Why Starbucks Will Probably Inevitably Modify Its Relationship With Green Mountain

Sep.24.12 | About: Starbucks Corporation (SBUX)

Last week, Starbucks (SBUX) launched their Verismo single-serve coffee, espresso and café beverage-making machine. The device is broadly seen as a major salvo in a developing war with Green Mountain Coffee Roasters (GMCR) and Nestle (OTCPK:NSRGF) for the $8 billion and growing single-serve coffee machine market.

The Verismo makes coffee, like Green Mountain's market-dominant Keurig "K-Cup" brewers, as well as espresso, lattes and some other similar lavish coffee beverages. Green Mountain's Vue and some models of Nestle's Nespresso machine have similar functionality. The Verismo is priced at $199, making it far more expensive than a standard K-Cup brewer, but in line with or cheaper than the equivalent models from these competitors.

So far, the Vue has not had much traction. Most consumers that already own a Keurig machine are staying with the one they use, rather than buying a more expensive second unit. Nespresso machines have had some success in finding a high-end market consumer, but it is probable that most Nespresso machine owners were more likely to buy a high-end espresso machine than a standard coffee maker or Keurig machine. Further, most retail stores do not carry Nespresso machines or their pods, with the company preferring to limit Nespresso's retail footprint to the Internet and high-end stores such as Williams-Sonoma (WSM).

With this move by Starbucks, the company is clearly attempting to grab a larger market share of the total coffee market by entering the at home/work single-serve machine market. The company already has a single-serve instant coffee option, with its Via Ready Brew packets. With both Via and Verismo, Starbucks acknowledges that no matter how alluring its stores are, the percentage of coffee prepared at home and/or work is too large to be ignored, and sufficiently large enough to attack on multiple fronts.

Though Starbucks may be substituting some $5 in-store coffees for cheaper consumption at-home sale, that consumption will not require Starbucks to pay a barista to prepare it. Additionally, the cost of human error in the preparation process will be borne by the consumer and not Starbucks. Further, these offerings could help Starbucks reinforce and expand its branded offerings, and entice new consumers to become patrons of their stores for not only coffee beverages, but also for food.

With thousands of stores in which to market the Verismo, Starbucks has a significant marketing advantage over Green Mountain and Nestle. The company can put its machine in front of consumers who are waiting in line for their coffee. The company gave out samples of Via in its stores when it launched that product, and routinely gives out small samples of various other beverages it sells. It is likely that Verismo-made samples will be available at many Starbucks locations in the coming weeks.

While Verismo is not a guaranteed market-leader for Starbucks, it probably is very bad news for the Keurig Vue and the Nespresso. The new competition should at least partially reduce their market share in a business that is only becoming more fractured and competitive as it grows. Because of this, the Verismo could limit GMCR's ability to expand its market footprint. Nonetheless, the larger market still appears to be the standard Keurig K-Cup style machine, where multiple machine designs exist at prices below half the cost of the Verismo. This fact also makes it seem highly likely that Starbucks will eventually expand into that market too.

Though Green Mountain and Starbucks have worked together for the past two years, there is some good reason to presume that Starbucks will ultimately reduce and/or sever its ties with Green Mountain. Prior to its affiliation with GMCR, Starbucks was in a distribution agreement with Kraft (KFT) regarding consumer packaged goods. Starbucks complained that it was dissatisfied with the manner in which Kraft was fulfilling its obligations to market and manage distribution of Starbucks goods, arguing that at least part of the reason for such mismanagement was due to Kraft's attention being focused on the takeover of Cadbury.

A more probable cause of any apparent drop in Starbucks CPG sales was the significant growth of the K-Cup, including its dominance over Kraft's competing Tassimo, though it is also possible that some Kraft mismanagement may have contributed to the hemorrhaging. Kraft denied this, arguing that Starbucks was brewing up a scheme to freely grab back a revenue stream that grew tenfold under Kraft. Starbucks believed the growth should have been far greater with proper handling.

Shortly after ending its joint venture with Kraft, Starbucks entered a joint venture with Green Mountain to start selling its coffee in K-Cups. A similar fate may be inevitable for its relationship with Green Mountain. While it may be a mere coincidence, the launch of the Verismo does coincide with the expiration of two patents that have allowed GMCR to control K-Cup construction.

In the coming months, K-Cup competitors will undoubtedly unveil themselves, forcing GMCR to cut its margins and offer more competitive prices to partners such as Starbucks and Dunkin' Brands (DNKN). Supermarket powerhouse SUPERVALUE (SVU) has announced plans to sell store-brand pods that will fit Keurig machines, as will TreeHouse Foods (THS) and other private-label product makers. If this competition, coupled with any Versimo traction, causes reduced sales of Starbucks K-Cups, it would provide Starbucks with a basis for negotiating better terms or backing out of its relationship with GMCR, much as it did with Kraft.

As a result of Starbucks' advance into the self-service machine business and the probable coming onslaught of competition in the production of K-Cups, it is likely that Green Mountain will lose market share in the sale of K-Cups, sustain narrowing profit margins and potentially lose some of its key production relationships in the coming quarters, hurting its bottom line.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.