Major Changes Are Coming to the U.S. Grocery Industry

In the next five years, German low-cost grocery chain Aldi is planning to spend billions expanding its U.S. footprint and revamping existing stores. Meanwhile, its fellow German rival, Lidl, is also taking steps to make its debut in the States.

In this episode of Industry Focus: Consumer Goods, Motley Fool analyst Vincent Shen is joined by Fool.com contributor Dan Kline as they discuss the new competition and how established chains like Kroger and Publix will have to slash prices to respond. They also cover the latest news from Microsoft (MSFT -1.27%), which officially unveiled the Xbox One X at the Electronic Entertainment Expo, and Wal-Mart (WMT 0.46%), whose employees may soon be showing up on your front step holding your online order.

A full transcript follows the video.

This video was recorded on June 13, 2017.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen, and it's Tuesday, June 13th. Last week, we looked at the S-1 IPO filing from meal kit delivery pioneer, Blue Apron. If you consider that an example of growing competition in the groceries industry at least on one end of the spectrum, our main topic for this episode comes from the other end, a more traditional brick and mortar expansion from the German grocery chain Aldi. We'll also spend a few minutes talking about interesting news from Wal-Mart and Microsoft, in addition to the expansion we're expecting from Aldi. Joining me via Skype today is Fool.com contributor, Dan Kline. Thanks for being here, Dan.

Dan Kline: Hey, Vince! Thanks for having me!

Shen: Sure thing. Kicking off, because we have a lot to talk about today, let's start with Microsoft. Back in March, I covered major developments in the video game industry, one of those was the expected launch of a console update from Microsoft, which at the time was just called Project Scorpio. I want to circle back on that story since the Electronic Entertainment Expo has officially started this week, and Microsoft made its big announcement, giving Project Scorpio an official product name, the Xbox One X. A lot of the rumors and projections for the new console have borne out. It touts 4K graphics, backwards compatibility, so your One X will play many of your old Xbox, Xbox 360, and Xbox One titles, while also working with your Xbox One accessories. Microsoft claims on its product page that the Xbox One X is "the world's most powerful console, with 40% more power than any other console." Dan, what are your first impressions here?

Kline: It's really expensive, and nobody is going to buy it. [laughs] But, I don't think that's what Microsoft is going after. It's $499. And Microsoft has already shown that people will buy a cheaper console rather than spend $499. They tried that last time when they introduced Xbox One, or the Xbox, and it had the motion detector, I don't even remember what it was called --

Shen: The Kinect.

Kline: The Kinect. And basically, people waited until they sold an unbundled version, and that gave Sony (SONY -0.71%) a little bit of a lead. But, Microsoft still has those products. This is a lot like what Apple does with the iPad Pro. They don't think a huge percentage of their audience is going to go buy the iPad Pro, but they want to capture the small percentage that want that, and have a building block for the future. So, this is the next Xbox that only a very small percentage of people are going to buy, and then, if the prices come down, they will eventually be the $399 Xbox or the $349, and it will be the one that ties in really well with HoloLens and all the other things that require processing power that Microsoft is building, and will become norms, maybe not this year but over the next few years.

Shen: Yeah. I think that's a very good point. I was thinking about who this console is really targeted for with the release, the price tag, the specs. Obviously, you have your die-hard Xbox fans out there. But, ultimately, this is still just an improved rehash of the Xbox One S that came out last August. So it's not a true next generation release.

Kline: Yeah. And we're probably seven or eight years from a true next generation. So this is really an answer to Sony having a similar high-end console, although I believe it's a little cheaper, and it's really building the platform so they can start to build out virtual and augmented reality. It doesn't add very much new, except a faster processor and 4K support. The previous Xbox One had the backwards capability, as well. So it's meant to be exciting, but the reason you announce this at E3 is because it's for hardcore gamers. It's not, right now, a mainstream product.

Shen: And the thing is, you have the Xbox One X, but I think the big thing this console lacks is these new titles that are coming out along with it that are exclusive and will gen up a lot of interest in the product. You have these Xbox One X Enhanced titles that will be able to take advantage of the more powerful hardware and specs in this release. Otherwise, the technology in the One X is supposed to make existing titles look better, and there might be updates to existing titles to help bolster their graphics with the 4K support.

Kline: Do you have an Xbox One?

Shen: I do not.

Kline: I do. And I've never looked at any game and thought, "Wow, this isn't really awesome." And I'm older than you, I remember playing Pac-Man on an Atari 2600, where it was amazing because it kind of looked like an arcade, so admittedly I'm somewhat easy to amaze when it comes to games, given when I started. But I don't think there's any person who's going to spend an extra $150 just for those enhancements, especially because you have to have a 4K TV to take advantage of them. This is really for the people who have that, they bought the 4K TV, they understand the difference, they watched the little bit of programming that's available. It's really just a niche audience, but eventually it will be a bigger audience.

Shen: I will add that 4K televisions are expected to make up about one in four TVs shipped worldwide in 2017. So the penetration is still limited, but a lot of the forecasts out there do say that 4K TVs are expected to grow in popularity, and become a bigger portion over time.

Kline: Sure. Shipped is not sold, though. They shipped a lot of 3D TVs as well.

Shen: Fair enough. Final takeaways for me, at least, I think the point you made about how this feels a little bit like history repeating itself. So you go back to 2013, a little bit of context, Sony and Microsoft unveiled their actual next generation consoles -- being the PlayStation 4 and the Xbox One -- and Sony priced the PS4 at $399, Microsoft charged $500 paired with that Kinect that you mentioned, Dan. And that ended up hurting the company, I think, with a little bit slower momentum in the beginning. And four years later, the divide in terms of sales performance between these two consoles has widened. Sony has led this generation with about 60 million units sold, and while Microsoft does not report numbers for the Xbox One, estimates put sales at approximately 25 to 30 million.

So today, we have this similar situation, the PlayStation 4 Pro, which is the closest competitor, released last year by Sony to this Xbox One X, runs $399. Then, the Xbox One X, you mentioned, it's $500, $100 more expensive. It might have stronger specs, but really, are they enough to get most consumers to buy in? And based on the experience so far, Sony hasn't released any specific sales numbers for their PlayStation 4 Pro but said it made up about 20% of PlayStation 4 sales since the release, so estimates of around 2.5 to 3 million. So not a blockbuster seller by any means. It will be interesting to see how they compete, $500 for the Xbox One X versus $400 for the Pro. The console is being officially released on November 7th.

Moving onto our next topic, we have Wal-Mart sales associates taking to the road. Dan, you pointed out this news to me recently. We often hear about how major brick-and-mortar retailers want to leverage their extensive geographic footprints as an advantage over online competitors. You have all these stores located across the country, whereas more pure play e-commerce players might have more limited networks of distribution fulfillment centers. These efforts, though, take various forms. And Wal-Mart is taking an interesting approach, announced earlier this month, where they want to have store employees actually deliver some of their online orders to nearby customers. This is a small test, with just one store in Arkansas near the company headquarters, and two in New Jersey, which is closer to the base for Jet.com, which Wal-Mart acquired for about $3 billion recently. The number of orders fulfilled this way with employee deliveries, it's only in the hundreds so far, so a very small test. What do you think, Dan? Is this another innovative idea? Or is this another dart in the wall among many efforts?

Kline: It's a mindset. When they bought Jet.com -- and I've written about this a lot of times -- they bought them largely from Marc Lore, the CEO, the serial entrepreneur. I saw Marc Lore speak at Shoptalk, and he talked a lot about infusing a start-up mentality into Wal-Mart. I used to run a piece of my family business, a ladder and scaffolding company, and if a customer called and said, "I need two braces or my scaffolding can't get up," because we were a family business, we had an all-hands-on-deck mentality. If that meant throwing it in the back of my station wagon and driving it out there in the middle of the night or on my way home or whatever it was, that's what you did. And that's what Wal-Mart's doing here. I don't think they expect that a large percentage of their orders are going to be delivered by store employees on their way home. But this is just creating a mechanism. You can't do it willy nilly at a big company the way you can at a small company. This is creating a system where, if an order needs to go out, a manager could say, "Hey, anyone going home in this direction?" Someone can raise their hand, the employee can get compensated for it. It's a failsafe. It's a start-up logic. At Jet.com in the early days, when you're trying to ship orders, anything goes. Marc Lore was probably stuffing boxes, that's just how it works. So this is really about getting Wal-Mart to think, "We are not a physical store, we are in the business of getting products to people however they want them."

Shen: OK, fair enough. Some numbers I will throw out there, though, to put this into perspective -- I know right now it's a limited test, and you're right, whether or not it becomes this major avenue through which they can bolster their e-commerce business, which has been growing quite well since their Jet.com acquisition, since Marc Lore has taken over the online side of the business. The company has 1.5 million U.S. employees. They mention this in the blog post about this initiative -- 90% of the U.S. population lives within 10 miles of a Wal-Mart store.

So how this essentially works, in terms of the details, the employees only need to have their own car, they need to pass a background check, and then they get outfitted with a mobile app that essentially plans their deliveries based on a route that's convenient to their commute. Then, they can deliver up to 10 packages daily, and there's some weight and size limits of their choice so that they can handle it. You mentioned that the company says that the employees are paid for their time, although there are very little details released regarding how, whether it's the number of packages you deliver or the amount of time you spent delivering them. But when it comes down to it, this touches on a topic, I think, that Dan, you and I covered quite some time ago, probably a year ago or more, when we were talking about last mile delivery and logistics, the idea that you might be getting your package from across the country, but that last mile often accounts for 50% or even more of the actual expenses of the delivery.

Kline: It's the big challenge, it's why Amazon has put warehouses in different markets, and they're working on crazy things like drones or trucks that can 3D print your item as you order, and pretty much every way possible working with partners to get it to your actual house. This, for Wal-Mart, becomes another arrow in the quiver. They're not going to stop using planes and trucks and distribution warehouses for online orders. But there's going to be times when you go to order something and the only one of what you order is in a warehouse or a Wal-Mart store three miles from your house, and the logical way to do it is pick it off the shelf and bring it to you. And that's something that Wal-Mart has been working on with internal apps and different tools so that their logistics get better, so they don't have one inventory for the store and one inventory for the digital operation. They're trying to make everything one operation. Having been a retailer myself, in a much smaller way, it is a big challenge when you have customers shopping in the store, and even someone who calls you up and says, "Do you have a so-and-so, can you set it aside for me?" when multiple people want the same thing at the same time. So this is a big headache for Wal-Mart, but they're figuring out how to get it done, and they're throwing a lot of technology at it and matching it with, "Hey, who's willing to help out?" which should be good for morale. And when a Wal-Mart worker shows up at your door to deliver your package, that's going to be good for brand loyalty, as well.

Shen: I will add, we talk a little bit about the expense side with last-mile delivery, and also the turnaround time. Obviously, you have the Amazons of the world competing with one-hour delivery, two-day standard. Wal-Mart noted that a lot of these employee-delivered packages made it to customers the day after they placed the order, so essentially an overnight fulfillment. This is, I think, another example, when it comes down to it, of how the company has tested partnerships. They went with ride-hailing services like Lyft and Uber delivering packages previously. You have companies like DoorDash and Instacart offering similar services. But this is just a little bit more efficient, instead of having the drivers from those companies come to your store, pick up the package, and deliver it, you have employees doing it on the way home. I think it will be really interesting to see, going forward, what other ideas like this Marc Lore will bring to the table, now that he's running the online business. It shows, the way you mentioned, this mindset, and how they are willing to experiment and grow that part of the company as necessary.

Kline: Yeah, I think everything is in the mix. If you're in a market where delivery via sled dog makes sense, or hot air balloon, or whatever it happens to be, or putting it on a raft and floating it out to the iceberg, all of these things, in some tiny way, are going to figure in -- OK, probably not the last one, but most of these things are going to figure in. And Lore is just building this culture of, we have promised a customer two-day delivery, how do we meet or beat that? And that's a very Amazon way of looking at things. I'll point out, as someone who orders five or six things at minimum a week from Amazon, it's pretty often that the two-day delivery shows up in one day.

Shen: Onto the Aldi expansion, with the expected price war that's heating up among the various players in the grocery industry in the U.S., the news is Aldi is spending about $3.4 billion to expand its store network, hit about 2,500 locations over the next five years. The company currently has about 1,600 stores. They will add 400 in 2017, and it well spend another $1.6 billion to remodel a significant number of them. On top of that, to throw another player into this, fellow German low-cost competitor Lidl will be opening its stores this month, June 15th, as it plans an initial base of 100 locations. The first ones are opening up in the Carolinas and Virginia. These are definitely some first shots in that price war that I mentioned among the grocery stores and supermarkets. Lidl has touted prices up to 50% lower than competitors. Aldi says they will be at least 21% lower. Do you think that the entry of these companies and the expansion of some of these German competitors is going to really shake things up like they've managed to do in Europe?

Kline: I think it's great for the American consumer on a number of levels. There's already been pricing pressure in the grocery game, because you have Amazon and other players who can deliver you some items, if not all items in certain markets. But Wal-Mart has already come out and said it's going to invest in pricing. Costco, when they raised their membership fees, said, "We're going to put most of this increase back into lowering pricing," which is what they have traditionally done, it's not necessarily a response here. But if you are in a market -- and I live in Southern Florida, we have Publix. Pretty much that's all we have. There's a lot of Publix, there's occasionally a Whole Foods, and sometimes there's a Trader Joe's. There isn't a Trader Joe's near me. If a Lidl or an Aldi comes in and it's conveniently located in the same realm as the Publix, Publix is going to have to go, "OK, my prices, I have to think about that." So, just the presence of competition is great for consumers.

The other really important thing about this, and it's partly why these companies are moving now, is that we have a glut of available retail space. So these companies -- and these are small stores, 12,000 to 20,000 square foot stores between the two chains -- they're going to snap up space in strip malls and malls that needs to be filled. And that's going to be good for other businesses. Even some businesses that are doing well, but are being hurt by the fact that, maybe the Sears that anchored their strip mall went out of business. So there's going to be a ripple effect by all these stores coming in.

Shen: Dan, I would like to add a little bit of detail on exactly how these companies operate, so that they're able to offer such competitive pricing. 

Kline: A lot of house brands.

Shen: Exactly. When it comes down to it, for a place like Aldi, to put up these prices where they can claim, "Our prices will be at least 21% lower than any competitor out there," the first thing is what you mentioned in terms of the smaller stores -- 12,000 to 20,000 square feet, versus a traditional Kroger or Harris Teeter, for example, might be around 50,000 square feet or more. The smaller stores means less SKUs, which are essentially, the stock keeping units, or the code, assigned to each item. That gives you a small footprint, it's less of an investment there, and also just a simpler supply chain with these in-house brands which, for Aldi, make up about 90% of their merchandise. This allows the company to work directly with the food producers, and they avoid a lot of the costs of marketing, and also the premium that you get that you have to pay for the big branded products out there when you have these in-house offerings.

Kline: It's also a varied merchandise. When you go to Publix, obviously there's a certain amount of seasonal merchandise. When Valentine's Day is coming up, they're going to have a Valentine's Day section, and that switches to Mother's Day when it's appropriate. But both Aldi and Lidl do things like sell flip flops when it's going to be summer, in a market where that's appropriate. And even their core food offering changes based on pricing. I've often joked that you can't go to Aldi knowing what you plan to make for dinner. You have to go to Aldi and see what they have, and then make your choices, which I have always found is a frustrating shopping experience. But that's how they drive value. If their buyer looks at the chain and says, "I was going to bring in lamb this week, but the prices are too high," they may not have that on their shelves at a given time, and you sort of have to go with the flow, but it does mean you're always going to get a better value.

Shen: Wrapping up a little bit of our discussion, I want to provide a little bit of context here, for what exactly this market looks like, what Aldi and Lidl are diving into, and what the competition and the size and scale of this market is. For U.S. grocery food and beverage industry, we're looking at hundreds of billions of dollars, about $800 billion. At this point, even with its 1,600 locations, reports I could find put Aldi share at single digits, low single digits at that. But it's growing very quickly, whereas if you go to the leader of the pack, which is Wal-Mart, they have closer to about a 20% share of the groceries business in this country. I was speaking to Sarah Priestley, another analyst here at The Motley Fool, before the show, and she brought up an interesting point in that, at this moment, especially with Lidl's entry this month into the market as well, I think a lot of American grocery chains, she mentioned, are getting the warning signs because Aldi and Lidl have made such a big splash in Europe, they're grown their market share very quickly, double-digit rates. From her personal experience back in the U.K., they forced major chains like Tesco to really bring down their prices and changed the competitive landscape there. So when it comes down to it, you have the giants out there like Wal-Mart and Kroger, but these guys can really induce some of those price savings for consumers overall, and change the expectations of what our grocery stores look like.

Kline: And I think it's going to force consolidation. Through the past couple decades, you've already seen not the total demise, but largely, the very small regional chains have gone away, or the single mom and pop grocery stores, a lot of those are gone. So some of these regional chains are going to have to combine to have the buying power. And you'll probably see some traditional grocery stores not be able to make the transition. You now have, in addition to Aldi and Lidl, you have Wal-Mart, Costco, Amazon, prices are being forced down. And unless you're Whole Foods, which has built up a premium audience, and they are having their struggles as well, it's going to be very hard to compete if you can't buy these items at the same prices as these much bigger companies.

Shen: Yeah. My last point here, it's a little bit on competition, going back to Wal-Mart. Their grocery business makes up over half of their revenue. I was reading about a test that they started earlier this year in over 1,000 stores, where they're doing a lot of pricing comparison to beat out places like Aldi and Kroger, in anticipation of this increasing competition, the more stores moving into the U.S. that they'll have to face off with. The hope is that they can lower their prices enough that Wal-Mart thinks they've won over customers pretty definitively, and then they can adjust their pricing as necessary. There were some leaks that Wal-Mart is going to some of their big suppliers, especially for some of the packaged goods -- think companies like Unilever and Procter & Gamble -- and basically telling them, "We need the prices that you charge us to be 15% lower," the idea being that Wal-Mart wants to reclaim the title of low-cost leader --

Kline: And that's a general big box practice. I've done some selling to big boxes, and if you get a SKU in, they will come back to you every year, every 18 months, and say, "How can you make it 3% cheaper?" And in some cases, they will even help you build a new factory, or do whatever it is you have to do, or, you could say, "Yeah, if you placed an order that was twice as big, here's what the price could be." So, they're going to work every angle. I think it's also worth noting that I had a story earlier this week that, at Sam's Club, the Wal-Mart version of Costco, their warehouse club, they consolidated their in-house brand from a whole bunch of different labels under one name. And I think that's something we're going to see more of, where Wal-Mart uses its Member's Mark brand and really tries to compete with these people. That's going to put some pressure on some of these name brands, to either lower prices or find new ways to compete.

Shen: Well, thanks, Dan. Any final points, takeaways with this expansion that's coming up for Aldi, and also for the openings expected from Lidl, before we wrap up here?

Kline: I think the next time I come to Virginia, I would like to see a Lidl. I've been to Aldi, I've been to Whole Foods 365, and I think as an American consumer -- frankly, as someone who cooks dinner every night -- this is an exciting time, and it's something that's going to be interesting to see how this all shakes out.

Shen: Alright. Thanks a lot, Dan, for joining us today. Listeners, you can reach out to us and the rest of the Industry Focus crew via Twitter @MFIndustryFocus, or send any questions to [email protected]. Don't forget to check out our other shows at podcasts.fool.com. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Fool on!