Troubles at Tesco, the UK’s leading retailer, are mounting. If round after round of profit warnings was not enough – group operating profits fell 20% between 2011 and 2013 and are likely to fall another 30% in 2014 — the company recently announced it had overstated its first-half profit by about $400 million. The “accelerated recognition of commercial income and delayed accrual of costs” undoubtedly flatters short-term results, but it soon catches up with you, as four suspended senior executives have found out. Tesco, the success story of the British retail scene for the last 20 years, has suddenly fallen from grace. How did this happen?

Successful companies are notoriously prone to pursuing tactical fixes rather than confronting strategic problems. They exhort their people to try harder, introduce overhead cost reduction programs, and reorganize – anything rather than admit that their strategy needs an overhaul. Fiddling the books is normally the last resort, when all else has failed. It is also often a sign of impending bankruptcy, but this shouldn’t happen at Tesco.  It is still the biggest player in the UK supermarket scene by a mile, but unless it opens its eyes to its strategic challenges and begins addressing them effectively – i.e., shows a little more Strategic IQ – it will continue to spiral down.

UK retail, like the rest of the developed world, is witnessing a few big long-term trends.  Private label (retail-branded merchandise) has been growing for years – since Sainsbury and Marks & Spencer invented it over 100 years ago – increasing in quality and forcing down brand premiums. It provides consumers with a viable, lower cost alternative to the manufacturer branded products.  Tesco came to the party much later in the 1980s but ended up winning with its “good-better-best” private label lines, setting the industry standard for how to play the private label game.

The rise of convenience store chains is another big trend in the UK. Consumers are increasingly shopping for a few items every day rather than waiting for the weekly or monthly supermarket trip. There have always been convenience stores in the UK, but the shabby, independent corner shops are giving way to sparkling new outlets run by the supermarket chains full of fresh merchandise, albeit at premium prices.  Of the big supermarket chains, Tesco was the fastest to pick up on this opportunity in the early 1990s (with Tesco Metro and Tesco Express), and it remains in the lead.

And of course, online shopping is the other big trend that started at the turn of the century.  Why travel to a supermarket for the monthly big shop if you can buy it online and have it delivered?  Tesco was quick to pioneer in this area with the launch of tesco.com in 2000 and is still the leader in the UK.

So with such a track record of strategic innovation, why has Tesco been blindsided by the hard discounters like Germany’s Aldi and Lidl? In the last three years, these two companies have rapidly gained share and now account for more than 8% of the market, while Tesco has lost more than 2% share, down to 28%.

Aldi opened its first UK store in 1990, but made little progress then. UK consumers didn’t seem to want to shop in cheap looking stores with only 1000 private label items on offer and minimal service. And yet Germans, even those with Porsches, shopped at Aldi. The hard discount format accounts for as much as 40% of the German market, and for some good reasons.

Aldi offers not just low prices, but convenience. There are over 4,000 Aldi stores in Germany – they are everywhere. Tesco’s idea of convenience, like most of the large UK chains, is small outlets in high-traffic locations stocked with a narrow line of products, many of them fresh food, at prices that are far higher than in the supermarkets. This is all very well for the rich punters prepared to forgive Tesco for its gouging, but for the majority of UK consumers, this premium isn’t viable. German consumers, in contrast, get convenience and quality merchandise at lower prices so they can afford the Porsche! Everyone shops at Aldi.

Now UK consumers are discovering that Aldi is good for them too. This is partly because they have gone through tough times in the recession and wages are stubbornly low. It is also because Tesco has raised prices in the UK to pay for its less profitable international ventures, which has left it vulnerable at home. (Wal-Mart, the world’s number one retailer, is also guilty of this – it makes most of its money in the U.S. and spends it in international markets. As a result, dollar stores have gained significant ground in the U.S.)

Finally, Aldi is growing because it is tailoring its offering to the UK market. Blindly transporting a retail concept across international borders is seldom a recipe for success. But Messieurs Barnes and Heini, joint managing directors of Aldi UK, have added more fresh products and up-market lines at prices 15-20% below those of regular UK supermarkets. The goal is to attract the British middle classes, and it appears to be working. Aldi UK sales grew from $6.3 billion to $8.6 billion in 2013, and operating profits increased 65% to $422 million. The company plans to double the number of outlets in the UK to 1,000 by 2022, and it won’t stop there if Aldi Germany is any indication.

You might wonder how anyone can make money with such low prices. The answer is simple – selling more. Hard discounters aim for twice the volume with the same fixed costs so they can make the same returns at half the gross margin. Aldi’s sales per employee are already twice those of Tesco in the UK.

Tesco and fellow major UK supermarket chains seem to be frozen like the proverbial bunny in the headlights in the face of these discount convenience stores.  But Tesco, with the biggest purchasing power, the best experience of private label, and strongest track record of strategic innovation, is hurting more than most.

And talent knows where the future lies. In its latest annual report, the Times places Tesco 23^rd in its ranking of top 100 graduate employers in the UK, down from 15^th last year; Aldi moved up from 6^th to 4^th place.

Many thousands of discount convenience stores are going to appear in the UK over the next decade. Tesco must decide whether it is prepared to risk cannibalizing its other formats and compete in this segment or be left behind. In the past, Tesco has demonstrated it has the wherewithal to add many more convenience stores a year than the target of 60 Aldi is setting itself, and it has consistently shown itself to be one of the first to embrace new formats. Whether they can do it this time depends on the strength of their leadership. Distractions caused by fiddling the books will not help.

This blog first appeared on Harvard Business Review on 10/06/2014.

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