RNG STRATEGY ALERT Understanding Discounters: 6 Basic Principles Oct 2009

Hello: In our report published on February 2009 we introduced the notion of a set of retailers operating under an emerging discounter segment as the number of distressed shoppers in the US climbed rapidly. Today, amidst what RNG expects will be a long & slow recovery, many retailers & CPGs continue to adapt their strategies to target distressed shoppers. Discounters have dealt with this type of shopper for years and have internalized a set of core principles that allowed them to grow in this environment. If the duration of the recovery takes longer than anticipated it is likely that others in the industry will look more closely into understanding & tapping into the discounter channel & its business practices. Read on for rapid view into the core principles that allowed the discounters to emerge during the downturn. For more information you can also download our latest Curriculum presentations on this topic. Kind regards, Aaron Chio Senior Analyst RetailNet Group

Enablers: What's giving rise to the discounters? In our last report we talked about the distressed shopper -- accounting for close to 1 in every 4 people in the US today. In addition, roughly 9 million jobs have been lost in the US during this economic downturn. According to the Wall Street Journal, assuming the average monthly pace of the most recent expansion, it would take 86 months (until December 2016) for the US to regain the job level at the start of this recession. There is no doubt there are millions of shoppers for who price & value is key to their value equation. This and a number of drivers should enable the discounters to continue to grow, including:

● The rise of distressed shoppers, including shoppers who are unemployed, underemployed, fixed income, and distressed shoppers who feel psychologically affected by the macro landscape (i.e., due to loss of wealth in stock market or real estate, unemployment, etc)

● Proximity & closer-to-consumption patterns. Shoppers simply opting to travel less & buying closer to their paycheck cycle by necessity.

● Real estate availability. Thousands of closings in the US have left shopping centers & real estate outlets wide open. Retailers with strong cash flow & balance sheets should be able to benefit from this.

● Immigration patterns. Consumers migrating within the US (from higher-end zip codes to lower-end zip codes, or from emerging to developed markets) might find it easier or more relevant to shop smaller outlets that offer a more austere shopping experience.

● Shift from discretionary to consumables. As shoppers focus on the essentials of life they will seek alternative outlets that match their new needs and situation more closely.

Six Principles for the Discounters

We can generally characterize the discounter's model in six basic principles (see figure below). We'll explore some of the key characteristics of each one of them, but as you read through keep in mind that mainstream retailers are incorporating these business practices into their day-to-day operations (see links underneath each section to other relevant RNG reports)

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Limited Assortment Discounters focus on fast moving but limited number of SKU's (2,000-5,000 SKUs) & categories. Since discounters have fewer & faster rotating SKUs they are able to gain significant economies of scale and buying power for their core assortment, enabling them to price much more aggressively vs. retailers that have 10-20x the number of SKUs and much slower rotation per building. In addition, given their limited assortment, discounters need a very clear understanding of the categories & items they want to win in and will ignore others where they can't gain a significant competitive advantage in terms of scale, pricing, margin & positioning. For this reason, discounters have a relentless focus on those products that really matter to shoppers. How are mainstream retailers thinking about this? See RNG's report on Category Lifecycle Management to understand how retailers are re-thinking their departmental & category assortments.

Low Operating Costs The discounter's real estate & labor model is significantly different from large-box operators. A typical store will have 5 to 10 employees that perform a wider variety of duties to keep labor costs to a minimum. In addition, discounters typically focus their smaller boxes on suburban areas allowing them to procure lower-cost real estate & focus on proximity-based retailing for convenience. Inside their stores, a no frills environment that uses simple messaging & packaging (PDQ's, shelf-ready packaging, pallets, case packs, pre-wrapped perishables, etc) is key to drive labor efficiencies (faster shelving & re-stocking, fewer tags, signage, etc) while keeping capital expenditure investments to a minimum (no frill environment, suburban real estate). Lastly, services & ancillary businesses are rare inside their stores as the added complexity of these businesses are seen as incremental operating expenses.

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How are mainstream retailers thinking about their operating costs? See RNG's report on changing retailer economics.

Limited Merchandise-ability Through the use of shelf-ready packaging, limited merchandising & promotional opportunities discounters are able to limit labor expenses while driving efficiencies into their stores. At the same time, lack of clutter enhances shoppability & navigation inside the store, making for an overall better shopping experience in these non-frills stores. The best discounters have branded themselves through a clear, consistent and dignified shopping experience that gets reflected down to the product with very clear packaging and messaging that stands out on the shelf on its own.

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Limited Marketing In line with their low-cost operating model, the discounter's marketing efforts are minimal. Short circulars are used (if at all), and there is often limited promotional space & brand advertisements/displays inside the store. One reason why discounters tend to rely less on traditional marketing to attract shoppers is the fact that their stores attract a much broader shopping mission that includes convenience, food, and stock-up trips (Figure 1). Real estate & location play a key role here, and as described in the low operating costs section, discounters' business models are well aligned against this. Figure 1: Preferred formats by shopping mission

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Source: Carrefour presentation

Low Prices Executing on all of the above principles allow the discounters to be the opening price point (OPP) players in the marketplace and have substantially lower prices than their competitors. For example, Aldi's company fact sheet says the retailer passes savings to consumers with prices up to 50% below traditional supermarkets. PriceRite says consumers can save up to 50% off of their grocery bills. To do this, discounters will often focus on smaller product sizes that hit a specific price (and margin) target to make their products accessible to lower income shoppers. Oftentimes discounters will actually be more expensive on a per-ounce basis vs. larger-sized products, but smaller sizes allow discounters to hit lower price points. These relatively "low" prices allow shoppers to fill out their carts with little money, feeding back the value perception that shopping this channel offers good value. Lastly, private label plays a key role in their pricing gaps and overall positioning. (see next point)

See RNG's reports on pricing, including pricing optimization, communicating value through pricing, get real on

pricing, and our pricing update.

Like-for-like Product Quality & Offer Key to the discounter model is a heavy focus and reliance on private label brands that offer like-for-like functional performance when compared against vendor brands. Private label helps the retailer drive margins & in some cases in-fill its assortment when a price/margin requirement can't be met by vendors. At the same time, private label allows discounters to be extremely price competitive against mainstream operators despite the fact that products will often be non-comparable because of unique SKU variations from the discounter's private label lines. Nonetheless, discounters have become much more sophisticated about the quality of their products & repeatability of the consumption & shopping experience when shoppers try out their stores & brands. The discounters have taken a very strategic approach to private label brand development and have in many instances emerged from simply replicating national brands to innovating & creating legitimate brands of their own. (Figure: Discounters Authority) Ultimately the key for like-for-like product quality is to surprise the shopper with a product that is better than expected for the price.

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Why is this important? The discounter channel continues to grow & gain scale around the globe, both in highly developed & advanced markets like Europe/US and also in emerging markets like Eastern Europe & Latin America. RNG believes there is a big repositioning going on in the industry, especially on proximity-based & discount retailing. The discounter industry can no longer be accurately viewed simply in terms of hard or soft discounting and limited or expanded assortment; many retailers have proven successful with large and small "first price" assortments of branded and private label products. In addition, there are many points of pressure that are guiding the need to adapt & evolve into new business models to stay competitive. New business models will have to emerge based on:

● Competitive & industry pressure. Are markets reaching capacity?

● Consumer dynamics. Distressed shoppers as outlined before are switching more than ever, looking for value wherever they can find it. That includes both inside the store, but also outside (i.e., online) of the store.

● Financial pressure. Operating expenses continue to rise for most retailers and gross margin pressure continues to push down (commodity prices & lower prices to lure shoppers/remain competitive)

● Entire categories will move to online. Technological advancements & changes in route to market and paths to consumption will change entire categories & departments which will disappear from the physical store and will move to the online world.

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