Kraft Deal Costs Starbucks Potential Grocery Sales

Starbucks Corp., the world’s largest coffee chain, will miss out on a surge in home-brewing unless it can break a 13-year-old deal that ties its fortunes to Kraft Foods Inc.’s slow-selling Tassimo machine.

Under the terms of the deal, Starbucks can’t put its coffee in the Keurig Home Brewer, according to a complaint from Kraft filed in federal court in White Plains, New York. Kraft’s brewing system has 2.6 percent of the grocery market; Keurig, which dominates the U.S. market for machines that make single cups of coffee in a minute or less and is owned by Green Mountain Coffee Roasters Inc., has 71 percent.

As Americans replace traditional coffeemakers with Keurig brewers, they’re forsaking ground coffee, cutting into Starbucks’ grocery sales, said Mitch Pinheiro, an analyst with Janney Montgomery Scott LLC.

“Starbucks is losing its addressable market by the day,” Philadelphia-based Pinheiro said in a telephone interview.

In November, Starbucks Chief Executive Officer Howard Schultz announced plans to terminate a deal under which Kraft distributes Starbucks coffee products to U.S. grocery stores.

Kraft says Starbucks can’t end the deal unless the world’s largest coffee chain compensates Kraft for the “fair market value” of the packaged coffee business. On Dec. 6, Kraft filed a complaint in the U.S. Southern District of New York, seeking to prevent Starbucks from taking any further action toward ending the partnership.

Photographer: Michael Nagle/Bloomberg

Starbucks Corp. coffee sits on a shelf at a grocery store in New York. Close

Starbucks Corp. coffee sits on a shelf at a grocery store in New York.

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Photographer: Michael Nagle/Bloomberg

Starbucks Corp. coffee sits on a shelf at a grocery store in New York.

Starbucks fell 77 cents, or 2.3 percent, to $32.48 at 4:30 p.m. in Nasdaq Stock Market trading. The shares increased 39 percent last year.

New Technology

In 1998, when Starbucks and Kraft first agreed to work together, the single-cup brewer was a relatively new technology. The machines use disposable cups or pods of ground coffee to dispense a cup of coffee. Starbucks was selling coffee pods that fit into a conventional espresso machine (the company has since stopped selling the machine and still sells pods), and Keurig sold brewers solely to offices.

When Keurig prepared to enter the home-brewing market in 2002, it sought investments from coffee companies, said Nick Lazaris, who was CEO at the time. Canadian coffee company Van Houtte Inc. invested $10 million in Keurig, and Green Mountain Coffee Roasters, the first brand to sell its coffee in Keurig pods, acquired a 41 percent stake in the company for $14 million (it bought the rest of Keurig for $104 million in 2006).

Starbucks, which at the time was focused on acquiring chains and opening stores worldwide, didn’t invest in Keurig.

‘Like Intel’

While Nestle, Kraft and Procter & Gamble Co. all got into the coffee pod business, Keurig grabbed the biggest market share in the U.S. by positioning its $250 brewer as a gourmet product and by giving consumers lots of choice, Lazaris says. Today Keurig brewers sell for about $100 and up.

Though competitors sold just a few brands of coffee, Keurig licensed its K-Cups for dozens of specialty coffee purveyors, such as Tully’s, Van Houtte and Timothy’s, and let different manufacturers make Keurig-style brewers, earning a royalty off each sale. It also included a special K-Cup that consumers could fill up with their own favorite ground coffee.

“We wanted to be like Intel,” former CEO Lazaris said in a telephone interview, meaning Keurig would be a technology present in multiple brands. It prevented consumers from “feeling cornered,” Lazaris said.

‘Share Erosion’

In the 52 weeks ending Oct. 31, the single-cup market, which excludes instant coffee, generated almost $200 million worth of U.S. sales, according to SymphonyIRI Group, a Chicago- based firm that tracks supermarkets. While that is 5.2 percent of the overall coffee category, single-cup coffee sales are growing 28 times as fast as the overall coffee market.

Even before publicly announcing his intention to pull out of the Kraft deal, Schultz had privately expressed his concerns to the Northfield, Illinois-based food maker.

“We cannot accept the continued share erosion and lack of progress we are experiencing down the grocery aisle,” Schultz wrote to Kraft CEO Irene Rosenfeld in an e-mail provided to Bloomberg News by Starbucks.

Determined to expand its grocery business, Starbucks has been putting its marketing muscle behind its own single-serve product, Via Ready Brew. A soluble powder sold in individual packets, Via requires no brewer and is simply dissolved in hot or cold water.

‘Grand Scheme’

For the 12 months ending in October, Via generated $16.8 million worth of sales in U.S. groceries, according to SymphonyIRI. During the same period, Green Mountain K-Cups alone rang up $72 million in U.S. grocery sales.

“In the grand scheme of things, it doesn’t look like Via is going to make a great deal of impact on the coffee category” in the U.S., said Jim Hertel, managing partner at Willard Bishop, a Barrington, Illinois-based retail consulting firm.

Starbucks expects Via to turn a profit in 2011, Chief Financial Officer Troy Alstead said during a Nov. 4 investor call, with the biggest opportunities overseas. Including sales in both Starbucks retail locations and grocery stores, the company sold $135 million worth of Via worldwide in the past year, Alstead said.

Starbucks’ agreement with Kraft limits exclusivity only to grocery stores, meaning the company can sell any single-serve system in its own stores or with specialty retailers such as department stores, Alan Hilowitz, a Starbucks spokesman, said in an e-mail today. Hilowitz declined to provide the contract, citing a confidentiality agreement.

“We are looking forward to providing Starbucks customers with more ways to enjoy Starbucks coffee, one cup at a time,” Hilowitz said via an e-mailed statement on Dec. 29.

To contact the reporter on this story: Burt Helm in New York at bhelm3@bloomberg.net.

To contact the editor responsible for this story: Robin Ajello at rajello@bloomberg.net.

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