Coffee War Brewing as Starbucks - Kraft Rift Widens

Includes: MDLZ, SBUX
by: World Market Pulse

Seattle-based Starbucks Corp's (NASDAQ:SBUX) impressive quarter had triggered a widespread Wall Street optimism, especially in the food and beverage sector, but analysts were keeping a close eye on the company after the coffee major had publicly announced its willingness to part ways with Kraft Foods Inc. (KFT), a move that could shake up the single-cup coffee market in U.S. grocery stores.

Although the companies had expressed confidence to resolve the matter in private, the rift is now open in the public domain after Kraft Foods Inc. launched arbitration proceedings against Starbucks Corp., challenging the coffee giant's plan to end a distribution deal with the former.

One the one hand, Kraft is looking to enforce certain provisions of the deal, including getting Starbucks to pay for ending a business that generated $500 million in annual revenue, Starbucks claims that it has the right to end the deal because of what it says are Kraft's failures to meet certain provisions in the contract, like adequate promotion. Starbucks claims that the violations give them a reason to terminate the pact before it is set to expire in 2014 after the two companies renewed the original contract in 2004 for 10 years while Kraft argues that the contract remains in effect indefinitely.

Starbucks-Kraft Deal: Starbucks' public statement about its intention to end the deal had earlier sparked a tit-for-tat exchange of press releases, with both companies accusing the other of having improperly characterized the terms of the pact. Kraft Foods Inc, which also surprised Wall Street with its profit report, said it was too early to say what the impact of the lost agreement would be on its results. Kraft, which itself makes coffee under the Maxwell House brand, has been distributing packaged coffee for Starbucks since 1998. Analysts believe that if and when the deal is terminated, it could mark a major shift for Starbucks' consumer-packed business, a key building block in Chief Executive Howard Schultz's strategy to drive future growth for the nation's largest coffee-shop chain.

Last year, Starbucks made a surprising entry into the single-cup coffee market when it unveiled Via, the instant coffee that racked up $135 million in first-year sales. According to analysts at WSJ, Starbucks Corp.'s customer-loyalty program, Via instant coffee and customized frappuccinos have been the main catalysts driving traffic to the coffee chain's stores during the fiscal fourth quarter, helping it post higher-than-expected earnings.

An Overview Of Possible Future Trends: Meanwhile J.P. Morgan analyst John Ivankoe said in a research report that Starbucks could enter into new partnerships, selling single-cup coffee packets used for one-cup brewing machines, but since 80% of Starbucks customers don't have a single-cup brewer at home, the company might look at some venture with Vermont based Green Mountain Coffee Roasters (NASDAQ:GMCR). Meanwhile, RBC Capital Markets analyst Ed Aaron in a research note, wondered whether this change could motivate Kraft to eventually divest Maxwell House.

Starbucks - IllyCaffe SpA Challenge: The Kraft deal rift is not the only reason for the coffee major to be worried as IllyCaffe SpA, an upscale Italian coffee company, is making inroads onto Starbucks' turf by serving coffee to well-heeled travelers in upscale hotels, two moves that could potentially shake up the single-cup coffee market in U.S. grocery stores. Italy based coffee major IllyCaffe SpA's new business plan to include hotel business is increasingly serving up a big challenge to Starbucks. Illy coffee is now served in 2,000 hotels around the world, up from about 700 five years ago, and Mr. Andrea Illy, chief executive of the company, says he plans to double the brand's hotel business in the next five years.

Starbucks, which dominates U.S. coffee culture with more than 11,000 retail stores in the U.S. and offerings at 15,000 U.S. food-service locations, including hotels and restaurants, has downplayed any substantial threat from the Italian company, saying it's been delivering a high-quality specialty coffee experience in hotels, restaurants and meeting spaces since 1994.

Disclosure: No positions