After Six Years and $50 Billion of Deals, One Investment Firm Has Turned the Coffee Market Into a Game of Capital

Nestlé and Starbucks have struck a $7.15 billion deal. Meanwhile, another new player is already in the market, and it threatens everyone.

Take in too much caffeine and your heart races, your mind speeds up, and you can't stop. That is exactly what the coffee market has looked like these past few years.

Last Monday, Nestlé closed the biggest coffee deal in its 152-year history, paying Starbucks $7.15 billion for its coffee retail business.

But this time Nestlé gets no physical assets. It gets only the worldwide right to use the Starbucks brand outside coffee shops — to make and sell coffee beans, instant coffee powder, tea and capsule coffee on Starbucks's behalf. That is a business with $2 billion in annual revenue, about 8% of everything Starbucks takes in.

Nestlé's previous coffee deal was as recent as 2017, when it paid $500 million for a controlling stake in Blue Bottle (valued at $700 million), the specialty coffee brand that took off in Silicon Valley. Blue Bottle has 49 stores in the US and Japan, and is popular for its fashionable coffee aesthetic.

Nestlé paid a steep premium for the little blue bottle — the equivalent of $14 million per store, and the smallest of those stores are under 10 square meters. Starbucks's stores cost more to build and run, yet each supports an average market value of less than $3 million.

The deal matters to Starbucks too: it needs Nestlé's sales network. Starbucks holds more than 10% of the coffee market only in the US. Everywhere else its influence is far smaller, and in some places nonexistent — either coffee culture there is so strong that Starbucks looks beneath notice, or there is no coffee culture at all.

Italy is the birthplace of Western coffee culture, and Starbucks did not enter that market until 2016. In China, Starbucks has more than 3,000 stores, but they cluster in first- and second-tier cities. Through Nestlé's distribution network, as fine-grained as capillaries across the globe, Starbucks can appear before consumers as packaged instant coffee and build brand recognition years earlier than it otherwise could.

Nestlé still has the channels, but its brand stopped being cool long ago. As Erik Gordon, a professor at the University of Michigan's Ross School of Business, told The Washington Post: "For anyone under 60, Nescafé is boring."

"Nestlé needs a big brand, and it needs one urgently," said Alain Oberhuber, an analyst at MainFirst Bank Switzerland, on the deal. "Starbucks is the only strong brand in the roast-and-ground coffee market. This is a fairly defensive move, a bit late, but strategically it is an absolutely crucial step."

Nestlé looks like the more anxious party; Starbucks is the stronger side here. Starbucks CEO Kevin Johnson said on a conference call that the company still intends to keep making K-Cup pods for Keurig Green Mountain's capsule machines, and is in talks with Keurig about it.

Yet it has been less than 10 years since Starbucks took the bagged-coffee business back from Kraft to run itself. Ending that contract three years early cost Starbucks $2.76 billion, paid to Mondelez International (Kraft split into Kraft and Mondelez in 2012). Now it is looking for a partner again, because Starbucks has run into new problems and has no attention to spare for its packaged business.

Behind the urgency is a new rival whose acquisition habit looks even worse.

This January, Keurig Green Mountain Coffee — fourth in US coffee market share, first in capsule coffee — spent $18.7 billion to buy the soda brand Dr Pepper, America's oldest soft-drink brand and one of the few carbonated-drink companies still growing. Dr Pepper's product line is narrow, though; Keurig bought it mainly for its powerful distribution.

Behind all of this sits JAB Holding Company (Joh. A. Benckiser Group). Since 2012, JAB has spent more than $40 billion on at least nine coffee-related acquisitions — including Keurig Green Mountain itself, the vehicle it used to buy Dr Pepper, which JAB had picked up in 2015 for $13.7 billion.

Before that, in 2013, JAB spent $9.7 billion on the Dutch coffee company D.E Master Blenders, then the following year led its merger with Mondelez International's coffee business (including Maxwell House, the brand behind "good to the last drop"). The merged company, Jacobs Douwe Egberts (JDE), holds 9.6% of the global coffee market, making it the largest coffee company after Nestlé.

Globally, Nestlé, with 22.6% of the market, has never faced a rival on this scale in coffee. Even Starbucks holds only 2.5% worldwide.

The companies under JAB control plenty of brands you know: Durex, Dettol, Calvin Klein, Marc Jacobs, Belle, Chloé — consumer goods and fashion alike. Yet apart from its big purchases of the past few years, it had nothing to do with the food industry at all.

Six years ago JAB was an outsider to the coffee market. It bought its way in by force and became a threat to everyone. The names it gives its companies — JAB, JDE, KDP (Keurig and Dr Pepper merged into Keurig Dr Pepper) — keep to the same blunt initials, as if the only urgent business were getting bigger.

Two of JAB's three partners once served on the board of Anheuser-Busch InBev, which has led some analysts to think JAB means to build a coffee empire the way AB InBev built a beer empire. The two industries have a lot in common: craft beer brands are fraying the nerves of the big brewers, and an upstart has barged in while everyone is distracted.

The Coffee Market Used to Be Relatively Stable

2018 happens to be the 80th anniversary of Nescafé. As the world's first "soluble coffee," it was developed to help soak up Brazil's surplus coffee beans, then spread around the world with American troops in the Second World War and, later, with television advertising. (After the war ended in 1946, per capita coffee consumption in the US soared to 9 kilograms a year.)

Nescafé's cheap robusta beans and its spray-drying process kept the price low and stripped out the aroma. Those traits opened a vast mass market for Nestlé, and they later became the stone in its path when it tried to make itself a premium brand. For its first 30-odd years, Nestlé took the global market with cheap, convenient instant coffee; by 1974, Nescafé's global share had reached an astonishing 30%.

By then Nestlé had already hit a ceiling. In 1970 it started work on the Nespresso capsule machine, looking for new room to grow.

The year after that project began, three classmates from the University of San Francisco founded Starbucks, meaning to give people better-tasting freshly brewed coffee. In a US market where coffee culture was already fairly mature, that set off what is called the "second wave" of coffee. The lead in the previous wave had been Nestlé, which first turned the farm crop of coffee beans into a standardized global drink, no longer confined to Italian coffee bars.

Starbucks's arrival cost Nestlé the US market, now the world's largest for coffee consumption — Americans drink nearly a third of global production. According to data Euromonitor gave QDaily, Nestlé holds just 5.7% of the North American market, which is led by Starbucks (12.2%), the American instant brand Folgers (11.2%) and Maxwell House (7.1%). Over the past five years, instant coffee has been the only category in the US market to keep shrinking, at a compound rate of -2.3%.

Nestlé's answer was the Nespresso mentioned above, which launched in 1986 after 10 years of work. Nestlé poured huge sums into developing the capsule machine and filed more than 1,700 patents on it.

A capsule machine is a classic "razor" business: you make your money on the blades. Nestlé wants consumers to buy a Nespresso machine so they will keep buying Nestlé's proprietary Nespresso capsules, a steady stream of revenue.

Nestlé licensed the machine's hardware patents to manufacturers and kept only the capsules for itself. Capsule coffee can carry a gross margin above 30%, twice Nestlé's overall 15%.

The capsule once carried Nestlé's hopes for where coffee was going: better taste, steady customers.

It did not work out. In the US, the industry's real upgrade turned out to be the freshly brewed coffee Starbucks popularized — better tasting than instant, and made for you by someone else.

The Nespresso machine still did not win the US back for Nestlé, and then Keurig Green Mountain appeared. Keurig took a different route; the way it opened up its capsule system has been called the Android of the capsule coffee market. Any coffee brand — Starbucks included — could pay a licensing fee and make pods that fit a K-Cup machine.

Capsule coffee itself — 5 to 6 grams of ground coffee in a sealed aluminum shell flushed with inert gas, extracted into espresso under high pressure — is a purely industrial product designed for convenience, neither friendly to the environment nor carrying any coffee culture. And yet it is also a product you have to operate by hand, one that tests how mature a market's coffee culture is, one that needs enough people who want a compromise between the two extremes of instant and specialty coffee.

A product with that many contradictions is unlikely to earn much loyalty from the people who choose it. As Nespresso's 1,700-plus patents began expiring from 2010, imitators flooded the European and American markets. Nestlé gave up insisting on selling capsules only through its own boutiques and worked with European supermarket chains to widen distribution.

From 2015, Nestlé moved Nespresso's spokesman George Clooney from Europe to the US, keeping the same line: "What else?" In hindsight, the second half of the line should have been "Starbucks."

Now that Nestlé can make and sell Starbucks-branded capsules and instant coffee, its position in the capsule market gains the strength of that name. It could also make operations harder, with Starbucks eating into Nespresso.

Starbucks got into instant coffee in 2009 — it refuses to call the product instant, calling it "VIA Ready Brew" to mark the difference — and claimed a taste that could match the fresh coffee in its own stores.

In Onward, the memoir by Starbucks founder Howard Schultz, he holds VIA up as proof that Starbucks dares to invent, spending many pages on its full history from the start of development in 1989 to launch. Schultz had meant the product to win over "coffee lovers who had never even considered drinking instant coffee," but in the end it "failed to win consumers' affection, which deeply disappointed me."

In 1998, Starbucks handed its instant business to Kraft, selling bagged Starbucks coffee through the department stores and other outlets Kraft supplied.

The deal was set to run to March 2014, but Starbucks argued that "Kraft did not properly fulfill its obligations under the contract, damaging Starbucks's performance," and ended it early, in 2011, intending to build the business itself. Two years later, Starbucks said publicly that the bagged business brought in $1.4 billion in revenue in fiscal 2013, with margins up 47% over the previous two years.

But held back by Nestlé's brand image and by Starbucks's business model, neither company managed to make the new market it entered any bigger. Even today, capsule coffee is only 6% of the global coffee market. Starbucks's instant coffee never caught on either.

The market kept growing, but not much changed: big companies still wanted scale and efficiency. A few years after Starbucks shut every US store for a day to retrain its staff in how to make coffee, all those stores were fitted with supposedly better automatic machines, and most baristas were left steaming milk and pouring hot water.

The Specialty "Third Wave" Broke Open a Static Market — Then Capital Took the Wave Over

What broke the static market was a movement known as the "third wave" of coffee, which began in the US around 2003. Consumers baptized in this wave were expected not only to rattle off the difference between a cappuccino and a latte without effort, but also to tell an AeroPress from a pour-over kettle from a V60 from cold-drip coffee.

Led by specialty shops such as Blue Bottle, Intelligentsia Coffee, Stumptown and Philz, people set out to understand more about where coffee-making came from. The third wave puts the barista at its center, stresses origin, and uses lightly roasted beans to keep the freshest flavor.

Coffee was already thought of as a healthy drink. During the scare over Starbucks coffee and cancer, nutritionists came out to explain that "drinking more coffee helps lower the risk of breast, stomach and liver cancer." Coffee fit neatly into the health trend the middle class has taken up in recent years, and specialty coffee's blend with the good-life aesthetic suited that crowd's taste too.

Euromonitor estimates the global coffee market grew at a compound rate of 5.5% over the past five years. Coffee is not only healthy; it is cheaper than other health drinks such as cold-pressed juice or craft beer, it does not spoil as fast, and it already has mature retail channels. And the third wave should give an industry with this many players a clearer division of labor.

Meanwhile the beverage giants have all become sugar-water companies and public menaces. PepsiCo and Coca-Cola are both in a hurry to change. Coca-Cola's ready-to-drink coffee brand Georgia Coffee, worth more than $1 billion, launched in Japan back in 1975 and has suddenly become what analysts call the dark horse of the coffee market. Jim Watson, a senior beverage analyst at Rabobank, wrote in a report: "I don't think they [Coca-Cola] have a 100% clear coffee strategy, but they have the strongest distribution system in the world."

Against that backdrop, small companies are easy for money to spot. Backed by Silicon Valley, Blue Bottle and Philz both took enormous investments from their own customers — the venture capitalists — and grew fast.

But no new Starbucks came out of them. Specialty coffee's positioning makes it hard to scale.

Philz Coffee, the brand poured at Mark Zuckerberg's wedding, still operates on its own. It has raised $75 million so far and opened only 45 stores, which is slow.

Blue Bottle sold to Nestlé. Amid the outcry, its CEO answered that he did it because the company needed capital. Going public should have been a dependable route, but the effort an IPO itself takes, and the chase after a set of results every three months, led Blue Bottle to sell to a thoroughly industrial group like Nestlé instead.

Blue Bottle's worry was not unfounded. Whole Foods, which also tried to ride the health trend and became the biggest of the new companies in healthy food, struggled for years after going public to grow and to make money, and finally sold to a cash-rich Amazon.

Among the new generation of independent coffee brands, the fast grower is Peet's, which has become steadily more industrial and steadily more like Starbucks.

In 2015, Peet's bought the specialty brands Stumptown and then Chicago's Intelligentsia Coffee. Those two, along with Counter Culture Coffee, are called the three most important names of the third wave.

Quiet and Secretive, JAB Has Reshaped the Coffee Business by Buying Since 2012

Behind Peet's, again, is JAB. It bought Peet's outright in 2012, the first deal in a buying spree that tore through the coffee market. After that, JAB bought everything: the market's best specialty coffee shops, the fading coffee businesses of big companies, capsule-machine brands in a slump, doughnut and bakery chains, even soda — anything to do with coffee, or anything that can be sold inside a coffee shop.

In every market except China, JAB now holds a company that can stand against Nestlé. The Singaporean company Super Group, which it bought for $1 billion, is Nestlé's closest competitor in Southeast Asia's instant coffee market. Super Group has 15 factories in the region; folded into JDE, it can lower production costs for JAB's other coffee brands.

JAB's run of acquisitions is the same old globalization story, told again now that the industry is contracting. The difference is that JAB owns the most complete chain from the top to the bottom of coffee consumption, and the most varied set of brands in the market.

Behind the lavish spending is a private pool of capital.

The party actually in control of JAB is Germany's secretive, low-profile Reimann family. Manager Magazin named the Reimanns the second-richest family in Europe in 2016; JAB is the family's investment vehicle. Moving into a new sector takes a decision inside the family, but once the direction is set, execution is entirely in the hands of JAB's three partners.

JAB moves when its targets are at their worst. When it bought Keurig Green Mountain, the company had just, under operating pressure, built a verification system into its new machines that locked out third-party pods. The move drew a fierce backlash and produced the first decline in Keurig's pod business since it started.

The Dr Pepper purchase was the same. JAB moved just as consumers chased health and turned away from carbonated drinks, and as Dr Pepper's debt reached 1.8 times its market value.

To pay for the big deals, JAB found more money.

Forbes reported that JAB controls more than $16 billion in cash. Clearly that is not enough.

JAB has issued a great deal of debt. For the $13.7 billion Keurig Green Mountain purchase in 2015 it borrowed $6 billion; for the Panera Bread chain in 2017 it borrowed $3 billion from banks. Then it used Keurig to swallow Dr Pepper, a company much larger than Keurig itself. That deal took its debt to five times annual revenue, an extremely high figure.

To swallow Dr Pepper, JAB issued another $8 billion in bonds, took $4.2 billion in bank loans, and drew on roughly $4.2 billion of Dr Pepper's own revolving credit. After the deal closed, Moody's — one of the world's three big rating agencies — cut Dr Pepper from Baa1 to Baa2 with a negative outlook, only two steps above junk. Moody's said the rating reflected the further rise in leverage after the merger.

The coffee empire JAB wants to build already carries the risk of too much debt. For now, at least, the banks still want to believe it has a future.

All that borrowing will push the industry toward further concentration. Bloomberg reported that JAB keeps special payment terms with some suppliers of up to 300 days, about three times Nestlé's.

Buy the raw material first and pay later, and the pressure of JAB's enormous debt eases: money from selling coffee can go to running the business first, with suppliers paid 300 days later. That leaves small and mid-sized coffee-bean suppliers carrying more of the strain, and it could consolidate the top of the coffee industry as well.

Capital is not only buying. It is also taking stakes and leaning on the management of big companies. By Fortune's count, 17 large listed food companies had replaced or planned to replace their CEOs as of August 2017. Almost all of them faced activist investors questioning their margins.

Nestlé among them. In June 2017 it received a "notice" from the investor Daniel S. Loeb, who had bought $3.5 billion of Nestlé stock and wanted the Swiss company to sell its stake in L'Oréal, prune its more than 2,000 brands, and concentrate on food.

This is an attractive market where demand is shifting, where the small companies need capital and the big ones need to change. But going public and raising money afterwards is not easy, and that is what let ambitious capital start buying in.

Andrea Illy, chairman of the old Italian coffee house illy and the third generation of his family to lead it, described this round of consolidation at Davos in 2016: "In an industry environment tending toward consolidation like this, you either become the prey or become the hunter."

Andrea Illy told QDaily last week that he believes the Nestlé-Starbucks deal will "change the market": "Together these two giants may reach close to half of the global market share."

illy, whose business is mainly with corporate clients, believes the market is still open and that a mid-sized player still has room to live. But Andrea also worries that the Starbucks deal means "Nestlé can offer clients a very rich range of products, so a restaurant can buy a whole package solution, and that will make some clients quite happy to buy their services."

illy is planning to expand the consumer division it set up not long ago. It has opened flagship stores in big cities including Milan and San Francisco, and plans to open more.

Seen globally, instant coffee still has room to grow in developing markets, while more and more specialty and capsule coffee is driving extra consumption among the middle class. In Andrea Illy's words: "That freshly brewed coffee is usually consumed outside the home, through food service and retail [like Starbucks], and that is a very common pattern in new markets. It is like the way wine developed in the US, starting around 1980 — at first it sold mainly in high-end restaurants, and after that people began buying wine to drink at home, collecting it, and specialized wine shops grew up too. I'm actually not that worried."

The other major coffee companies are consolidating too. Lavazza, another Italian family coffee business, has made four acquisitions in the past three years; the $800 million purchase of Carte Noire, which holds 20% of the French market, pushed it to third place in global coffee. A May 2017 report said Lavazza, then sitting on €700 million in cash, planned to raise another €1.5 billion to keep buying, aiming for €2.2 billion in revenue by 2020. Last month word came that Lavazza had received acquisition offers from both JAB and Nestlé, and turned them down.

The Buying Is Done. What Now?

In the ideal case, the companies JAB has bought can squeeze costs out through integration.

Whatever coffee you make, there is always overlap in sourcing beans. Dr Pepper's decades-old soda retail channels can carry coffee too. Peet's stores can help sell Keurig's espresso machines and the drinks of JAB's other brands.

Everyone is huddling together. The question is who will be the one to open up the market and cultivate consumers. Starbucks once did exactly that. Will the ambitious JAB, and the Nestlé now answering it, be next?

Starbucks may not have the energy for it right now. Its US same-store sales growth has slowed over the past two years, and it has more competitors all the time — chain coffee shops, McDonald's, the doughnut chain Dunkin' Donuts, everyone is talking about freshly brewed coffee. One cold brew catches on and every player scrambles to follow. And cold brew was Blue Bottle's trend to begin with. Starbucks is no longer a player that disrupts this market.

Starbucks got Nestlé's $7.15 billion in cash. According to the announcement, more than two-thirds of the proceeds will go mainly to buying back stock, raising the planned $15 billion buyback to $20 billion — the largest in Starbucks's history.

Fewer shares outstanding makes each one worth more, so the price rises while the business itself is unchanged. In other words, Starbucks is spending the money to lift its own share price. Companies are usually keenest to please shareholders this way when earnings pressure is high.

Nestlé got the manufacturing and distribution rights to several Starbucks brands: Starbucks, Seattle's Best Coffee, Starbucks Reserve, Teavana, Starbucks VIA and Torrefazione Italia — not including bottled and canned ready-to-drink products such as Frappuccino.

Mark Schneider, coming up on two years as Nestlé's CEO, said: "This transaction means a great deal for Nestlé's largest high-growth business, coffee."

Look back now at Nestlé's purchase of Blue Bottle eight months ago and you may see it differently.

Nestlé says it will help Blue Bottle open 39 more shops in 2018. Set against the slogans of Chinese coffee entrepreneurs, who talk of "rolling out hundreds of stores" without blinking, that number is conservative.

"I don't think Nestlé is trying to reinvent itself as a retailer," said Robert Waldschmidt, an analyst at the London investment bank Liberum. "Given that JAB is the epitome of multi-brand, they may consider rolling out more multi-brand products."

The Nestlé-Starbucks agreement makes that more likely: buy and back a more varied set of coffee brands, then manufacture the packaged products for them. The only problem is that the market holds few specialty coffee shops with both Blue Bottle's recognition and its customer loyalty — and there is only one Starbucks, and it was very expensive.

A new coffee market is brewing, and what is speeding up the roast is capital chasing returns. The new crop of fashionable specialty shops all say the barista is the heart of it. Judging by what the coffee companies do, their thinking may still be exactly the opposite.

Graphics: Wu Lingwei

Cover image from Pixabay and Maria Fernanda Gonzalez on Unsplash