500 store posts.
• Morrisons cut 700 head-office staff in 2015 and 1,500 store-management roles in 2018 (while creating 1,700 more junior roles).

VERDICT: Generally positive results but hints of cutting too far Retailers have largely been successful in stripping out costs without substantially impacting the shopper experience. However, we think this success has not been universal, and that Sainsbury’s store-level restructuring is one instance in which cuts have visibly degraded store standards. During our store visits, we saw the impact on product availability, store standards and checkout lines, and we expect many other shoppers have noticed these effects, too. Sainsbury’s management continues to point to comparatively strong availability and service levels, as represented in the slide below, taken from the company’s first-half results for fiscal 2019. [caption id="attachment_84309" align="aligncenter" width="720"] The Grocer 33 is a weekly mystery shopping survey undertaken across various supermarket chains by The Grocer magazine.
1Grocer 33 average availability (percent) for the 28 weeks ended Sept. 22, 2018
2Grocer 33 service wins for the 28 weeks ended Sept. 22, 2018
Source: Company reports [/caption]   Nevertheless, the position of Sainsbury’s has always been firmly upscale of that of its biggest rivals, and we think that that position is slipping. Sainsbury’s continues to face a significant challenge in heading off the discounters on price (at least to some extent) while maintaining its differentiated position; it now seems willing to sacrifice that differentiation in a bid to cut costs. 2.     Driving Volumes through Slimmed-Down Ranges A key part of Aldi and Lidl’s operating model is to offer limited choice — traditionally, a single private-label stock-keeping unit (SKU) in each category — and channel high volumes through each SKU. In most supermarkets, an abundance of choice dilutes sales per SKU. However, nondiscount retailers have been borrowing ideas from the discounters. Under CEO Dave Lewis, one plank of Tesco’s strategy has been to slim down its ranges. In 2015, Tesco was reported by the Guardian to be planning a cut of up to 30% of its total offering. At the end of fiscal 2016, Tesco noted it had cut its total number of products by 18% under its “Project Reset.” At the end of fiscal 2017, Tesco noted it had achieved a 24% cumulative range reduction while maintaining a strong pipeline of new product development. [caption id="attachment_84310" align="aligncenter" width="720"] Source: Company reports[/caption]   Branded suppliers have seen delistings, though Tesco management has noted that some suppliers benefit from higher volumes going through their core ranges. However, simplifying and removing supplication from private-label ranges and removing duplication have contributed, too. In 2018, The Grocer magazine reported that Tesco is embarking on a cull of suppliers, which could involve cuts to its ranges. On the company’s 1Q19 earnings call, Dave Lewis remarked, “If we've got range which is not productive, that's taking up the space at the volume that we need for the highest-selling lines, then we'll continue to change the portfolio accordingly.” At the same time, Tesco has been relaunching thousands of private-label products: In its 3Q19 trading update, Tesco said 74% of 10,000 private-label products had so far been relaunched. And it gave those own-brands greater prominence on shelf, encouraging more favorable private-label-versus-private-label comparisons between Tesco and the discounters. VERDICT: A successful move to drive volumes per SKU Tesco’s range reductions have allowed it, on average, to more profitably channel higher volumes through each line. Its range resets have coincided with a recovery in its top line and a return to total volume growth, confirming that shoppers have not been deterred by slimmed-down ranges. The retailer’s product range remains more substantial than those of the discounters, giving it a strong competitive advantage. 3.     Launching Their Own Discount Formats and Brands Tesco has been imitating the discounters not only in reducing choice but in building its own discounter-type brands. In January 2019, the company reported that its new low-price “Exclusively at Tesco” brands had been 95% rolled out and that 82% of Tesco shoppers had bought items from the range. On the company’s 3Q19 earnings call, CEO Dave Lewis acknowledged demand for these low-price products, which replaced its previous Everyday Value range, had brought some trading down from more expensive (and so higher-margin) ranges but said that he was “very comfortable with the level of adoption” and its impact on the business. [caption id="attachment_84311" align="aligncenter" width="720"] Exclusively at Tesco brands
Source: Tesco [/caption]   Tesco has launched discount-format stores, too. In autumn 2018, the company launched Jack’s, which, like Aldi and Lidl, is built on a proposition of small stores, limited ranges and a private-label focus. [caption id="attachment_84312" align="aligncenter" width="731"] Jack’s store
Source: Tesco [/caption] However, we note some differences to the offerings at Aldi and Lidl, which we think put Jack’s at a potential disadvantage:

• Instead of stocking the kind of “fake brands” that customers see in Aldi and Lidl, all of its private-label products are offered under the Jack’s name. Aldi’s and Lidl’s brands encourage shoppers to switch from a brand-heavy basket of goods at nondiscount retailers to a private-label-focused basket at discounters. The single-label strategy at Jack’s could prevent such switching. Moreover, if shoppers are happy to fill their carts with a single value private label, they can do that at a nondiscount retailer — such as Tesco.
• Aldi and Lidl have developed very strong premium lines, including the Specially Selected brand at Aldi and the Deluxe brand at Lidl. Jack’s offers a single tier of products, providing little opportunity for shoppers to trade up.
• Our final concern regards the Jack’s claim that “8 out of 10 food and drink products will be grown, reared or made in Britain.” In the UK, Aldi and Lidl have strongly pushed their British sourcing credentials — but this push has largely been limited to fresh categories such as meat, dairy, fruit and vegetables, while imported products have made a significant contribution to the two grocers’ premium ranges. The Jack’s 80% British promise makes it difficult for the banner to cater to this demand for imports, and this challenge dovetails with the limited premium offering mentioned above.

At April 18, 2019, Jack’s had just nine stores. VERDICT: Doubts linger over “me-too” formats Tesco’s management has hailed its discounter-type private labels as a success, pointing to the already-high adoption rates. However, we are more cautious about the Jack’s venture. Its apparent position at the lower end of the discount spectrum threatens to limit its appeal to shoppers. Moreover, Sainsbury’s made a similar foray into discount formats between 2014 and 2016, when it launched a chain of Netto discount stores in a joint venture with Netto Dansk (Netto Dansk had abandoned its solely owned operations in the UK market in 2010). The two-year joint venture was limited in scope, with just 16 Netto stores opened by the time the plug was pulled in mid-2016. Sainsbury’s CEO Mike Coupe said that, to be successful, Netto would “need to grow at pace and scale,” and this would require significant investment that Sainsbury’s was apparently unwilling to commit. This suggests Tesco will need to go “all or nothing” on Jack’s. 4.     Expanding Outside of Grocery Retail, Including Through M&A Several of the biggest grocery retailers have looked outside their core grocery retail operations for opportunities to grow sales and build margins. In March 2016, Sainsbury’s issued an ultimately successful bid for Home Retail Group, whose main interest was the Argos general-merchandise chain. The acquisition boosted Sainsbury’s higher-margin nonfood business, albeit at the cost of exposure to more cyclical discretionary categories. And, the company has cut costs at the acquired company by installing Argos shops-in-shops in larger Sainsbury’s supermarkets while closing some standalone Argos stores. Sainsbury’s is currently pursuing a merger with Asda, which we discuss later. In January 2017, Tesco announced a merger with Booker, the UK’s largest cash-and-carry wholesale supplier. The merger further boosted Tesco’s scale (though by less than 10%). Tesco pointed to the potential for it to capture greater share in the faster-growing, £85-billion out-of-home food market, as well as generate £175 million in cost savings and £25 million in revenue synergies. To this end, excess space in some Tesco hypermarkets has been carved off for cash-and-carry-type operations under the Chef Central banner. In February 2016, Morrisons struck a wholesale supply deal with Amazon, under which the supermarket chain supplies groceries for sale on Amazon Pantry and Prime Now. In August 2017, Morrisons signed a wholesale deal to supply grocery products to convenience chain McColl’s, which prompted Morrisons to launch a new range of private-label products for wholesale customers, including independents, under the Safeway brand. In fiscal 2019, ended January 2019, Morrisons reported it reached £700 million annualized wholesale supply sales, ahead of its end-2018 target date. It expects to make £1 billion in annualized wholesale supply sales “in due course.” VERDICT: Diversification has proven generally successful Diversification has been successful, reducing retailers’ reliance on the core grocery retail sector while driving grocery volumes through adjacent channels, giving them access to higher-margin or faster-growing markets. The wholesale model, such as that adopted by Morrisons, looks particularly successful. Morrisons enjoys a degree of vertical integration and is a significant food producer in its own right. Wholesale has driven its strong comparable sales growth and, as noted above, its wholesale operation is on course to become a £1 billion business. 5.     Seeking Greater Scale Through Combination The disruption in the UK grocery market has prompted a proposed merger between two of the biggest players: Sainsbury’s and Walmart-owned Asda. The planned merger would effectively be an acquisition of Walmart-owned Asda by Sainsbury’s and Walmart would own 42% of the combined business. The CMA is currently conducting the second phase of its investigation into the proposed merger. However, on February 20, 2019, the CMA published its provisional findings, indicating that it could be a bad deal for consumers and that remedies could include the company being forced to sell one of the brands as well as a tranche of stores. The commentary was a shot across the bow for Sainsbury’s, which is effectively acquiring Asda, and throws the deal into serious doubt. In its provisional findings, the CMA stated that “shoppers could face higher prices, reduced quality and choice, and a poorer overall shopping experience across the UK.” The CMA noted several potential options for addressing its concerns and restoring competition in the market, including requiring the merging companies to sell off a significant number of stores and other assets — potentially including one of the Sainsbury’s or Asda banners — or simply blocking the deal. Despite the onerous criteria that would likely come with a store-disposal requirement, the CMA noted: There is a significant risk that a divestiture will not be effective in this particular case given the substantial scale and complexity of [store] divestiture likely to be required, the potential impact of a divestiture of this scale on the ongoing operations of the parties, and the practicality of the divestiture process itself. On March 19, 2019, Sainsbury’s and Asda issued a statement saying they strongly disagreed with the CMA’s provisional findings and making extra post-merger commitments. These included delivering £1 billion of lower prices annually by the third year, post-merger, a cap on Sainsbury’s fuel gross margin and improved payment terms for small suppliers. VERDICT: Doubts over viability of merger We see little surprise in the CMA’s conclusion that the merger could drive up prices over the long term, even if Sainsbury’s and Asda give pledges that apply to the medium term. The merger would result in a highly concentrated UK grocery market: At their current scale, Sainsbury’s and Asda would together control 31.2% of the UK grocery market, according to Kantar Worldpanel data. Sainsbury-Asda and current market leader Tesco would in total control almost 60% of the UK grocery market, creating an exceptionally consolidated market. The CMA’s announcement indicates that even if the it allows the merger, it will require a substantial number of store disposals, and these would most likely be large superstores given Asda’s focus on this format. This could bring risk for Sainsbury’s and Asda:

• Disposing of a large tranche of stores, or even one of the Sainsbury’s or Asda banners, could undermine the economics of the merger.
• The merged company may struggle to dispose of the large number of superstore sites it has: Rivals may not be interested in superstores given that UK grocery retailers are shifting from large stores to smaller formats — and are opening fewer stores.

There are no signs of Sainsbury’s abandoning the merger. But, its core business needs fixing in the near term, and a challenging merger process could further distract Sainsbury’s management from confronting the retailer’s existing challenges. The CMA will issue its final report by April 30.

Key Insights

• Nondiscount grocery retailers have undertaken radical cost-cutting, shedding thousands of staff in several rounds of job cuts at head-office and store levels. Generally, the visible impact to shoppers seems to have been minimal. However, we perceive a slippage in store standards at Sainsbury’s that is risking its long-established differentiation.
• Range reductions have allowed Tesco to channel higher volumes through each line. Its range resets have coincided with a recovery in its top line and a return to total volume growth, confirming that shoppers have not been deterred by slimmed-down ranges.
• Tesco’s new, discounter-type private labels look to be a success, although they are encouraging some trading down at the retailer. Tesco’s launch of the Jack’s chain is a bold move, but we think the position at the lower end of the discount spectrum limits its appeal.
• Diversification away from core grocery retailing has been successful, creating new revenue streams and growing grocery volumes through nontraditional channels and giving retailers access to higher-margin or faster-growing markets. The wholesale model, such as that adopted by Morrisons, looks particularly successful: Wholesale has driven its strong comparable sales growth.
• There are doubts over whether the planned Sainsbury’s-Asda merger will succeed. Sainsbury-Asda and current market leader Tesco would in total control almost 60% of the UK grocery market, creating an exceptionally consolidated market. And the CMA’s announcement indicates it would require a substantial number of store disposals or even eliminating either the Sainsbury’s or Asda brand, which would undermine the economics of the merger.

Appendix: Aldi and Lidl Selected Metrics Aldi and Lidl are characterized by limited choice, smaller stores and a very strong emphasis on private label: We provide selected metrics on these three measures in the table below. For comparison, market leaders Tesco and Sainsbury’s had average supermarket sizes (excluding convenience stores) of around 37,000 sq ft and 35,000 sq ft, respectively, in fiscal 2018. Nondiscount supermarkets traditionally stock around 30,000 grocery SKUs versus 2,000 or fewer at the discounters. [caption id="attachment_84313" align="aligncenter" width="720"] *Based on new stores.
Source: Company reports/Kantar Worldpanel/CMA/Coresight Research [/caption]