Friday, February 28, 2020

The Aldi Business Model

Note: after reading "Bare Essentials: The ALDI Story", I wrote a word document that was posted on this blog with what I thought were the key points of their business model. In this article I will dive deeper into that.

PDF version of this article

Over the course of this article I will dive into some of Aldi’s core beliefs and ways of doing business. But first, let’s have a look at this table, that succinctly explains their extraordinary success.

Aldi is the 5th largest retailer in the world. Because of Aldi business model, hard discount stores’ sales account for about 50% of grocery sales in Germany versus about 20% for Europe overall. Hard discounters have become more and more important in Europe, doubling their share of grocery sales since the beginning of the 1990s. 

In the last 20 years, however, the company has changed with a new wave of “professional managers” deviating the company from its original roots. However, below I will go back to some of Aldi’s most basic principles and understand how the operation worked. The company has actually been quite secretive for a long time due to the way it’s fiscally organized - German regulations didn’t mandate the company to disclose its books because Aldi was not under one company, but under various “independent” companies. 

Aldi began in 1948 with two brothers a couple of years after the Second World War with a 100 sq. meter store. They only stocked the essential items - frugality was not an option, it was the only way to survive as capital was scarce. The plan, as one would expect, was to expand the product range and naturally increase the number of stores to compete more effectively with the other shops. Offering a wide range of groceries, was and is, something customers like. Nevertheless, what the brothers realized was that actually, they were quite successful with their limited product range, and because of that operating costs as a percentage of turnover were a fraction compared to other operations. This allowed the company to have a smaller gross margin (cheaper products) and still have the same (or higher) pre-tax profit margins. 

Aldi has standardized and strict policies. Stores are 1,100 sq. meters, 5 isles and 15-25 workers. No decorations (and items are left in their pallets) and a policy of avoiding high-rent locations - no shopping centers, but instead it chooses peripheral areas. Its product range consisted of ~250 items versus several thousand for other supermarkets (one kind of rice, one kind of beans, no packaged legumes since packaging makes products too expensive). And mark ups range from 5-12%. Average turnover per store is over EUR 7M. The company also kept to growing organically, choosing only acquisitions in foreign countries. 

Operational expenses as a percent of turnover are about 11% at Aldi, 18% for Jerónimo Martins and 20% for Walmart. As for Continente, which has the largest number of stores in Portugal, there’s no segmented information given by its parent Sonae. However, we can assume a 20% gross margin (in line with Pingo Doce and other supermarkets). That would get us to operational expenses of 18% of turnover. I would estimate it’s actually higher than this. Continente usually chooses more premium locations like shopping centers. And the turnover and EBIT figures I’m using to do this don’t only include Continente but some other stores too – although Continente accounts for the majority of sales. Part of the higher costs as a percentage of turnover is reflected on the fact that around 40% of Continente’s stores have a sale area of almost 7,000 sq. meters with about 35,000 SKUs. 

How do the economics of a supermarket with a much smaller range work? Aldi’s turnover per item is +5x as Walmart’s. Less inventory means less storage space is needed; therefore, distribution centers can be smaller. In other words, items sell faster, there’s more inventory turnover which means you can have smaller distribution centers. It also means less employees stocking items, less employees checking expiry dates. At a supermarket an item must be “sourced, negotiated, ordered, stored, suppliers are checked and audited, packaging is designed” and prices have to be chosen, which adds a lot of complexity. Obviously, it also means less working capital and more cash generation ability. Higher inventory turnover also means supermarkets sells product to customers and collects cash very quickly, in other words, quicker than they need to pay suppliers, meaning merchandise suppliers finance the business. This is a key point in such an inventory-dependent business as a supermarket, as the invested capital turns out to be less, and therefore returns on capital are higher.

Note: I only had 2017 figures for Aldi, so I used 2017 figures for all the companies.

Have you every walked into a small, local, grocery shop? How many varieties of milk or coffee will you find from different brands? A small selection is vastly better. That extends to the procedures for quality control, which are different when you have 20,000 items or 2,000 items. In this respect, Aldi resembles Costco, which has a profit margin of 2.4%.

Procter & Gamble has estimated that at large supermarkets, a quarter of all items do not sell more than once a month. That’s very valuable real estate that’s being thrown away for product that is not moving. That’s a lot of money tied up. Let’s think about a supermarket with 20,000 items, 10,000 stores and a product that costs the supermarket EUR 1.00 and retails for EUR 1.05. A quarter of those items only sell once a month, so in those 10,000 stores, there’s EUR 50M, every single month, tied up in items that do not sell. Your gross margin is a terrible 5% and your returns in capital is non-existent because you are only turning them over once. In supermarkets gross margins are not very high, so high inventory turnover is a must to cover operating expenses and for high returns on capital. 

Private label has also been something that Aldi pursued religiously, almost all items sold are private label - these unbranded items are typically made by the same CPG companies. Private labels did as well or better than branded products, and the price was vastly different. At Continente, only 30-40% of SKUs will be private label. 

Part of Aldi’s lesson is that if you’re not giving your customers a wide range of product then what you have to give them are the lowest prices.


Back to history: by 1950, there were already 13 stores - with over-the-counter service. And in 1961, the brothers divided their chain into the North and South business units, the former being more adventurous. Decentralization was important to Aldi, as it has been for Berkshire Hathaway. Decisions were made quicker, and all numbers, prices, etc. were discussed between the brothers - except profit figures. 

To know if you’re looking at an Aldi North or Aldi South store, just look out for the brand logo:

An Aldi company will not grow to more than 80 stores (at an average turnover of EUR 6M per store, each company does about EUR 500M in revenue), as when this point is reached a new Aldi company is created with its own bookkeeping, sales, logistics department, etc. Through this method details become more important, there’s more flexibility, less complexity, less hierarchical layers, more internal competition between Aldi companies and employees don’t feel part of a big, anonymous organization. 

One of the most basic arguments for centralization is that double-costs are avoided. Whether it’s sales, accounting, etc., being kept to one central location is better. Aldi view is that it’s better to have 1 million things to work on at 10 different locations, than 10 million at 1 location. More data gets more generalized and is not looked over as thoroughly as if one were only looking at 1 million things. 

Low prices and good quality have many advantages, but one of those is that the product sells itself. Aldi spends very little on advertising. How little? Well, 20 years ago it was as little as 0.3% of turnover, Walmart currently spends 0.7% of turnover and Costco doesn’t advertise.

The Now

In the last 20 years, Aldi has increased the assortment - partly because of pressure from companies like Lidl, where companies battle for sales growth - and the management from the 90s has been replaced by “professional managers”, 

Now the company ‘boasts’ over 2,000 SKUs, which can translate into 4,000 different items (vs. +20,000 for other supermarkets). Nowadays, at big supermarket chains, as Dieter Brandes says, shelves are almost vendor trade booths. By 2017, total turnover was EUR 82bn, and with 4,000 items, that’s a turnover per item of EUR 20.5M. For a hard discounter to be successful strict discipline is needed and high inventory turnover is required for a high ROIC. 

However, one can argue that Costco – a retailer with a 2.4% profit margin and a 11% gross margin (vs. typical supermarkets +20%) – has 4,000 SKUs and still manages to offer low prices. How come? Costco is efficient, as efficient as Aldi used to be. Items are sold in warehouses with no decoration. Furthermore, and again like Aldi, when a product is delivered by the truck to the supermarket, the forklift simply takes the product to the sales floor – no time is spent on unboxing, moving and stocking inventory. The major difference between Costco and Aldi is that the former requires that people be members of their program to be able to shop there. There are 50M members paying $60 a year each – that’s $3bn in revenue that drops to the bottom line. Naturally, this program lets Costco “subsidize” their operations. Costco also pushes people to spend more per item because they only sell in bulk size – on an absolute basis Costco makes customers pay more for Ketchup, but on a relative, per milliliter basis, customers pay less. 

Whilst Aldi still carries a fraction of the items other supermarkets carry, the advantages of being a disciplined hard discounter are eroding. Aldi is increasing its assortment and putting itself in a position where it’s no more a hard discounter, but also doesn’t sell as much product as a big supermarket. Is there a market in between? Will Aldi try to put its stores in better and better locations, more decorations, etc. to make up for the fact that is sits in between two business models? Perhaps, and competition from the likes of Lidl, might even determine the company to do more of that. Advertising spend as a percentage of turnover is 5x more than it was 20 years ago. The company has been losing focus from the principles that allowed it to get where it is.

(Now these figures are not totally fair for Aldi. The figures come from Aldi Portugal, consisting of 68 stores, and naturally the turnover on opening is not the same as when the stores reach a certain level of sales - as is evidenced by the inventory turnover increasing from 10 to 17. In Portugal the company does EUR 260M in turnover, which is almost EUR 4M per store (same as Lidl), which is under the average of EUR 7M+.) 

It’s very tempting to add another product, because when talking about more than 14,000 stores, a new product that sells just 3 times a day and retails for EUR 2.00 in every store, will add more than EUR 30M in revenue. The costs and complexity are not so much a quantitative calculation that can be easily done.

Besides increasing the number of items, inventory losses (known as “shrinkage”) have increased as more fresh products are added; more brand-named products have also been added, which reduces price competitiveness; and price promotions have been intense. Price promotions confuse the consumer, it will lead them to question what that item is actually worth if on one week you can keep the same item for €2.00 and the next for €1.00. In Portugal, for example, Lidle has been extremely aggressive in this respect, and other retailers have jumped on the bandwagon, including Aldi. The percentage of sales under promotion in Portugal has gone from around 20% in 2011 to probably around 40% today. 

Aldi South has had success abroad, penetrating countries like the UK, Portugal, etc. Not only because of its merit but because the competitive landscape in other countries, like the UK, was very poor. Tesco and other retailers, for example, had high margins for a long time due to not being exposed to serious competition. Tesco had to increase margins to finance the ever-increasing cost and complexity of their 90,000 items. In fact, a significant part of profits came from listing fees from vendors.

Whether Aldi does well or not over the next is hard to tell. It's still doing well abroad and hard discounting is still taking share from grocery sales. But it's certain that the philosophy has changed, and it shows how hard it is for an excellent company to survive the test of time.