New grounds for concern at Starbucks

By the Financial Times

The best thing Santa brought this year was a gadget I want to show off to friends: not an iPod or a Wii but a Nespresso machine.

Nestlé's (NSRGY, news, msgs) star product has pride of place beside our kettle, and I enjoy sliding aluminum pods of coffee into the slot at the top, pushing a green-lit button and watching a rather nice shot of espresso gurgle out and into a cup, covered with crema that I used to get at only at Starbucks (SBUX, news, msgs) or other coffee bars.

That thrill may soon disappear, but there are other things to appreciate. One is the dozen shiny-colored "grand cru" pods the machine takes. When I buy them online (as one of 3.1 million members of the Nespresso club) they will be delivered to our home by a United Parcel Service (UPS, news, msgs) man in a uniform of a similar brown to the "Livanto" pod, which holds a "uniquely rounded and well-balanced espresso characterized by delicate woody and cereal notes."

Then there are the Nespresso boutiques -- not just plain bars -- where I can feed my Nespresso habit. I recently visited the one in Bloomingdale's in New York's SoHo neighborhood and was served a seasonal almond espresso shot (not as bad as it sounds). The boutique itself, one of 40 intended for the United States, has the feel of Switzerland rather than Seattle. Instead of velvet sofas and comfy music, it has hard surfaces, bright colors and European hostesses.

Stop there, you may think. I want to drink coffee, not join a cult. And there is something about all this -- matching machines and pods, George Clooney advertisements in Europe, Sharon Stone's unveiling of its flagship boutique on the Champs Elysées -- that is totalitarian.

Nespresso is "an experience" rather than coffee, Nestlé told analysts last year and, boy, is it all-enveloping.

Steep but affordable

But one cannot argue with success. Nobody forced Santa to spend $229 on the Nespresso Essenza machine in my home, nor me to buy 10 pods for $5.40. Yet Nestlé leads the global market in "single-serve coffee," as the burgeoning category is known, and its customers last year bought 1.4 million Nespresso machines and 2.3 billion pods. There must be lessons here.

One is that there is surprisingly strong demand for goods and services that are a step below luxury but a cut above the ordinary -- call them premium, luxe or "affordable luxury." It did not occur to me before the Nespresso came along that I ever needed such a thing. Now that I have it, however, I am attached to it.

The trick is to make such goods alluring and to set a price that is steep but affordable. Newspaper executives sometimes moan that consumers refuse to pay $1 for a newspaper when they spend $4 on a coffee at Starbucks, but a newspaper is not the same thing as a Starbucks espresso. A shot of Nespresso -- essentially -- is the same.

"People can have their own coffee shop at home. They save because, even though it is more expensive than drip coffee, it is still a third of the price of Starbucks," says Jay Brewer, founder of singleservecoffee.com, a Web site devoted entirely to, well, you get the idea.

A second lesson is that you can make more money with a combination of goods and services than by selling objects alone.

Nestlé is only one among many companies that saw the opportunity for pod coffee machines. L.G. Philips (LPHLF, news, msgs) and Douwe Egberts produce the Senseo machine, Kraft Foods (KFT, news, msgs) and Braun sell the Tassimo, and Keurig, the U.S. maker of office coffee machines, has its own range of home devices.

Nespresso is not only the most expensive contender, it's the most proprietary. Many roasters make "K-Cup" pods to fit in Keurig machines and other machines are, to differing degrees, open to other pod-makers. But the only pods that fit a Nespresso machine are Nespresso pods and you can only buy them through Nespresso.

There is an obvious similarity between this and Apple's (AAPL, news, msgs) iPod/iTunes combination, which comprises a physical device and an online service to fill it up. But Nestlé does not even have to share its revenues with others in the way that Apple does with music companies, apart from paying coffee growers for beans and film stars for endorsements.

All kinds of partnerships

A third lesson is that some products are tricky to launch because they require cooperation between various industries -- iPod/iTunes being an example. Because you need both a machine and coffee to make espresso, all kinds of partnerships and joint ventures have been launched by food companies and device makers.

Nestlé did not make machines, nor did it have an established espresso brand -- it was most famous, when I was young, for making Nescafé freeze-dried instant coffee. But it launched a new brand in Italy and Switzerland, made deals with machine manufacturers and steadily extended its presence around the world.

That leads to my final lesson, which is that successes usually do not occur overnight. Nestlé patented some of its pod technology in 1976 and did not start making Nespresso machines until 1986. Even then, it largely confined its efforts to commercial machines: A decade ago, it was selling only 75,000 machines a year.

By the time manufacturers were able to turn out high-pressure espresso machines for less than $300 each, Nestlé had the technology and the brand to sell direct to consumers. That has left companies with more established espresso and cappuccino brands, including Starbucks, trying to catch up.

Thus, despite the naff eurotrash marketing and unsettling boutique decor, there is a lot to emulate about how Nespresso has inveigled itself into my home (and those of a few others in New York this Christmas, to judge by a straw poll).

With that, it is time for my morning cappuccino.

This article was reported and written by John Gapper for the Financial Times.