Amazon’s recent acquisition of Whole Foods has shaken the grocery industry, and its impact is already being felt. But the industry’s troubles go deeper than the sea change likely to be brought about by the tech giant. Traditional grocers and, by extension, consumer packaged goods (CPG) companies and grocery-anchored real estate investment trusts (REITs), were already facing a significant threat from retailers known as “hard discounters,” such as Europe-based grocery chains Aldi and Lidl, that are making inroads in U.S. markets.

Not Just Discounts, but a Different Model

Compared with traditional U.S. grocers, hard discounters offer a unique approach to the business of selling groceries. Rather than offer shoppers several brands of a single product like paper towels, hard discounters focus on providing one high-quality, private-label option at a lower price point than the branded versions available at other stores. They also avoid the rotating special discounts that traditional grocers use to draw foot traffic into stores.

This approach enables hard discounters to stock fewer items and eliminates the need to reshuffle their stock based on whether a particular item is on special. Fewer items mean smaller stores as well as fewer employees, resulting in lower real estate and labor costs. Meanwhile, many customers appreciate hard discounters’ lower, steady price points, reliable quality and the reduced complexity resulting from having fewer brands to choose from.

Aldi already has a strong U.S. presence, with more than 1,600 stores, and it plans to open another 900 locations in the next five years. Lidl is just getting started in the United States but has declared its intention to open as many as 600 stores there.

Hard Discounters Offer Consumers Substantial Savings

How Private-Label Products Benefit Stores

Private-label products, also known as store or phantom brands, may carry the name of the store offering them but, more often today, are sold under a brand name created by the retailer. Offering a portfolio of private-label products provides several benefits to stores—both hard discounters and traditional grocers. Importantly, they are cheaper for stores to procure than branded goods, which enables savings to flow through to customers. Private labels also help shift the balance of power toward stores and away from CPG companies. For traditional retailers that sell a mix of private-label and branded items, having a strong private-label portfolio can act as a bargaining chip when negotiating prices with CPG companies because these store-branded items pose a threat to their hard-won market position. For hard discounters, a heavy focus on private-label items gives them significant control over what they sell and how items are placed on shelves.

Wide-Ranging Impacts for Grocers and Related Businesses

We believe the influx of hard discounters in the United States will help reshape the grocery industry. Traditional U.S. grocers will see increased pricing pressure as they try to compete with the consistently low prices offered by hard discounters, resulting in lower margins. As hard discounters draw market share from traditional grocers, CPG companies will also suffer as those customers shift their dollars toward private-label items.

The rise of hard discounters may also hurt REITs that contain shopping centers with grocery stores as anchor tenants. Increasing competition is likely to hasten the pace of consolidation among traditional grocers like Kroger and Safeway, and hard discounters are demonstrating that it’s possible to thrive with smaller store footprints. Fewer supermarkets and less demand for large spaces may leave REITs facing rising vacancies and lower rents.

A Vigorous Response Likely from Walmart

The country’s largest retailer, Walmart, has firsthand experience with market share loss to hard discounters in Europe, where it owns the Asda chain of supermarkets. As these stores encroach on its home turf, we anticipate an aggressive response from Walmart that, given the company’s size and influence, could overshadow the impact of the hard discounters themselves.

Walmart has already engaged in a multi-year initiative to improve the in-store experience for customers by lowering prices and offering higher wages to attract better employees. These investments have come at the expense of earnings growth, but the company views the tradeoff as essential to improve its long-term competitiveness among brick and mortar retailers.

Today, Walmart is expanding this initiative to include its suppliers. While it has not traditionally charged fees for preferential shelf space – a practice common among traditional grocers – the company is starting to demand financial concessions from suppliers that lower the wholesale prices of the products. CPG companies that want to continue to leverage Walmart’s distribution platform will be forced to pay the concessions or risk being displaced by competitors or Walmart’s own growing private-label portfolio. This new policy is likely to help Walmart keep its prices competitive, enabling it to draw share from traditional grocers while also fending off the newer hard discounters.

Investing in Change

It’s worth noting that the companies poised to succeed in the context of this theme tend to be private, like Aldi, Lidl and many private-label manufacturers, or family controlled, like Walmart. These companies are often run with a longer-term mindset than public companies that are beholden to investors who judge them on a quarterly basis. As such, they can withstand short-term pain in the service of longer-term rewards. Within our portfolio, a handful of the companies that we believe are most likely to suffer in this disrupted environment – larger traditional grocers, CPG companies and grocery-anchored REITS – are attractive targets for short positions that stand to benefit from a share price decline.

Five years ago, traditional grocers were adjusting to stiff competition from mega-retailers like Walmart and Target. Today, the nature of the competition has changed irrevocably and the pace of that change is accelerating. Many forces – including an influx of hard discounters – are working against companies involved in the traditional grocery business. While we’ve already seen share prices for traditional grocers drop by as much as 35% in 2017 (largely, though not entirely, on the heels of the Amazon-Whole Foods announcement), we believe the pain is likely to continue over several years. In our next blog, we will examine another critical factor impacting the grocery industry: the rise of online shopping.

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