Café-X In Search of Strategy: Nestlé

New Espresso Maker 1 In 1986, the Swiss giant Nestlé introduced a new type of espresso machine in the Swiss market. It represented one of the most innovative new products developed by its R&D department. Through the use of coffee capsules, the patented system combined the taste of real espresso coffee with convenience and ease of use. However, despite an enthusiastic reception from connoisseur coffee drinkers and very promising market research, the first few years after its introduction, the CoffeeMaker was far from living up to its expectations. In fact, the dedicated business unit was losing money. Therefore, in March 1988, Nestlé appointed a new, young Managing Director, called Jean-Paul Gaillard. Gaillard was considering what to do to improve the new product’s fortunes. He realized that, unless sales of the CoffeeMaker would pick up considerably soon, Nestlé would have no choice but to stop investing in the new product. He wondered whether he should give the current strategy more time to play itself out, or should he proceed with a new strategy?

Coffee Industry Trends Market research showed that in existing coffee sectors, consumers were becoming more adventurous in their buying behavior and tended to favor the premium and super premium end of the market. These new markets were growing at the expense of instant powdered coffee. Other changes taking place in the coffee market included: (1) increasing popularity of cafes and coffee bars; (2) rising brand consciousness; and (3) the rising price-consciousness of the mass market consumer, who switched to supermarket brands if the price of coffee rose. The Rise of Espresso Espresso coffee is coffee of the greatest possible strength. Its quality is determined by the “fineness” of the coffee used. The fineness of coffee depends on the grind as well as on the type of appliance in which it is used. Espresso machines, in which water and steam are forced through the ground coffee under pressure, need the finest grinds of all in order to produce coffee of the greatest possible strength.

Espresso coffee was traditionally popular in Italy, Spain and France but it was also becoming more popular in other European countries and the US. Nestlé’s Positions in Coffee Nestlé held a dominant market position in instant coffee. Soluble coffee was the biggest money-maker for Nestlé. It represented more than 80% of Nestlé’s coffee sales, with the rest being occupied by roast and ground coffee sales. It had strong brands in all the sub-segments of the instant-coffee market, yet Nestlé felt it could not rest on its laurels. Its traditional competitors were becoming more aggressive and supermarket chains were entering the market through their own brands. Nestlé began to segment the soluble coffee market into finer and finer segments. This gave a further boost to the demand for instant coffee but did not attract the high-end consumer who required a foamier coffee, achievable only with the use of pressurized water.

This case is based on research by Costas Markides, Professor of Strategic & International Management at the London Business School

History of the EspressoMaker The origins of the new EspressoMaker dated back to the late 1960s. Continuous experimentation over a ten year period had led to the final system that consisted of two parts: a coffee capsule and a machine. The coffee capsule contained 5g of roast and ground coffee. The machine was jointly developed with the Swiss machine manufacturer Turmix. The use of the new system was straightforward. The capsule was manually placed in the handle, which was introduced into the machine. This action pierced the coffee capsule at the top. At the press of a button, pressurized, steamed water was passed through the capsule. The result was a creamy, foamy, high-quality cup of espresso coffee. Strategic Positioning, 1985-87 The success of the EspressoMaker depended not only on the coffee product (i.e. the coffee capsules) which Nestlé controlled, but also on the quality of the appliances used (outside Nestlé’s control) and on the ability to produce and sell to a mass market.

This dependence on outsiders was unusual for Nestlé. In addition, the product threatened to cannibalize the sales of other Nestlé products. Nestlé set up a joint venture with a Swiss-based operator called Sobal to sell the new product2. The joint venture (Sobal-EspressoMaker) purchased the machines from Turmix and the coffee capsules from Nestlé and then distributed and sold everything as a system—one product, one price. A separate unit called EspressoMaker S.A. supported the joint venture and provided technical and marketing advice. As shown in Exhibit 1, twenty-two other distributors were given permission to sell EspressoMaker machines. Choice of Customers With the EspressoMaker, Nestlé would no longer be selling merely a product, but also the required hardware and the related services. This required Nestlé to focus on the production of high quality coffee capsules, a service offering to reassure the customer, the manufacturing of reliable machines, the training of people on how to operate the system, and the organization of a maintenance workforce. Once the target countries were chosen (initially Switzerland, Italy, France and Japan), Nestlé further defined target market segments. Nestlé felt that the high cost of the machines and of the capsules meant that household users would not find the EspressoMaker product attractive.

By contrast, offices and small companies were thought to be less price-sensitive and more likely to buy the EspressoMaker system as a perk for their employees. Small and medium sized companies were therefore identified as the primary target market—these companies were unlikely to buy a sophisticated, large-scale espresso machine but would be receptive to the EspressoMaker system as an attractive alternative due to its relatively cheap price and its ease-of-use and reliability. Selling and Distribution The EspressoMaker machines were sold either by Sobal- EspressoMaker or by 22 other distributors. SobalEspressoMaker approached customers through a direct mailing campaign all over Switzerland. If interested, the customer filled out and returned a simple form at which point the Sobal salespeople approached him/her. The EspressoMaker machine would then be delivered to the customer. The joint-venture had no sales force, so it depended on Sobal personnel. However, the Sobal sales force consisted of two representatives and two technicians for whom the sale of EspressoMaker machines was only one of their numerous responsibilities. As a result, the 22 other distributors of the EspressoMaker machines played an important role.

Sobal was a small company active in the distribution of a wide variety of products (appliances, cosmetics, etc).

The customer could order coffee capsules either directly from the Sobal- EspressoMaker joint venture or from the distributors. The joint-venture preferred to sell the machines at a high price but kept the prices of the coffee capsules low. On the other hand, the distributors favored leasing of the machines and selling the capsules at a high price. It was in the sale of capsules that the distributors made their money. Production It was decided that one of SPN’s (Société des Produits Nestlé) small coffee factories located in Switzerland would be responsible for the production of the coffee capsules. The production of the machines was a more difficult issue. Natural partners to manufacture the machines included companies whose existing business included the manufacture and distribution all kinds of household appliances, including coffee machines.

Sub-contracting manufacturing to one of these companies was risky because they had little incentive to promote the EspressoMaker machines. Most of these potential partners were already in possession of a machine for roast and ground coffee which they were selling under their own brand name. However, Nestlé believed that these subcontractors would realize that it was better for them to cannibalize their own products than for one of their competitors to do it for them—especially with an innovation as promising as the EspressoMaker system. Therefore, the real issues for Nestlé related more to the volumes and the margins that it would be willing to accept from these subcontractors than whether to subcontract to them or not. In the end, Turmix was selected as the main subcontractor for the production of the machines to be sold in Europe. Pricing and Services Test markets showed that coffee made with a EspressoMaker machine was excellent but that there were few customers who would buy a machine at SFr. 600 and pay an additional SFr. 0.30 per cup of coffee.

It was therefore decided that potential clients would receive machines on a trial basis. Coffee capsules would now be sold at SFr. 0.60 a piece. For EspressoMaker, the lending of machines to customers would stimulate interest in the new system. For the customer, the “try now, buy later” approach was very attractive. Those interested in owning a machine could purchase the machine with or without services (services included a five year warranty and on-site assistance). The coffee capsules were manufactured by SPN in Orbe, Switzerland, and sold to the joint venture. As with the machines, the capsules were either directly sold to customers of the joint-venture or through dealers. Results of the first two years: 1986-1987 Table 1 presents the results of the first two years in terms of machine sales. The targets were far from being reached and the actual results barely amounted to half of the targeted figures. Table 1: Machines Model Manufactured Sold Number of machines manufactured and sold in 1986/87 (in units) C 100 15,662 9,852 C 1100 3,939 2,487 C 1101 2,800 Total 22,401 12,339

In terms of coffee capsules, the volume sold in the first two years was also far below the forecast volume. Despite a major jump in 1987, the volume sold in tons of coffee did not reach the amounts expected by Nestlé at launch time in 1985. Unless the sales of machines picked up considerably, there was little hope that coffee capsule sales could improve a lot.

The financial numbers (Table 2), reflected the disappointing sales of machines and coffee capsules. Investments in the launch of the EspressoMaker system in Japan worsened the situation. It should be noted that R&D costs spent up-front (about Sfr, 1,756,000) are not accounted for in Table 2. There were other warning signs on the horizon. The machines were not reliable, leading to continuous maintenance and service. Defective parts led to high costs of repair which often outweighed the cost of a new machine. On the distribution side, distributors had not reached sales targets, making EspressoMaker’s survival difficult. Table 2: Operating results for EspressoMaker S.A. and worldwide,1986-87 1986 Sales Cost of goods sold Operating margin Fees on machines sold R&D Operating results of EspressoMaker S.A. 1,485 -1,512 -1,082 71 —–1,011 1987 3,842 -3,357 -1,979 197 -500 -2,282

Operating results of EspressoMaker S.A. Operating results of Nestlé Japan Loss on transfer pricing Operating results of SPN Gains on taxes Financial costs

-1,011 NA NA NA NA NA -1,011

-1,782 -1,974 -343 -277 1,167 -90 -3,799

What to do? It was clear that the current strategy was not producing the desired results but Jean-Paul Gaillard was unsure whether the strategy had to be changed or whether it was a just a matter of allowing the current strategy to play itself out. Even if he decided in favor of changing the current strategy, the question was, “change to what?”