Nespressoâ€™s Brewing European Coffee War

Nespresso’sBrewingEuropeanCoffeeWarEthicalCoffeeCompanyandSaraLeeEnterAMonopolist’sMarket

AnupAnajpure,ErikKiewietdeJonge,IgnacioLarrain,RaimundoSilva

Anajpure,KiewietdeJonge,Larrain,Silva

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ExecutiveSummary

The case is a subset of the coffeewar currently brewing inWestern Europe betweenNestlé,

SaraLeeandEthicalCoffee.Nestléistheincumbentinthemarketwithamonopolyoveritshome‐

coffeesystemwith1,700patents.Thecoffeemachine‐coffeepodsmodel isalmost identical to the

razor‐razor blade businessmodelwhere Nestlémakesmoney primarily on the coffee pods. The

caseoutlineshowtwonewcompaniesonelarge(SaraLee)andonesmall(EthicalCoffee)enterthe

coffeepodmarket inFrance.TheinflexibilityofNestlétopricecompetitively, floodthemarketor

potentially legally defend its patents presents an opportunity for new entrants. Sara Lee openly

declarescommitmenttoenteringthismarket.EthicalCoffeesignalstoNestléthatitisnotviolating

anypatentsandthusalsolendscredibilitytoSaraLee’sentry,whichwillmostlikelybearthecost

ofalegalbattlewithNestlé.EthicalCoffeewillgetfreeriderbenefitsofthelegalfightbetweenthe

twolargecompaniesandminimizesitsexposuretolegalbattles.

NestléandNespresso

George Clooney famously asks, “What else?” in his role as the face of Nespresso’s brand.

Nespresso,awhollyownedsubsidiaryoftheglobalfoodconglomerateNestlé,hasledthehigh‐end,

individual espresso coffee brewing business since bringing its first product to market in 1986.

Clooney’sassociationwiththishigh‐endbrandworks:Nespressohasheldamonopolyonthischic

personal espresso system cited by some as the “’most expensive coffee you canbuyper cup’ for

homeuse.”1

TheNespressoSAcompanywasfoundedinVevey,Switzerlandin1986undertheownershipof

theNestléGroup.NespressopartneredwithaSwissmanufacturer,Turmix,toproduceandlaunch

the first Nespresso coffee system in the office coffee market in Switzerland and Italy. Nestlé

producedthefirstcoffeecapsulesatitsSwissfactoryinOrbe.Nespresso.Nestlétracestherootsof

Nespressobacktothebeliefthatconsumerswantedtohavecafé‐styleespressoexperiencesinthe

home and work place. Nespresso believed that the perfect combination of the highest quality

1BusinessWeek(Bloomberg).Mulier,Tom.“SaraLeeAnswersClooney’sNespressoQuerywithCheaperCoffee.April7,2010.QuotefromJamesAmoroso,afoodindustryconsultantbasedinWalchwil,Switzerland.


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coffee,waterandairpressurewasnecessarytodeliverasuperiorespresso.Withthisthinkingthe

Nespressosystemwasborn.2

Since1986NespressohasexpandedbeyonditsinitialpartnershipwithTurmixforproduction

of itsNespressomachines. Today,Nespressocountsaspartnerssuchprecisionmanufacturersas

DeLonghi, Jura, Koenig, Krups, Miele and Siemens, all of whom provide a global distribution

network of precisionNespressomachines. Thesemachines, starting at €149 ($200), are sold at

over12,000pointsofsaleglobally,predominatelyinlargedepartmentstores.Nespressohasalso

cultivated a prestigious boutique presence in global cities like London, New York and Paris. To

complete the Nespresso system, Nespresso produces its aluminum, hermetically sealed coffee

capsulesinNestlé’sSwissfactories. ThesecapsulesaresoldthroughNespresso’sexclusiveonline

coffeeclubandspecialtycoffeeretailers.3

Nespresso has enjoyed amonopoly status in the high‐end personal espresso systemmarket

since 1986. A complexweb of an estimated 1,700 patents protect its systems from competitive

infringement,4meaningthatoncecustomershavepurchasedaNespressomachine,theyarelocked

intobuyingNespresso‐onlycoffeecapsules.Thismonopolypositionhasresultedinstrongpricing

power: a 10‐pack sleeve of Nespresso capsules sells for as much as €3.70 ($4.95) in France, a

whopping€0.37acapsule.Tosoftenthehighprice,Nestléclaimsthatonly1%oftheworld’scoffee

supplymeetsitsexactingstandards.5Nestlédoesnotdiscloseprofitsoncapsules,thoughanalysts

sayNespressomakesmostofitsmoneyfrompods6–aclassicrazorandrazorbladestrategy.

SaraLee

SaraLeeCorporationisaDownersGrove,IL–basedglobalfoodconglomeratewithbrandslike

AmbiPur,BallPark,DouweEgberts,HillshireFarm,JimmyDean,Kiwi,Sanex,Senseo,andSaraLee

in its portfolio. Founded in 1939 by Nathan Cummings’ purchase of C.D. Kenny Company in

Baltimore,MD, theSaraLeeCorporationwentbymanynamesuntilofficiallyconsolidatingunder

2Nespresso.“AboutUs–OurHistory.”3Ibid.4BusinessWeek(Bloomberg).Mulier,Tom.“NespressoRivalSaysOrderBookFullat4BillionCapsules.”March31,2010.5BusinessWeek(Bloomberg).April7,2010.6TheWallStreetJournal.Passariello,Christina.“NestleStakesItsGroundsinaEuropeanCoffeeWar.”April28,2010.


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theSaraLeeCorporationbannerin1985.SaraLeefirstdippeditstoesinthecoffeemarketwithan

investmentinthe257year‐oldDutchcoffeeandgrocerycompanyDouweEgbertsin1978.7

Notuntil2002didSaraLeeenterthepersonalcoffeemachinebusinesswithitsSenseosystem,

ledbyDouweEgbertsandpartnerPhilipsElectronics in theNetherlands. SaraLee launched the

SenseosystemintheUnitedStates,UnitedKingdomandtheDenmarkin2004.8TheSenseosystem

targets mid‐market customers and does not carry the same prestige as the Nespresso system.

Coffee capsules are sold globally through traditional supermarket and retail channels. Senseo

machines start at around $50 in the US, significantly less expensive than Nespresso machines.

Senseo is not a direct competitor of Nespresso, since the former favors themid‐market and the

latter thehigh‐endmarket. SaraLee’sSenseomachineoutpacedNespressoas thebiggestselling

coffee system several years ago, with 26 million machines having been sold. Sara Lee is now

interestedinNespresso’spremiumcustomers,whospendmorethanSenseocustomers.9

Starting in 2005, the company announced its commitment to focusing on its global food,

beverageandhouseholdandbodycarebusinesses.Throughout2005and2006,SaraLeedivested

itsapparel,Europeanpackagedmeats,USretailcoffeeanddirectsalesbusinesses,transformingit

intoa company focusedon its core food,beverageandhouseholdandbodycarebusiness.10 Sara

Lee’sinternationalbeveragebusinessaccountedforhalfofitsprofitsinQ42009(operatingincome

of $172million)when excluding the household and body care divisions. Beverage sales figures

increased15%to$884millioninQ4,highlightingtheimportanceofSaraLee’scoffeebusiness.11

EthicalCoffeeCompany

Ethical Coffee Company is a Swiss start‐up led by Jean‐Paul Gaillard, the former head of

Nespressofrom1988to1997.12ManycreditGaillardwithNespresso’ssuccessinpositioningitself

as an elitist brand in the Europeanmarket. WhenGaillard became head ofNespresso, he had a

marketingbudgetof800,000CHF(~$1M)fromNestléandheborrowedanother800,000CHFfrom

UBS. Within a few years, Nespresso, under Gaillard’s leadership, became the upmarket leader,

where it remains today.13 Hismarketing skillshonedatNespressonodoubt informhisbusiness

7SaraLeewebsite.“Aboutus–OurTimeline.”8Ibid.9TheWallStreetJournal.10Ibid.11ChicagoBusiness.Sterrett,David.“SaraLeeCEOBrendaBarnesfiresashotinamust‐wincoffeewar.”April5,2010.12BusinessWeek(Bloomberg).March31,2010.13RadioTélevisionSuisse.“LesgoutsdeluxedeNespresso.”October8,2004.


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pursuits today, making him a potentially formidable rival to Nespresso, who he knows quite

intimatelyfromhistimethere.

Today Gaillard leads Ethical Coffee’s 12 Swiss employees and 35 employees in Chambery,

France,whereitwillproducebiodegradablecoffeecapsulesforuseinNespressocoffeemachines.

Ethical Coffee counts among its investors the Bennetton family and an agricultural investment

company Unigrains. Currently, Ethical Coffee is targeting the French market with its launch of

Nespresso‐compatible capsules, with the German market on deck for later this year. Gaillard

expressedinterestsinenteringSpain,AustriaandSwitzerlandinthefuture.14

RecentMarketConditions

Nespresso

Nespressohasoperatedas amonopolist in theNespressomachine compatible coffee capsule

businesssince1986.Lifehasbeengood:in2009Nespressorevenuesroseby22%to$2.6billion,

following2008salesgrowthof33%.15Nespressoprovidedaboutone‐fifthofNestlé’ssalesgrowth

in2009,excludingacquisitionsandcurrencies.16 Around80%ofNespresso’s8millioncustomers

are concentrated inWestern Europe,with France as the biggestNespressomarket. Nespresso’s

customersbought5.5billioncapsulesin2009,withsalesinFrancealonerisingby22%,according

to market data firm Euromonitor.17 Current prices for Nespresso capsules hover around €3.70

($4.95) in France, or€0.37 a capsule.18 Nestlé has a capsule production capacity estimated at 9

billion capsules per year in 15 varieties.19 Nespresso estimates portioned coffee (i.e. pods) to

expandto25%ofEuropeanandNorthAmericanmarketby2015,upfrom19%in2009.20Inother

words,Nespressobelievesinstronggrowthforitscapsuleandsystemsales.

SaraLee

Sara Lee currently plays in themid‐market portioned coffee sector, though it has announced

entrance into the premium spacewith Nespresso‐compatible pods. Euromonitor estimates that

14BusinessWeek(Bloomberg).March31,2010.15DowJonesDeutschland.“NestleCoffeeGrowthEngineChallengedbyFormerMgr.”March8,2010.16BusinessWeek(Bloomberg).April7,2010.17TheWallStreetJournal.18BusinessWeek(Bloomberg).April7,2010.19BusinessWeek(Bloomberg).March31,2010.20BusinessWeek(Bloomberg).April7,2010.


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SaraLee,withitsSenseo,DouweEgbertsandL’ORbrands,holds9.7%ofthe$16.8billionWestern

Europe coffee market. Nestlé leads with 19.1% marketshare, with Kraft trailing at 16.9%

marketshare.21 Sara Lee’s international beverage business contributes substantial profits to the

overall firm, making growth in the Western European market a top priority for Sara Lee

management.

EthicalCoffeeCompany

Asastart‐upentrantintotheportionedcoffeesector,EthicalCoffeeCompanydoesnothaveany

currentmarketshare,thoughitsupcomingpresenceinNespresso’smarketwillchangethis.

EthicalCoffeeandSaraLeeSeparatelyAnnounceEntranceIntoNespresso’sMarket

On March 5, 2010 Casino Guichard‐Perrachon SA, the parent of Casino and Monoprix

supermarkets, announced that it will begin selling Ethical Coffee’s biodegradable, Nespresso‐

compatible coffee capsules under private label in its French stores by mid‐May 2010. These

capsuleswillbepricedat20%lessthanNespresso.Nestlé’ssharepriceabruptlyfellby1.8%upon

theannouncement.22Otherretailers,includingSwitzerland’sCoopandMigrossupermarketshave

expressed interest in the Ethical Coffee’s products.23 Retailers have asked for 4 billion capsules

fromEthicalCoffee,whichhassincestoppedacceptingorders. AccordingtoCEOGaillard,Ethical

Coffee has “annual production capacity of 350 million capsules and aims to increase that to

between800millionand1.2billionbytheendof2010.Nextyear,withfurtherproductioncapacity

increases,EthicalCoffeeaimstoproduce2billioncapsules.”24

Given Nespresso’s 24‐year successful run of being the sole provider of Nespresso capsules,

analystshavequestionedwhetherEthicalCoffeeisinfringingononeormoreofNespresso’s1,700

patents.Confidentinhisandhislawyersassessments,Gaillardclaimed“’Weknowthatthereisno

problem…Youcanpatentthewaytogetaneffect,butyoucan’tpatenttheeffectitself.Youcannot

patenthotwater.Youcanpatentawaytoheatwater.”25GaillardsaidinaninterviewwiththeWall

StreetJournal,“’Nespressowasarealinnovation,butit'sstilljustcoffee….Theconsumerwantsthe

21BusinessWeek(Bloomberg).March31,2010.22Ibid.23DowJones.24BusinessWeek(Bloomberg).March31,2010.25Ibid.


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righttasteandagoodprice.”Hewentontosay,“’Wehaveamodelwithoutbling‐blingadvertising

…NoClooney,noglossymagazine,onlycoffee.’”26

OnMarch30, 2010 Sara Lee announced that itwas launching itsNespresso‐compatible L’OR

Espresso capsules in French retail outlets on April 7.27 The head of Sara Lee’s international

beverageandbakerydivision,FrankvanOers, said2millionL’ORcapsuleshadbeen shippedby

mid‐April,with distribution planned in 2,000 French supermarkets. Sara Lee has recommended

that the L’OR capsules be priced at €2.99 per 10, around a 20% discount off Nespresso brand

capsules. L’ORcapsules,ataround€0.30apiece,areconsiderablymorethanmid‐marketSenseo

capsules at €0.13 a capsule. Like Ethical Coffee’s capsules, L’OR capsules are not aluminum, but

ratherplastic.28

SaraLeehasplaced resourcesbehindensuring theL’ORbrand isa success. Industryanalyst

TimRameysaid,“CoffeeisSaraLee’slargestbusinessanditsmostimportantgrowthfranchise.”A

companyspokesmanindicatedthatSaraLee“isplanningtelevision,printandin‐storeadvertising

as well as sampling promotions to introduce the product to customers.”29 Sara Lee spokesman

ErnestoDurannotedthatL’ORhas“thepotentialtobeaglobalsuccess.”30

Ethical Coffee and Sara Lee have both made bold claims on the potential success of their

products in stealingmarket share from the incumbentmonopolist Nespresso. Nespresso is not

sittingidlyby:NespressoCEORichardGirardothaspatentexpertsporingoverSaraLee’spodsand

will do the same in May when Ethical Coffee’s pods enter the market. If either infringe on

Nespresso’spatents,GiradotsaysNestléwillpursue its legaloptions.Healsonotedthathe isnot

concernedaboutGaillardpossessingNespressocompanysecrets,sincethemachineshaveevolved

significantlysinceGaillardleftin1997.31

GameAnalysis

Sara Lee and Ethical Coffee announced their entry into Nestlé’s most profitable business

segment, the high‐end coffee consumers. Thosewho already have aNespressomachine at home

26TheWallStreetJournal.27SaraLeeCorp.PressRelease.“SaraLeeLaunchesNewEspressoCapsuleCompatibleWithNespressoCoffeeAppliances.”March30,2010.28TheWallStreetJournal.29ChicagoBusiness.30BusinessWeek(Bloomberg).April7,2010.31TheWallStreetJournal.


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willbeabletobuyalternativecoffeecapsulesatamuchlowerpriceandthroughabroaderrangeof

distributionchannels.

What should Nestlé do? In order to estimate Nestlé’s best response, we studied the

relationshipsbetweenthecompanyandthenewentrantsandtheirintuitiveperceptionsaboutthe

differentoptionsandrespectiveconsequences.Forthepurposeofthisgame,wewillestimatethe

differentpayoffsasthenetpresentvalueoftheprofitsforeachofthecompaniesinvolved.

The firstdecisionof thegameconcernsNestlé.Apotential flawon itsNespresso’spatents is

supposedtobethemainreasonwhySaraLeeandEthicalCoffeedecidetoenterintothesingle‐cup

capsules market. The game starts with Nestlé deciding whether to signal legal and/or capacity

threatstodeterthenewentrantsfromentering,ortoinitiatealegalbattletopreventSaraLeeand

Ethicalcoffeefrombringingtheirnewproducttomarket(SeeFigure1:GameAnalysis).

FigureNo.1:GameAnalysis

The lowerpartof thedecisiontreeshowsthepathof thepreemptive legalbattle.Nestlésues

the new entrants for patent infringement under the argument of signing contracts with third

partiesforproducingandcommercializingNespressocompatiblecapsules.IfNestléwins,itwould

havemanagedtokeepthenewentrantsout.Iftheylose,theywouldgain2extrayearsofmonopoly

pricingandquantitybeforetheyhavetotakealong‐termstrategicdecisionaboutit.


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For thepurposeof theanalysis, in caseNestlé loses the legalbattleandentrants successfully

enter into the market, we have narrowed down Nestlé’s potential strategic responses to four

options:i)Donothing,ii)Initiateapricewar,iii)Increasedistribution,oriv)Combinationofprice

anddistribution.

Strategicresponsesandtheirassumptions:32

i) Do nothing: This means Nestlé will try to accommodate and leave room for

competitors. Itwill trytofocusontheimageandthequalityassociatedwiththe

Nespresso capsule, under the idea that a good enough product is notwhat you

want for your Nespresso coffee experience. We assumed that 50% of Nestlé’s

clients are loyal to the brand, and another 50% that are “shoppers”, andwould

movetootheralternativesifthereisapricedifferential.

ii) Initiateapricewar:Forthisoption,weassumedNestlématchesthenewentrants’

prices,whichwouldresultinaprofitmargindeclineforthesegmentandaslight

variationinthecurrentmarketsharedistribution.Specifically,wehaveassumed

long‐termmarketsharesof60%,20%and20%forNestlé,SaraLeeandEthical

Coffee,respectively.

iii) Increasedistribution:Forthisoption,weassumedNestlématchesthedistribution

convenience of the new products by expanding its distribution capacities to

wholesalers,butkeepsitspriceattheoriginallevel.Asaresultofthisstrategy,we

haveassumedlong‐termmarketsharestobe60%,20%and20%forNestlé,Sara

LeeandEthicalCoffeerespectively.Additionally,forthepayoffsanalysis,wehave

assumeda30%wholesalermark‐up for theNespresso capsules, soNespresso’s

revenuepercupwillbeaffectedduetothisnewdistributionchannel.

iv) Combination of price and distribution: This is the pure fight scenario.We have

assumedlong‐termmarketsharestobe85%,7.5%and7.5%forNestlé,SaraLee

andEthicalCoffeerespectively.

Let’stakealookattheupperpartofthetreenow.Inthiscase,insteadofjustlaunchingalegal

battlebeforecompetitorsmanagetoenter,Nestléhastheoptionofsendingsomesignalstodeter

enterwithoutengaginginthelegalbattlebeforehand.WhatareNestlésignalingoptions?Nestlécan

mainlydotwothings:1)signalthroughtheuseofthemediathattheyarewillingtofightbackany32FordetailsoneachscenariopleaserefertoExhibits1to4.


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attempt of entry by engaging on price, distribution and legal wars, and 2) signal by preparing

openlyforapossibleresponsetoentry;inthisparticularcase,bybuildingenoughcapacitytoflood

themarketascompetitorstrytoenter.Ifthesesignalsendupbeingeffective,thenewentrantswill

stayout,meaningbusinessasusualforalltheplayers.Thegamewouldendwithano‐godecision

fromthenewentrants.However,ifSaraLeeandEthicalCoffeedecidetoenterdespitethesignals,

Nestlé can either respond by following one of the four types of strategic responses described

before,orasanalternative,initiateinthisstagealegalbattleforinfringementofitspatentsrights.

Iftheywinthelegalbattle,thenewentrantswillhavetoexitthemarket,butiftheylose,theywill

havetofollowoneofthefourlong‐termstrategicresponses.

Solvingthegame

In order to start solving this game,we first approached the payoffs of scenarios that do not

involvelegalissues(upperpartofthetree),andassumedthatforalltheseplayersaredrivenonly

byprofitmaximizingobjectives.Theresultsaresummarizedinthefollowingtableinbillionsof$:

Using this data, we can see that from Nestlé’s point of view, they have a dominant strategy

withinthefourlong‐termstrategicresponses:DoNothing.Byunderstandingthis,wesimplifiedour

decisiontreebyeliminatingthebranchesassociatedwithdominatedstrategies.FigureNo.2shows

thesimplifieddecisiontree.

Nestle SL&EC Nestle Nestle SL EC

Signal Stay out 45.40$ -$ -$

Signal Enter Do Nothing 23.44$ 6.13$ 6.02$

Signal Enter Only Distribution 21.31$ 4.92$ 4.86$

Signal Enter Only Price 21.38$ 4.89$ 4.83$

Signal Enter Price & Distribution 18.79$ 1.82$ 1.82$

Decisions Payoffs


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FigureNo.2:SimplifiedDecisionTree

As a second step,weapproached thenodes that refer to legalbattles,byacknowledging that

now,thetwopossiblescenariosafterthelegalbattleare:1)awinforNestléor2)anentryfromthe

otherswithaDoNothingresponsefromNestlé.Inaddition,webasedourassumptionsonthefact

thatEthicalCoffee is a startupwith limited resources andhasopenlydeclared that theywill not

fightNestléinthecourts.WealsoassumedthatEthicalCoffeewillfreerideatSaraLee’sexpensein

casealegalbattleisrealized,sinceSaraLeehasdeeppocketsandhasstatedthatitwilldoanything

toenterthiskeysegmentforitsfuturegrowth.

Wecalculated lobbyingexpenses (usingaMcCain‐Schummerapproach)andexpectedpayoffs

foreachplayerforthefollowingcases(figuresinB$):

1) Legalbattleafterentry

Sara Lee (SL) &

Ethical Coffee (EC)

announce entry

Initiate legal battle

(Before Entry)

Signaling to deter entry

Nestle (N)

Do nothing

N Wins

N Loses (Only

postpones EC & SL entry)


N loses

N wins

SL, EC stay out

SL, EC enter

Do nothing

Do nothing

Nestle SL EC

Payoffs if Nestle wins (no legal fees) $44.47 $0.31 $0.20

Payoffs if Nestle losses (no legal fees) $23.44 $6.13 $6.02

Net Difference (Max - Min) $21.03 $5.82 $5.82

Legal expenditures $3.57 $0.99 $0.00

Expected payoffs $36.34 $0.59 $1.46

Probabilities

Nestle Wins 78.3%

Nestle Loses 21.7%


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2) Legalbattlebeforeentry(includestwoyearsofextramonopolyforNestlé)

Usingalltheavailableinformationwesolvedthetreebylookingforward–reasoningback.The

resultsareshowninFigureNo.3:

FigureNo.3:Lookforward–reasonback

Fromtheresultswecansee thatNestlé’sbest response is toactually initiatea legalbattleas

soonaspossible,tryingtostopentryatleastforawhile.Thislookslikeaveryreasonableresponse

after 24 years ofmonopoly and 1,700 patents protecting the product. Butwhen analyzingwhat

happenedinreality,westartedfacinganewdilemma:whydidNestlégoforthesignalingstrategy

andleftthelegalactionsjustasathreatincaseofentry?

Nestle SL EC

Payoffs if Nestle wins (no legal fees) $45.40 $0.00 $0.00

Payoffs if Nestle losses (no legal fees) $25.26 $5.61 $5.53

Net Difference (Max - Min) $20.14 $5.61 $5.53

Legal expenditures $3.43 $0.96 $0.00

Expected payoffs $37.58 $0.27 $1.21

Probabilities

Nestle Wins 78.2%

Nestle Loses 21.8%

Sara Lee (SL) &

Ethical Coffee (EC)

announce entry


(Before Entry)

Signaling to deter entry

Nestle (N)

Do nothing

N Wins

N Loses (Only

postpones EC & SL entry)

(45,0,0)


N loses

N wins

(23,6,6)

SL, EC stay out

SL, EC enter

Do nothing

Do nothing

(36,1,1)

(38,1,1)


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AgoodplacetostartsearchingforananswertothissituationisinJean‐PaulGaillard’s–CEOof

EthicalCoffeeandformerheadofNespresso–words:“NoneofNestlé’spatentsarebeingviolated”.

AsaformerheadofNespresso,webelieveJean‐PaulGaillardknowsexactlywhatheisdoing,and

wouldnotstartanewcompanywithoutbeingsurethathecangetaroundNestlé’spatents.This,in

additiontoNestlé’schosenpathofsignaling,leadsustothinkthatNestlé’schancesofwinningthe

legal battle are very much on the low side, and the results we got using the McCain‐Shummer

approachhavetoberevisited.

Asafirstapproach,usingthesamelobbyingexpensescalculatedbefore,wefoundoutthatifthe

chancesofwinning the legalbattle are8% forNestlé, then the companywouldbe indifferenton

whethertostartthelegalbattleorjustallowentryandaccommodate.Soourintuitiontellsusthat

Nestléactuallyexpectedaverylowprobabilityofwinningthelegalbattle, ifanyatall,andthisis

whytheywentforthesignalingpath.Adjustingtheprobabilitiesto0%winningand100%losing

forNestléthetreenowlooksasfollows(eventhoughthisseemsextreme,itisagoodwaytoshow

howthegamechangesforNestléhavingachanceofwinninglowerthan8%):

Withtheseadjustments,theactionsNestléhastakensofarmakemuchmoresensefromagame

theory perspective. We also know that Nestlé has indeed sent signals to deter entry from its

potentialcompetitors:Theyhavepubliclystatedthattheywillfightincourtanyattempttoenter,

andtheyhavealsobuiltadditionalcapacity(upto9billioncupsayear,intheorderof40%more


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capacitythanneeded),withthe intenttoshowthattheyhavethetoolstorespondaggressively if

needed.Sothereisonlyonelastquestiontobeanswered:Whydothesesignalsseemnottohave

stoppedSaraLeeandEthicalCoffee’sentrysofar?Let’sanalyzethemanddrawsomeconclusions:

1) “If you enter ourmarket segmentwewill either take a legal path or respondusingprice

and/ordistributionwars”.

Clearly,afteranalyzing thepayoffsofeachstrategic response,wesawthatdoingnothing isa

dominantstrategy forNestléoverpriceanddistributionwars,so this threat isnotcredible.Also,

usingourpreviousanalysisonNestlé’s lowchanceofwinninga legalbattle, the threatof a legal

battlehasnocredibilityeither. Inaddition, the fact thatNestlédidnotbegina legalbattle in the

beginningmakesthethreatevenlesscredible.

2) 40%extracapacityalreadyinplace

Again,wecanseedirectly fromNestlé’spayoffs that floodingthemarketwouldnotbeawise

decisionasastrategicresponse,sinceaccommodatingisadominantstrategy.

Finally, even though if the signalswherecredibleandNestléhadprofitabledeviations if they

undertookanyofthethreats,ifNestlédoesnotstartalegalbattlebeforeentry,theexpectedpayoffs

fortheentrantsarealwayslargerthanzero,meaningthatenteringisadominantstrategyforSara

LeeandEthicalCoffeefromthatpointgoingforward.

Additionalissuesofthegametotakeintoaccount

1) Thesmallergamebeingplayed:SaraLeeversusEthicalCoffee

FromouranalysisweconcludedthatSaraLeeandEthicalCoffeeshouldenterthemarketand

that Nestlé’s best response is to accommodate. But, there is a sub‐game being played that, even

though it does not affectNestlé’s response, itmight change theway the entrants approach their

pricingstrategies.Bothcompanieshavealreadyannounceda20%discountoverNestlé’sprice.To

seeifthisisapossibleequilibriumlet’sanalyzepossiblestrategiesfromthesecompanies.

This isagamethatwillbeplayedconstantly fora longtime. Ifonecompany lowers itsprice,

thentheothercandosoinarelativelyfastmanner.Also,theyareenteringthepremiumsegmentof


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the market, with current prices of around $0.40 per cup. The segment that follows is the mid‐

market segment,withprices in theorderof$0.22percup.Thus,a firstapproach is to think that

SaraLeeandEthicalCoffeewillatleastmaintainapricingstrategythatkeepstheminthepremium

segment.Weassumedalowercapof$0.3fortheanalysis.Usingthisinformation,plusthefactthat

Nestléwillaccommodateandthetwoentrantswillfightforjusta50%ofthemarket,wecanbuilda

game in itsnormal formforasingleyear. Ifonlyoneplayerdefaults,hegetsa50%totalmarket

share,andtheotheronegets0%. Incase theycooperateordefault, theirshare is25%each.The

gameisasfollows(payoffsin$B)33:

Wecanseethattheplayersarefacingaprisoners’dilemmawhenanalyzingasingleyear.Butin

ordertoseeifequilibriumcouldbereachinthebeginning,wehavetoanalyzewhathappensgoing

forward if one of the players defaults. From a single year, if one player defaults and the other

cooperates, theonethatdefaultsgetsanextra$0.09 for thatyear.Butsince theotherplayerwill

default in the next period, the expected payoffs going forward (talking into account the value of

moneywitha10%discountrate),willbeB$2.8lessthaniftheyhadcooperatedindefinitely.Since

the game will be played for a very long time, we believe that there is a high chance that both

entrants will cooperate at a high price point, at least in the beginning.We have seen that both

companieshaveindeedsignaledthattheyareenteringthemarketatasamepricepoint,whichgoes

inlinewithouranalysis.

2) IsNespressoabettercoffee?HowloyalareNespresso’scustomers?

While we do not have any information on whether the coffee sold by Nestlé is significantly

different/betterthanthecoffeesoldbySaraLeeandEthicalCoffee,weassumeherethatthequality

ofcoffeewouldbe‘verysimilar’.SaraLeeisknownforbringingqualityproductsinthemarketand

so it will be difficult for them to sell something that lowers their brand image. Ethical Coffee’s

33Thenumber$0.35Bcomesfromyear2012ofExhibit1,wherebothplayershavereacheda25%marketshare.Therestofthepayoffsofthissmallergamewherecalculatedbyadjustingpricesandmarketsharesonthissamescenario.

Cooperate Default

Cooperate 0.35 , 0.35 0.44 , 0.00

Default 0.00 , 0.44 0.22 , 0.22


15

declaration that we sell “Coffee and not Clooney” seems to indicate that its coffee is similar to

Nestlé’sbutthatNestléhasclaimedpremiummarginsbecauseofthepremiumimageithasbuilt.

This iswhyforthisparticularanalysisweassumedthatwillingnesstopaywassimilar foranyof

thebrands.

However, inorder to give someadditional insight,weplayedwith someof ournumbers and

realizedthatifthosenon‐loyalcustomershaveawillingnesstopaythatis10.75percentagepoints

higher for Nespresso than for the alternative coffee, then Nestlé is indifferent between

accommodating and starting an “only price” response (the percentage was calculated on the

original price, so it would be around $0.05). But, in case the difference in willingness to pay is

higherthan10.75percentagepoints,thenNestlé’sbestresponsewouldbetoinitiatean“onlyprice”

response,inwhichtheywouldkeepmorethan50%ofthemarketwithapricecutthathashigher

benefitsthroughincreasedmarketshare.

On another issue, for our analysis we assumed that 50% of Nestlé’s clients are loyal to the

brand,andwillnotchangeonthebasisofalowerprice.Forthispercentageofloyalty,Nestlé’sbest

response is toaccommodate.Butwhat if itwas lower?Wecalculated that if the loyalswereonly

45%,Nestléwouldbeindifferentbetweenaccommodatingandinitiatingapurepricewar.Forany

percentageabove45%Nespressowouldaccommodate,andbelowthat,theirbestresponsewould

betostartplayingwithprice.

Conclusions

Afteranalyzingthisveryentertainingcase,wecanseehowbothSaraLeeandEthicalCoffeeare

using a judo strategy by exploiting Nespresso’s inflexibilities: premium brand image, selective

distributionchannelsandhighercosts.Nestléfacesthepotentialoflosingitspremiumimageand

highmarginsbyengaginginnewdistributionchannelsand/orpricecuts,andthecostsofreacting

throughthesetacticsarehigherthanitsbenefits.

Inaddition,thiscasewasfilledwithsignaling.Wediscoveredhowthedifferentsignalschanged

the outcome of the game depending on signal credibility. Nestlé’s signals over legal battles and

price/distribution threats turnedout to be very ineffective, and thus Sara Lee andEthical Coffee

were not scared of going forward with their respective entry strategies. On the opposite side,

EthicalCoffee’ssignalsaboutnotsteppingonNespresso’s1,700patentsisverycredibleasEthical


16

Coffee’sCEOranNespresso forseveralyears,andclearlyunderstands the legal issuesbehindthe

business,andNestlé’spoliciesonthesematters.

AninterestingpointtoacknowledgeishowbothSaraLeeandEthicalCoffeehaveclearlystated

thattheywillnotsteponNestlé’sdistributionchannels,asasignaltofurtherconvinceNestléthatit

is in their best interest to accommodate and keep that distribution channel for itself, while

maintainingamorepremiumimageoveritsnewcompetitors,andthusbeingabletokeepcharging

ahigherprice.Bothentrantshavesomehowcommittedtostayingoutofthatexclusivechannelby

securingcontractswithretailersatalowerpricepoint(SaraLeeshippeddirectlytoretailerswhile

Ethical Coffee closed deals to be sold as private label). It is also costly for them to develop this

exclusivechannelfromscratch,makingtheirsignalsmorecredible.

WealsosawsomepossiblefreeridingfromEthicalCoffeeintermsoflobbyingexpenses.This

freeridingproblemendsuppushingthenewentrants’overall lobbyingexpensestoa lowerthan

optimal level, diminishing their chances of winning the legal battle. However, in this particular

case,wehavesomehintsthatleadustothinkthatthelegalbattleseemslostforNestlédespiteits

lobbyingexpenditures.ThisideaissupportedonthesignalsthatEthicalCoffeehassentthroughhis

CEO, a person that clearly knows the rules of the games that they are starting to play, and in

addition,bythefactthatNestlédidnotundertakethisstrategybeforethenewplayersenteredthe

market.

Wealsoacknowledgethatthereisasmallergamebeingplayedbetweenthenewentrants,and

howacooperativeequilibrium–withsignalsondistributionchannelsandpricepoints–isavery

plausible outcome for them. We think both new entrants have understood the benefits of

cooperating as they enter simultaneously, and not only cooperating on price and distribution

channels,butalsoactingaccordinglyinordertosuccessfullyapplyajudostrategyagainstNestlé,a

situationthatbenefitsbothofthem.

As a final comment, we believe that Nestlé will indeed take an accommodating strategy in

response to thesenewcompetitors in themarket, since fightingonpriceanddistributiondonot

yieldattractivepayoffsrelativetothe“donothing”approach. Timewilltell ifourpredictionsare

correct.


17

Sources

1. BusinessWeek(Bloomberg).Mulier,Tom.“NespressoRivalSaysOrderBookFullat4

BillionCapsules.”March31,2010.http://www.businessweek.com/news/2010‐03‐

31/nespresso‐rival‐says‐order‐book‐full‐at‐4‐billion‐capsules.html

2. BusinessWeek(Bloomberg).Mulier,Tom.“SaraLeeAnswersClooney’sNespressoQuerywithCheaperCoffee.April7,2010.http://www.businessweek.com/news/2010‐04‐

07/sara‐lee‐answers‐clooney‐s‐nespresso‐query‐with‐cheaper‐coffee.html3. ChicagoBusiness.Sterrett,David.“SaraLeeCEOBrendaBarnesfiresashotinamust‐win

coffeewar.”April5,2010.http://www.chicagobusiness.com/cgi‐

bin/mag/article.pl?articleId=33226

4. DowJonesDeutschland.“NestleNestléCoffeeGrowthEngineChallengedbyFormerMgr.”

March8,2010.http://www.dowjones.de/site/2010/03/nestleNestlé‐coffee‐growth‐

engine‐challenged‐by‐former‐mgr.html

5. Nespressowebsite.“Aboutus–OurHistory”

http://www1.nespresso.com/precom/aboutus/aboutus2.php

6. RadioTélevisionSuisse.“LesgoutsdeluxedeNespresso.”October8,2004.

http://www.nouvo.ch/52‐1

7. TheWallStreetJournal.Passariello,Christina.“NestleStakesItsGroundsinaEuropean

CoffeeWar.”April28,2010.

http://online.wsj.com/article/SB10001424052748704388304575202402216730116.html

?mod=WSJ_business_MediaMktNewsBucket

8. SaraLeeCorp.PressRelease.“SaraLeeLaunchesNewEspressoCapsuleCompatibleWith

NespressoCoffeeAppliances.”March30,2010.

http://www.saralee.com/~/media/C360C6E28E4549008444323FD5ED2BF4.ashx

9. SaraLeewebsite.“Aboutus–OurTimeline.”

http://www.saralee.com/AboutSaraLee/OurTimeline.aspx


18

ExhibitNo.1–Nestlérespondsbyaccommodating

Growth Rate of market first 5 years 20%

Growth Rate of market after 5 years 3%

Discount Rate 10%

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Estimated Total Market (Billion capsules) 5.5 6.6 7.9 9.5 11.4 13.7 14.1 14.5 15.0 15.4 15.9

Nestle's Price per capsule ($) 0.500 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50

Sara Lee's Price per capsule ($) 0.400 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40

Ethical Coffee's Price per capsule ($) 0.400 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40

Nestle's Revenues per capsule ($) * 0.470 0.47 0.47 0.47 0.47 0.47 0.47 0.47 0.47 0.47 0.47

Sara Lee's Revenues per capsule ($) ** 0.277 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28

Ethical Coffee's Revenue per capsule ($) 0.277 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28

Nestle's Cost per capsule($) 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15

Sara Lee's Cost per capsule ($) *** 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10

Ethical Coffee's Cost per capsule ($) 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10

Nestle's Capacity (Billion capsules) 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00

Sara Lee's Capacity (Billion capsules) 2.00 4.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00

Ethical Coffee's Capacity (Billion capsules)**** 0.35 1.00 2.00 4.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00

Nestle's Unit Market Share 80% 65% 50% 50% 50% 50% 50% 50% 50% 50% 50%

Sara Lee's Unit Market Share 14% 20% 25% 25% 25% 25% 25% 25% 25% 25% 25%

Ethical Coffee's Unit Market Share 6% 15% 25% 25% 25% 25% 25% 25% 25% 25% 25%

Nestle's Sales (Billion capsules) 4.40 4.29 3.96 4.75 5.70 6.84 7.05 7.26 7.48 7.70 7.93

Sara Lee's Sales (Billion capsules) 0.75 1.31 1.98 2.38 2.85 3.42 3.52 3.63 3.74 3.85 3.97

Ethical Coffee's Sales (Billion capsules) 0.35 1.00 1.98 2.38 2.85 3.42 3.52 3.63 3.74 3.85 3.97

Nestle's Sales (B$) 2.07 2.02 1.86 2.23 2.68 3.22 3.31 3.41 3.52 3.62 3.73

Sara Lee's Sales (B$) 0.21 0.36 0.55 0.66 0.79 0.95 0.98 1.01 1.04 1.07 1.10

Ethical Coffee's Sales (B$) 0.10 0.28 0.55 0.66 0.79 0.95 0.98 1.01 1.04 1.07 1.10

Nestle's Cost of Sales (B$) 0.66 0.64 0.59 0.71 0.86 1.03 1.06 1.09 1.12 1.16 1.19

Sara Lee's Cost of Sales (B$) 0.08 0.13 0.20 0.24 0.29 0.34 0.35 0.36 0.37 0.39 0.40

Ethical Coffee's Cost of Sales (B$) 0.04 0.10 0.20 0.24 0.29 0.34 0.35 0.36 0.37 0.39 0.40

Residual Value *****

Nestle's Net Contribution Margin (B$) 1.41 1.37 1.27 1.52 1.83 2.19 2.26 2.32 2.39 2.47 2.54 36.29

Sara Lee's Net Contribution Margin (B$) 0.13 0.23 0.35 0.42 0.51 0.61 0.62 0.64 0.66 0.68 0.70 10.04

Ethical Coffee's Net Contribution Margin (B$) 0.06 0.18 0.35 0.42 0.51 0.61 0.62 0.64 0.66 0.68 0.70 10.04

Nestle's NPV (B$) $23.44

Sara Lee's NPV (B$) $6.13

Ethical Coffee's NPV (B$) $6.02

* Net revenues for Nestle include a 5% cost of distribution

** Net revenues for Sara Lee and Ethical Coffee include a 30% markup taken by retailers

*** Sara Lee and Ethical Coffee's cost assumed lower because they use cheaper package

**** Ethical Coffee has small initial capacity but has announced a rapid increase

***** Residual value calculated with a yearly growth rate of 3%


19

ExhibitNo.2–Nestlérespondsbyonlyincreasingdistribution



Discount Rate 10%

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020


Nestle's Price per capsule ($) 0.500 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50

Sara Lee's Price per capsule ($) 0.400 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40

Ethical Coffee's Price per capsule ($) 0.400 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40

Nestle's Revenues per capsule ($) * 0.396 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40

Sara Lee's Revenues per capsule ($) 0.277 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28

Ethical Coffee's Revenue per capsule ($) 0.277 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28

Nestle's Cost ($) 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15

Sara Lee's Cost ($) 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10

Ethical Coffee's Cost ($) 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10

Nestle's Capacity 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00 9.00

Sara Lee's Capacity 2.00 4.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00

Ethical Coffee's Capacity 0.35 1.00 2.00 3.00 4.00 5.00 5.00 5.00 5.00 5.00 5.00







Nestle's Sales (B$) 1.74 1.83 1.88 2.26 2.71 3.25 3.35 3.45 3.55 3.66 3.77

Sara Lee's Sales (B$) 0.21 0.27 0.44 0.53 0.63 0.76 0.78 0.80 0.83 0.85 0.88





Residual Value







* Revenues for Nestle include a 20% cost of distribution (5% on original channel and 30% through retailers)


20

ExhibitNo.3–Nestlérespondsbyonlyloweringprice



Discount Rate 10%

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020


Nestle's Price ($) 0.417 0.42 0.42 0.42 0.42 0.42 0.42 0.42 0.42 0.42 0.42

Sara Lee's Price ($) 0.400 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40

Ethical Coffee's Price ($) 0.400 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40

Nestle's Revenues ($) 0.396 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40

Sara Lee's Revenues ($) 0.277 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28

Ethical Coffee's Revenues ($) 0.277 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28

Nestle's Cost ($) 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15

Sara Lee's Cost ($) 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10











Nestle's Sales (B$) 1.74 1.83 2.04 2.26 2.71 3.25 3.35 3.45 3.55 3.66 3.77

Sara Lee's Sales (B$) 0.21 0.27 0.38 0.53 0.63 0.76 0.78 0.80 0.83 0.85 0.88





Residual Value








21

ExhibitNo.4–Nestlérespondswithbothpriceanddistribution



Discount Rate 10%

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020


Nestle's Price ($) 0.417 0.42 0.42 0.42 0.42 0.42 0.42 0.42 0.42 0.42 0.42

Sara Lee's Price ($) 0.400 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40

Ethical Coffee's Price ($) 0.400 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40

Nestle's Revenues ($) 0.305 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.30

Sara Lee's Revenues ($) 0.277 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28

Ethical Coffee's Revenues ($) 0.277 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28 0.28

Nestle's Cost ($) 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15 0.15

Sara Lee's Cost ($) 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10 0.10











Nestle's Sales (B$) 1.59 1.81 2.05 2.46 2.96 3.55 3.65 3.76 3.88 3.99 4.11

Sara Lee's Sales (B$) 0.04 0.09 0.16 0.20 0.24 0.28 0.29 0.30 0.31 0.32 0.33





Residual Value







Documents

Nespressoâ€™s Brewing European Coffee War