Cafe-X In Search of Strategy: Nestle's New Espresso Maker In 1986, the Swiss giant Nestle 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. Despite an enthusiastic reception from connoisseur coffee drinkers and very promising market research, in 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, Nestle appointed a new, young Managing Director, by the name of Jean-Paul Gaillard. Gaillard was considering what to do to improve the new product's fortunes. He realized that, unless sales of the CoffeeMaker picked up considerably soon, Nestle 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 whether to devise a completely new strategy for the product? 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) an 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, implying thicker consistency and more caffeine per unit volume than most beverages. Its quality is determined by the "fineness" of the coffee used, which in turn depends on the grind as well as on the type of appliance with which it's being prepared. 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. Nestle's Positions in Coffee Nestle held a dominant market position in instant coffee. Soluble coffee was the biggest money-maker for Nestle and it represented more than 80% of Nestle's coffee sales, with the rest coming from roast and ground coffee sales. It had strong brands in all the sub-segments of the instant-coffee market, yet Nestle 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. Nestle 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 date 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 rather 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 and 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 Nestle controlled, but also on the quality of the appliances used (outside Nestle's control) and lastly, on the ability to produce and sell to a mass market. This dependence on outsiders was unusual for Nestle. In addition, the product threatened to cannibalize the sales of other Nestle products. Nestle set up a joint venture with a Swiss-based operator called Sobal to sell the new product . The joint venture (Sobal-EspressoMaker) purchased the machines from Turmix and the coffee capsules from Nestle 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, Nestle would no longer be selling merely a product, but also the required hardware and the related services. This required Nestle to focus on the production of high quality coffee capsules, a service offering to satisfy the customer, the manufacturing of reliable machines, the training of people on how to operate the system, and t aintenance workforce. Once the target countries were chosen (initially Switzerland, Italy, France and Japan), Nestle further defined target market segments. Nestle felt that the high cost of the machines and 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. Sobal- EspressoMaker 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 (Societe des Produits Nestle) 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 already had in their product offerings a machine for roast and ground coffee sold under their own brand name. However, Nestle 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 Nestle 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 sub- contractor 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 i've 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 hall of the targeted figures. Table 1: Number of machines manufactured and sold in 1986/87 (in units) Machines Model C 100 C 1 100 C 1101 Total Manufactured 15,662 3,939 2 800 22,401 Sold 9,852 2,487 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 Nestle 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 Sir, 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 1987 Sales 1,485 3.842 Cost of goods sold -1.512 -3.357 Operating margin -1.08 -1.979 Fees on machines sold 71 197 R&D Operating results of EspressoMaker S.A. -1.011 -2,282 Operating results of Espresso Maker S.A. -1.011 -1,782 Operating results of Nestle Japan NA -1.974 Loss on transfer pricing NA -343 Operating results of SPN NA -277 Gains on Cave NA 1.167 Financial costs NA -90 -1,011 -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 radically 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 towards what'?"