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Nespresso case.

In April 2013 Nespresso, the pioneer and category leader in the single- cup portion coffee segment, was undergoing a transition in its top management. Jean-Marc Duvoisin had just taken over as CEO at a time when the company was coming under assault from copycats selling cheaper capsules that were compatible withNespressoscoffee machines. The 1,700 patents protecting the"Nespresso system,"the machine and its coffee capsules, did not seem to have discouraged competitors from selling copiesof the companysprofitable capsules.

For most of its history, Nespresso had been growing at an average of 30% annually to reach revenues of CHF 3.5 billioniin 2011-the last year the company announced its turnover. As a profitable and fast-growing business within Nestl,it operated more than 300 boutiques in 49 countries. Estimates for 2012 put the number of Nespresso consumers- called "Club Members" -at more than 10 million.

The growth and profitability of the portion coffee category, pioneered by Nespresso more than 30 years earlier, had attracted a rising number of rivals. By early 2013 dozens of competitors, including private labels from retail chains, were attackingNespressos capsule businessworldwide. The competition was most severe in Europe where the company generated about 80% of its revenues.2It was estimated that copycats had captured a substantial part ofNespressos capsulemarket in less than three years. It was also believedthat the companysphenomenal growth rate had significantly declined as a consequence.

Against a backdrop of growing competition, market share loss and declining growth, industry observers wondered how long Nespresso could maintain its leadership of the portion coffee segment it had helped to create.

Success against All the Odds3

Nestl began work on portioncoffee extraction technology in 1974 with the acquisition of apatent. But it took many years for Nestl to bring its Nespresso proprietary system to thehousehold market. The first machines were designed to target the food service and office sectors. However, the market response was negative and the business was showing lossesyear after year. In 1986 Nespresso was separated from Nestls coffee division to give itmore autonomy in developing its own strategies. Camillo Pagano, then a senior vice presidentat Nestl, justified themove:

The business was physically moved out of Nestl so that it could establish credibility and [not] have to fight against all the company rules...Small satellites like this can help people gaininsight into how a business could be developed differently.4

Two years later, Nestl hired a new head for Nespressofrom outside the company as a last effort to save the money-losing unit. The new hire, Jean-Paul Gaillard, was a former executive at Philip Morris with a strong marketing track record in a non-food sector. He was given the challenge of turning around the portion coffee business. Pagano recalled:

The Nespresso business was at a point where we needed an entrepreneur to take it further. Weneeded somebody who wouldnt react like a Nestl manager.5

Soon after his arrival, Gaillard decided to refocus Nespresso on the household market. His decision went against initial market research showing limited potential among consumers for an expensive coffee-making system. He also faced internal skepticism about features of his strategy to develop the household businessii:

• Positioning Nespresso at the top. Nespresso was to be positioned as a high-end single portion system for coffee connoisseurs in the household market where, Gaillard believed, there was a latent demand for gourmet quality coffee made at home. Nespresso machines were designed by the company but produced by international manufacturing partners, such as Philips and Eugster/Frismag, and sold through high- end appliance retailers. Nespresso would fully invest its resources in production and sales of capsules.
• Nespresso "Club" and direct sales model.Consumers would become Nespresso"Club Members" upon the purchase of their first machine. The Club was the mainsales channel for capsules. Consumers could order their capsules around the clock, but only through the Clubs toll-free phone lines, and receive their orders within two business days. The Club would give Nespresso direct contact with the customers, offer personalized advice, inform them of new products and handle after-sales services of the machines. To preserve margins and directly engage with consumers, retailers were to be bypassed as a sales channel for capsules.
• Word-of-mouth. Initially Nespresso would rely on word-of-mouth from happy consumers to promote the system. Major advertising campaigns were excluded due to their high cost at a time when the company was showing losses.

The proposed strategy of direct Club sales with no advertising support had never been triedat Nestl. It was a radical departure from the companys usual practice of large-scale production, mass marketing and distribution; it was also a source of continuing skepticism. Nevertheless, Gaillard had the support of a few senior executives in the company who had given him the space to experiment in return for meeting the challenge of tripling the sales volume within one year; the alternative was seeing his company closed down. Gaillard was so convinced of his strategy and the potential of Nespresso that at one point he offered to buy the company. His superiors described him as a strong-willed individual who did not give up easily.

The household strategy was launched in 1988 and despite some initial disappointing market tests with consumers, it began to show results soon afterwards. Sales and Club membership grew steadily. The company broke even in 1995 and by the time Gaillard was promoted in1997 to another position inside Nestl, Nespresso boasted CHF 100 million in sales and220,000 in Club membership.

The Club and direct sales business model remained operative over the years althoughNespressos strategy evolved to include company-owned boutiques as another sales arm forboth machines and capsules; boutiques accounted for about 35% of the companys turnover.6International expansion and vigorous consumer acquisition policies became engines for thecompanys growth. Successive advertising campaigns featuring American actor George Clooney helped to make Nespresso a household name in many countries.

Throughout the years, Nespressospositioning remained true to its original concept of super-premium quality and an icon for "perfect coffee" to "delight" and "indulge" consumers.7A number of Nespresso machines had won awards for their exceptional designs.8(Refer toExhibit 1for an overview of Nespresso's development.)

In 2003, Nespresso initiated the AAASustainability QualityTMProgram aiming to help coffee farmers acquire the know-how needed for producing quality coffee beans in an environmentally sustainable way while improving their living standards. In 2009, Nespresso launched itsEcolaborationprogram to recycle its capsules in response toconsumersincreasing concern about their environmental impact. By 2012 the company claimed that it had reached 75% capsule recycling; the program was now available in more than 20 countries.9

Nespresso was a highly profitable part of Nestls large and diversified businesses. Its grossmargin on capsules, which contained 5 grams of ground coffee and sold at between CHF 0.50 and CHF 0.57 per unitiiidepending on the blend, was estimated to be around 85%.The companys operating margin was quoted to be 38%, more than double the Nestl Groups average of15%.10

Nespresso seemed to know clearly where it wanted to go. In a corporate communicationreleased in early 2010, the management highlighted the keys to the companys outstandingsuccess:

Unsurpassed coffee quality and proven coffee expertise; unstoppable drive for innovation, distinctive design and in-house R&D expertise; global brand community and dynamic, direct consumer relations; inspirational iconic global brand; exclusive route to market; expertise in sustainable quality development.

Competition

Nespressos early rivals in portion coffee had their own proprietary systems. Senseo -developed by Philips for Sara Lee in Europe- and Green Mountains Keurigsystem in the US were among the strongest performers but none seemed to seriously challengeNespressos global marketleadership.

The more recent competitors selling Nespresso-compatiblecapsules, however, represented adirect challenge to the companys market position. In April 2010 Sara Lee introduced in France, one of Nespressos largest markets, its transparent plastic compatible capsules under LOR Espresso, a sub-brand of its well-established Maison du Caf. Positioned as premium quality coffee, LOR capsules were distributed in 2,000 major French retail outlets at a consumer price that was 20% lower than Nespressos.12

Just one month later, Nespressos former head Jean-Paul Gaillard,who had left Nestl years earlier, announced the launch of his companys own compatible capsules under a private label for Casino, one of Frances biggest retail chains with close to 9,500 points of sale. Gaillards new company, Ethical Coffee Company (ECC), produced its capsules in Franceand claimed that they were biodegradable and environmentally friendly. ECCs capsulesretailed at 25% below Nespresso prices. Press reports quoted that ECC had a manufacturingcost that was 20% higher than Nespressos.13

Gaillards entry into Nespressos market attracted much press attention. He was quoted at length about his former company and the patents protecting Nespressos system:

Nespresso lost its DNA after my departure... They missed the biodegradability train...14Themaze of patents is supposed to impress people, but it doesnt impress me. I created that b******t! People say Im killing my baby, but business is business....15I hope Nespresso will attack us. This will be the best advertisement for us!16

It was generally known that a number of Nespressos patents were to expire by 2012 but, in the words of Gaillard, EEC had found a "hole" in the companys patent wall allowing itsearly entry.

By early 2013, Sara Lees coffee operation in Europe was selling compatible capsules across Europe; ECC had also launched its own brand Espresso, which the company intended to sell in all continents. These early competitors had been joined by other, primarily local,compatible capsule brands such as Caff Vergnano in Italy, Nicola in Portugal and a growing number of private label producers for food chains like Migros, Coop and Denner in Switzerland, the home of Nespresso.

By early 2013, Nespresso found itself competing with an estimated 50 compatible capsule brands worldwide, all selling a range of capsules of different blends and coffee tastes. (Refer toExhibit 2for a comparison between Nespresso and its main compatible rivals.)

Euromonitorestimated that the global portion coffee market including all systems was worth close to $8 billion in 2012 and expected it to grow by about 30% annually in the coming years. Some estimated that in 10 years, the single-cup portion coffee would constitute the biggest segment of the entire coffee market.

Nespresso's InitialResponse

Nespressos initial public statements on the arrival of copycats were measured. Richard Girardot, the CEO at the time, outlined the key managements policies following the 2010entry of the first compatible rival, Sara Lee:18

• [Our] answer is therewont be retaliation. We have to further differentiateourselves.
• No need to lower the price, because they are only 10% cheaper than us. Imagine a household that consumes 50 capsules every month; buying Nespresso capsules costs themonly 1.50more.
• This competition will oblige us to be even closer to [millions of our] consumers in the world. We have to be even better at improving the quality of distribution and service.
• We will launch two-hour express home delivery service in Paris and want to open five moreshops to reduce customers waitingtime.
• We will always take appropriate steps to defend our intellectual property rights when they have beeninfringed."19
• Attempts by Nespresso to challenge Sara Lee and ECC in court for patent violation had not stopped either company. Gaillard was combative regarding the lawsuits:
• ...we have more lawsuits against Nestl than they have against us. We dont infringe any oftheir patents whatsoever.20
• Gaillard filed a counter-suit. He was quoted in the press as accusing Nestl of puttingconsumers at a disadvantage.21
• Consumers
• Unlike Nespressos past growth strategy built on international expansion and consumeracquisition, copycats aimed to exploit the companys existing customer base of more than 10 million "Club members" and switch them to their lower priced brands.
• Consumer reactions to copycats were mixed. The growth of compatible capsules showed thata segment of Nespressos consumers were price sensitive and ready to switch. Others were not. A review of views expressed on social networks, including Facebook, showed that consumers were mainly concerned about the quality of coffee, the compatibility of copycats with Nespresso machines, and their environmental friendliness. Opinions did not seem toconverge. For example, conflicting views could be found on Sara Lees LOR Facebookpage:22
• Thanks for the new samples! I very much liked the three aromas but I prefer Exuberance [a capsule name]. Its taste was refined and delicate. Loved it!
• It is really a shame. Your capsules are almost at the same price as the ones of Nespresso butstill I taste the difference of quality. If its less expensive, I might use it every day. Butgiven the price difference, I would rather pay 2 [Euro] cents more for each capsule and have the best ones!

1. Contrasting views were also observed on ECCsFacebook page:23

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• Just tried Ethical Coffee Company capsules and they are great. Good price. As good, if not better, than Nespresso orLOR.
• Im extremely disappointed by your products. It has a bad compatibility with Nespressomachines.But whats worse is that the coffee has no taste. I regret having bought fourboxes of capsules that I will not drink.
• On Nespressos Facebook page, many of the praises and complaints were about service:24
• This company has to be one of the most efficient, courteous & professional companies I have EVER dealt with. They have 24 hour turnaround with the capsule orders and 30 minute response to a query about an error I had with my machine. Thank you Nespresso Australia.
• Dismal experience today at the Nespresso Opera Shop [Boutique in Paris]: bad welcome, endless waiting, unfriendly staff... Bad day or complacency of your success?
• Other factors that consumers seemed to find attractive about compatible capsules were shopping convenience and availability, since they were widely distributed in supermarkets and grocery stores. (Refer toAppendix 1for more consumer reactions and comments.)
• Recently, Swiss consumer interest magazineBon Savoirinvited a jury of coffee experts for a blind test of five different espresso coffee brands including Nespresso. The results werestartling to many. Nespressos popular Arpeggio blend was ranked third in taste behind two lower priced private labels, Caf Royal from Migros and Espresso from Denner.25
• In the days that followed, the article elicited strong written reactions from Nespressos loyalconsumers expressing their disagreement with the results of the blind test:26
• I was surprised by the results because my friends and I have been very disappointed by thecapsules of Nespressos competitors. Their tastes varied from too roasted to badly balancedbitterness.
• If I agree with your experts on the results of blind test, I regret that you have not consideredthe question about capsule recycling. At Nespresso, everything can be recycled and its thereason why I waited long before I chose its system.
• However, a blind test run bySonntagsBlick, a Swiss German magazine, showed different results. Four coffee experts compared Nespresso capsules with those of five other retailers- Coop, Migros, Denner, Aldi and Spar. In this test, Nespressos Ristretto capsules scored farhigher than those of their competitors.27
• Tough Choices
• The odds for Nespressohad never been so challenging. The fiercest "capsule war" took placein the recession-hit Europe where consumer budgets were constrained. It was expected that more low-price competitors would enter the market as more of Nespressos patents expired.Nespressos successful strategy built on the pillars of premium coffee quality and superiorconsumer service through the Club and the boutiques was being severely tested.
• For continued growth, Nespresso was aggressively pursuing opportunities outside Europe, primarily in the US, Asia and Latin America. Nespresso had ambitious plans for the US portion coffee market, estimated at $1.1 billion, or third in size after France and Germany. But expansion in the US was not going to be easy. The company had to fight for market sharewith

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established local players like Keurig, with a market share of 75%,28and the new entrantStarbucks Verismo, witha market share of 10%.29Both companies had their own proprietary coffee systems. In Asia the company was faced with a tea drinking culture where espresso coffee was a novelty.30American food giant Mondelez International-a spin-off of previous Kraft Foods, already theworlds secondlargest coffee maker and third largest in portion coffee, primarily in the US-was planning to sell its own brand of Nespresso-compatible capsules across Europe in the second half of 2013. Initial markets were Germany, France, Austria and Switzerland.31

Many thought that Nespressos expansion plans were going to be hampered by the presence of compatible capsules. The fact that the global market for portion coffee was growing at an estimated 30% was no consolation to Nespresso management who had witnessed declines inboth the companys share and growth in recent years. It was estimated that Nespressos 35% share in 2011 of the worlds portion coffee market (including both compatible and non- compatible capsules) had slipped to under 30% in 2013 due to rising competition and thecompanys slower growth.32

In Switzerland, Nespressos home market, where the brand enjoyed one of the deepesthousehold penetration rates, growth had slowed down alarmingly to single digits. One estimate put growth during the first quarter of 2013 at 8%, the slowest ever.33The same source projected flat sales for the rest of the year.

Since the arrival of compatibles, Nespressos management was kept busy fighting copycatsfor patent infringement in various courts both in and outside Europe. The lawsuits were not all successful in stemming competition. For example, the company lost its legal bid to restrict the sale of compatibles in Germany, Switzerland and the UK.34

Observers familiar with the history of Nespresso and recent changes in the competitive environment were divided as to what course of action the company should take. Some believed it was time for Nespresso to reinvent itself by amending its old business model to more effectively deal with the compatible competition. It was important, they said, that the company should retain its customer base through innovative and possibly radically different products, channels and services. Others disagreed. They thought a radical departure from the tried-and-proven model carried immeasurable risks at a time when the market was experiencing major shifts.

Among strategy recipes advocated by these outside observers were:

1) Fight fire with fire

Some argued that launching a lower quality and lower priced sub-brand sold through retail chains was the frontal strategy needed to fight the copycats. This would allow Nespresso to attract the more price sensitive segment of consumers while taking advantage of its well- established house brand. Under this scenario, Nespresso would continue to sell its premium quality capsules through the Club and its boutiques. Others thought this strategy riskedcannibalizing Nespressos direct sales of its quality coffee. The counter-argument was"Better to cannibalize yourself than have somebody else eat your cake."

2) Reinforce product leadership

Others thought that consumer goods sectors were generally undergoing a major long-term transformation with shoppers shifting their purchases to either the premium quality and specialty brands or the low-end "good-enough" commodities. They argued that Nespresso

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should defend its reputation for product leadership by introducing new varieties of coffee superior to its current line to serve the discriminating segment of consumers and to furtherdistance itself from the "low-end" copycats. These observers pointed to the highly successfulpremium blend, Hawaii Kona Special Reserve, recently introduced as a "Limited Edition." Itwas priced at $2 per capsule, almost four times the regular capsule price, and the entire stock sold out within a few weeks.35

3) Introduce new machines

A few argued that yet another way to regenerate growth was to introduce new machines thatwould not work with competitors capsules. This strategy might require the redesign ofcurrent capsules but would allow Nespresso to gain further patent protection against competitors. The counter-argument questioned the appeal of a second coffee appliance among consumers who already owned a Nespresso machine.

4) Enhance consumer experience

While some thought changing the product or the system was a recipe for stemming competition, a number of observers believed Nespresso should focus on improving the"consumer experience,"which they thought was an unexplored battlefield for differentiation. In their eyes,Starbuckssuccess was not so much due to any particular product advantage but rather to the unique experience that the retailer offered consumers. They also pointed to a Bain & Company study across many industries that showed a customer was four times more likely to defect to a competitor if the problem was service-related than price- or product-related.36They argued that Nespresso had the opportunity to offer its consumers a total experience that went far beyond a superior product, which was increasingly challenged by the competition. They identified enhancement of the shopping experience at the boutiques, innovative Club services and the like as arenas to create holistic andhighly positive "Nespresso experience."Products can be copied, they said, but a superior consumer experience is harder to match.

5) Stay the Course

Against those who called for new strategic recipes were observers who thought thatNespressos strategy was still robust and that making no radical changes was the right courseof action. They argued that the strength of the iconic Nespresso brand, its coffee quality andClub services were the companys strongest weapons against the newcomers. They drew attention to the fact that many loyal consumers found Nespressos quality superior to that ofothers and some who had tried competing brands had switched back. According to these observers, Nespresso enjoyed a premium lifestyle brand image that no other competitor hadmanaged to create so far. One said: "You need a strong brand for times like this."

The newly appointed CEO seemed to agree with the latter views. In a recent interview, Jean-Marc Duvoisin had underscored what he believed were the keys to Nespressos success asthe leading brand in portion coffee:

Competition has existed for many years. There are about 50 different capsules that arecompatible with our machines. [But] we offer the best coffee quality. At the end of the day its what you have in capsules that counts... Are we going to change the [the direct-to-consumersales] model? No. Its a very successful model. [Some] see it as a complication for thecustomer. I see it as very beneficial for the customer. If you dont have the direct connection, you cant ask consumers [what they think] and you dont have insight. Consumer insight isuseful for the business but at the end of the day its more useful for the consumer.

Questions:

Pros and cons of the marketing strategy of Nespresso