Quotes of the Day

European retailers sure didn't have a holly jolly Christmas. The annual end-of-year shopping orgy can account for as much as 40% of a retailer's annual sales, but most of the tallying so far has left the big stores crying "Bah, humbug." And the bad news kicked in even earlier. British supermarket chain J Sainsbury last week said its same-store sales, excluding gasoline, fell 1.2% in the third quarter. Two months earlier, the company had declared a $72.5 million pretax loss for the first half — the first loss in its 135-year history. One of its food-and-retail competitors, Marks & Spencer, earlier this month reported a 6% dip in U.K. same-store sales for the third quarter, and warned that factors such as weak Christmas sales meant profits for the year could be as much as $140 million lower than analysts expected. French retail giant Carrefour has been slashing prices to regain market share after a brutal 2004, during which sales at its flagship hypermarkets dropped by 2.6%. And German chain KarstadtQuelle, which already plans to sell 77 of its 181 department stores, posted 9.5% lower sales in the fourth quarter.

From all the gloomy news, you might think Europe has stopped shopping. But that's not the problem; these may not be the best of economic times, but they're far from the worst either. Why are so many venerable stores struggling?

The reason is that Europeans are changing the way they shop. Once loyal to a single local store, they are becoming avid, American-style comparison-shoppers, sniffing out bargains and variety from a large number of competitors. Stores like Britain's Tesco (which now pulls in half of British shoppers every month) and ASDA (owned by the world's No. 1 retailer, Wal-Mart), and Germany's Aldi (the powerhouse of discounters) use their size as a potent weapon in dealing with suppliers. That in turn enables them to continue lowering prices and capitalizing on the price revolution, which has finally hit Europe.

But price isn't the only weapon. When European shoppers aren't taking the low road, buying $7 blue jeans at Tesco or slippers and bratwurst at Lidl, they're traveling the high road: splurging on organic honey at Britain's Waitrose or Yves Saint Laurent blouses at France's Printemps, stores that have demonstrated an uncanny ability to identify and cater to the nuanced needs of high-end consumers. All of which squeezes out the middle. "There are bipolar developments," says Johanna Waterous, a McKinsey & Co. director, who leads the retail practice in the consulting firm's London office. "You see the top end or premium doing very well and the value-led end doing well. Being in the middle is not comfortable."

There's no better value-led example than Tesco. Founded in 1924, the company was known until recently as a down-market alternative to the tonier Sainsbury's. But today, Tesco operates 2,318 stores in 13 countries and is eating its competition for lunch. Analysts expect sales at Tesco to rise 6-7% when it reports holiday results this week.

How did Tesco do it? Under the leadership of former chairman Ian MacLaurin and current chief executive Terry Leahy, Tesco cleaned up its dingy stores, expanded into more convenient central locations, and offered a more inspiring product line without sacrificing rock-bottom prices. It developed its premium Finest and economy Value private-label ranges and moved into higher-margin nonfood items such as electronics, housewares and clothing (with styles that actually make the fashion pages of mass-market women's magazines). That helped Tesco accomplish a simple but crucial task: getting bodies into the store. Tesco's British grocery market share rose to an estimated 22.9% in 2004, as onetime leader Sainsbury's stagnated at 12.1%, according to Verdict Research in London. "They don't do anything brilliantly, but they do everything well," Peter East, retail director of market-research firm TNS in London, says of Tesco.

For those willing to pay for it, there's more excitement to be found at the top end of the spectrum, where niche grocer Waitrose (a division of privately held John Lewis Partnership) has expanded its number of stores from 116 to 166 since 2000. Founded in 1904, Waitrose has a small but growing share of Britain's grocery market, estimated at 2.4% last year, and is closing in on players like Marks & Spencer. Waitrose has eaten into M&S's luxury food side by targeting the cosmopolitan tastes of well-traveled foodies. Its shelves are stocked with vast selections of olive oil, organic meats and wines ranging from $6 to $1,500 a bottle.

"If you want to find something different or with extra quality, you'll find it at Waitrose, but at a premium," says Mark Price, Waitrose's director of marketing and selling. The stores still draw in affluent, health-conscious families for an average $50 trip, he says, but also attract discerning shoppers who hit the store several times a week — buying one or two luxury meals each time.

To succeed, upmarket retailers have to specialize and understand their customers, says Serge Weinberg, chairman of the management board of retail and luxury-goods firm Pinault-Printemps-Redoute, best known for its 17 Printemps department stores in France and its Gucci line. "In order to be successful you need to be located in areas where you have sufficient high net worth customers to create demand," Weinberg says. The strategy helped Printemps maintain its profit margins, even during the weak economy in 2002 and 2003.

Next door in Germany, shoppers are addicted to discounting. Supermarket discounters such as Aldi and Lidl sell discounted PCs next to the potatoes — and capture 36% of Germany's retail market share. A branding survey last year by the GfK consumer research group found Aldi was Germany's third most respected corporate brand after Siemens and BMW. "The discounters are doing this to achieve a quality improvement and are undermining the middle market," says Antonella Mei-Pochtler, a senior partner at Boston Consulting Group in Munich.

The strategy is working — and squashing middle-of-the-road players like KarstadtQuelle. In the 2004 financial year, group sales at the Essen-based retailer's 516 stores and shops slipped 7% to j14.2 billion from the same period a year before, according to preliminary sales figures released last week. The company's stock has lost nearly 60% of its value in the past year.

This kind of sustained retail competition raises an age-old question: How low can they go? A price war may be a windfall for consumers, but it can punish investors. When Carrefour fired its price salvo in October, for example, that news combined with a lower earnings estimate sent its stock reeling from j42 a share in early September to a low of j33 in late October. The company last week issued a sales report for the fourth quarter that was less dire than anticipated, and Carrefour stock bounced above j37. But as Credit Suisse First Boston cautioned in a research note: "One quarter's sales improvement does not necessarily constitute the start of a trend."

Perhaps not, but the high-and-low trend is in Europe to stay. Customers hooked on quality will continue to seek it out, while discounters stand to gain if consumer spending slows down unexpectedly or more workers lose their jobs. Those who can't compete on either scale may find that the joyless Christmas shopping season was just a harbinger of even rougher days to come.

• ANDREA GERLIN
• Europe's retailers need to adjust to shifting consumer habits