Pod of Gold

Mike Radlauer stumbled across the Nespresso machine during a demonstration in a gourmet shop in SoHo in New York City. The customer next to him was rhapsodizing. "She said, 'Tomás just loves the crema,'" he recalls. "I had no idea what she was talking about, but I said to myself, Hell, if the crema is good enough for Tomás, it's good enough for me." (Crema, by the way, is the tan foam that floats atop a well-made espresso.)

Count Radlauer as another Nespresso convert. He now pops at least one 55 cents single-serving espresso pod into his machine every day. "The price of the pods is ridiculous, but it's still the best contraption I've ever bought," says Radlauer, a New York City software developer. "Fifteen seconds, and you've got as close to a barista espresso as you can get at home."

That, in a demitasse, explains Nestlé's remarkable patented crema-crankin' money machine — fast, tasty, idiotproof espresso under a generous layer of marketing froth to make the steep prices seem less daunting. How steep? At 55 cents for a 4-g capsule, Nespresso coffee works out to a nerve-jangling $62 per lb. ($137 per kg).

The result is that Nespresso now dominates the fastest-growing part of the global coffee industry: single-serving coffee made at home, whose worldwide sales are up an average of 28.6% a year, compared with 5.9% for drip. In Nespresso's stronghold of Western Europe, its pods account for only 1% of total fresh-coffee volume but 7% of its $11 billion value, according to Euromonitor International. Nestlé doesn't break out profits, but a former executive puts gross margins at about 85%, compared with 40% to 50% for regular drip-coffee brands.

Nespresso's hefty markup doesn't seem to bother its fans, who can go pretty gaga over a cuppa joe. "I bow down to the artists in Switzerland!" wrote Berlin's Bianca Melanie Jahn on Nespresso's Facebook page when the brand hit 500,000 friends. Nespresso says raves like that from its 7 million customers generate half its sales. For the past decade, the brand has grown an average of 30% a year, steaming straight through the recession. Sales in 2010 were expected to exceed $3 billion, making it Nestlé's fastest-growing brand.

There are other single-serving coffee makers, of course, but so far, Nespresso has enjoyed a comfortable lock on the top end of the market, where the big profits are. The machines, licensed to several small-appliance manufacturers, start at about $130, but even the much pricier models don't make much money for anybody. Their niftiest feature — for Nestlé, that is — is that they accept only Nespresso capsules.

It's the classic razor/razor-blade business model. Nespresso calls its captive audience "club members," and it lavishes perks on them accordingly. Capsules can be delivered by courier within 24 hours — at no extra charge for sizable orders. Liveried personnel in Nespresso's 220 jewel-box boutiques around the world offer customers a monogrammed china cup of the company's latest exotic blend, or grand cru in Nespresso's flowery winespeak. At the Nespresso store on Paris' elegant rue du Bac, there's almost always a long line to buy capsules, and no one looks remotely grumpy about it. But the fact is, they've got no choice; it's Nespresso or nothing.

At least it was until recently. Since last summer, two competitors have been trying to rattle Nespresso's gilded cage. There will undoubtedly be others leading up to 2012, when Nespresso's daunting 1,700 patents begin to run out.

Giant Sara Lee, which makes the mass-market Senseo single-serving system, and a small Swiss-based outfit, Ethical Coffee Co., have brought out Nespresso-compatible capsules that sell for a quarter to a third less than Nespresso's. Nespresso promptly sued for intellectual-property infringement. "We don't mind competition — we counted 31 competitors at the end of last year — but when someone comes into your home and uses your bathtub, you are certainly going to say, 'Hold on! That's my bathtub!'" says Richard Girardot, Nespresso's chief executive.

It particularly galls Nestlé that one of the intruders built the bathtub in the first place. Ethical Coffee's Jean-Paul Gaillard was Nespresso's CEO and spent 10 years tending the product's transformation from unloved start-up to Nestlé's crown jewel. "However much they loved me back then, I understand, that's how much they hate me now," says Gaillard, who has recently been working out of an office in Lausanne, Switzerland, with no name on the door and the curtains drawn.

In Gaillard's telling, he signed on in 1987 to develop a system purchased years earlier from the Battelle Memorial Institute, a kind of industrial think tank in Columbus, Ohio. Growth was painfully slow, and Nestlé funded the project grudgingly, almost pulling the plug several times. "For the first four years, I spent most of my time fighting the bureaucracy," says Gaillard. "Nestlé didn't really believe in the product."

He left Nespresso in 1996. Sales were only $250 million a year, but by then the course was clear. Nespresso had brought bling to coffee. Gaillard climbed higher on the Nestlé corporate ladder, but he always considered himself more a cowboy than a company man, and eventually he quit.

Three years ago, he says, he was reading over Nespresso's patents and found something Nestlé had overlooked. The upshot is a capsule made entirely out of biodegradable cornstarch; Nespresso's capsules are aluminum. (The company spends heavily to give customers options for recycling them.) "The maze of patents is supposed to impress people, but it doesn't impress me," says Gaillard. "I created that bullshit! People say I'm killing my baby, but business is business."

The question of whose coffee tastes best — Gaillard's, Sara Lee's or Nespresso's — is endlessly debated on blogs throughout France, the only market where all three are available. But the bigger question is whether cheaper, comparable-tasting coffee capsules can pry some of Nespresso's massive profits out of its strongbox. "I would love a third party to come out with an alternative," says Nespresso fan Radlauer.

Expect to see a lot more third parties. For instance, HSB, Morocco's largest Coke bottler, is working on Nespresso-compatible pods just for that market. "If you work on a smaller scale, take smaller margins and stay in one country, you have a pretty good business model," says Andrew Hetzel, a coffee consultant who is advising HSB. "It's always easier to buy better coffee in smaller quantities — like wine."

Nespresso is hardly back on its heels. After a false start, it has relaunched its assault on the U.S. with big new boutiques in Miami and SoHo this year. A new machine automatically dumps steamed milk into espresso, the way Americans like to drink it. "The U.S. is the market where we must succeed. They drink lots and lots of coffee," says Girardot. Still, Americans may prove tougher nuts to crack with their habit of toting around coffee in a cardboard vase, which consultants call a companion cup.

Nespresso also just opened big flagship stores in Sydney and Shanghai, whose tea-swilling residents might appear an even tougher sell than Americans. Don't underestimate the smirky charm of George Clooney, Nespresso's spokesman outside the U.S. He's been worth every penny Nespresso has paid him — $2.4 million his first year and probably a lot more since he's made Nespresso's "What else?" tagline maddeningly unforgettable around the world.

Nestlé is even testing the proposition that what works for coffee should work for tea. The Special.T machine, being tested in France since September, reads a pod and then automatically adjusts for ideal water temperature and brewing time for 25 fancy tea varieties.

Everything else comes straight from the Nespresso playbook, from the tightly controlled distribution to the expansive language. "I'm not saying that what you drink every day is bad tea, but it's not ... optimal," says Special.T CEO Henk Kwakman. Even if Special.T garners just a sliver of the global tea market, at 2 trillion cups a year, it's a big pie.

In the end, it might not be so bad for Nespresso that it's got compatible competition. "If I were Nespresso, I wouldn't mind losing share if the other guys were helping to grow the category," says Richard Haffner, head of global beverage research at Euromonitor International. Says Hetzel: "Single-serve is clearly the future of the coffee business. If it gets even 15% of what is now the drip-coffee market, we'll all be pledging allegiance to King Nespresso."

Source: http://www.time.com/time/magazine/article/0,9171,2053573,00.html

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