Yet More Evidence Of Growth To Come In The Single-Service Coffee Market

Starbucks Corp.’s partnership with Green Mountain Coffee Roasters in the single-service coffee pod market created $5 billion in shareholder value for the two companies when it was announced last week. Unfortunately, that amount was split evenly between the two companies, and Starbucks shares soon gave up most of the bump from the news.

The market’s reaction suggests that Starbucks could have created more long-term shareholder value by acquiring Green Mountain and introducing its Keurig brewing technology internationally. That potentially could have made Starbucks a major player in the global single-serve coffee market.

The Green Mountain deal follows Starbucks’ cancellation of a distribution agreement with Kraft Foods Inc., (Kenco Singles and Tassimo) which among other things had given Kraft the right to sell Starbucks coffee for pod brewing machines. But cutting ties to Kraft, Starbucks has hoped to regain control over key areas of potential growth in both the grocery aisle and single-serve. Kraft lost against the split but is still pursuing damages.

It can be argued that the new Green Mountain alliance will only pay dividends in the long term so it should not have a dramatic impact on Starbucks’ stock. But the fact that Green Mountain’s stock ran up 40% on the news versus 10% for Starbucks shares and Starbucks has retained only a third of those gains while Green Mountain has held onto 85% suggests that Starbucks management left value on the table.

Starbucks is playing the role of kingmaker for Green Mountain’s Keurig brewing system. Keurig has an installed base growing 5 million units per year and accounted for five of the top 10 models representing 50% of holiday sales dollar volumes in the U.S. But there is a long way to run, as single-serve machines have penetrated only about 6% of U.S. households, and 80% of Starbucks customers don’t own one. Of those that do, 25% indicated in a recent Morgan Stanley survey that Starbucks would be their primary single-serve brand.

Under the agreement, Green Mountain brewing machines will be distributed via Starbucks’ 11,000 domestic retail outlets, nearly a 50% increase over Green Mountain’s 23,000 current locations.

Gaining access to the Starbucks brand is a coup for Green Mountain, which now has licenses for four of the top five coffee brands in the U.S. — Folger’s, Starbucks, Dunkin Donuts and Green Mountain. In addition, it bought itself protection from Starbucks, which might have developed its own machines or partnered with one of Green Mountain’s pod rivals.

Given the value contributed by Starbucks, it’s hard to see why Starbucks’ management didn’t make a bid for Green Mountain and the Keurig technology. Green Mountain had hit a high of $47.81 on February 14 on media reports of partnership talks with Starbucks before falling to $40.16 when Starbucks suggested it was considering a range of single-serve alternatives.

Green Mountain’s founder still serves as chairman and he and his children control 18% of the company, so Starbucks could conceivably have offered a modest premium to the recent highs. Starbucks could have offset dilution by raising leverage for a cash-and-stock bid.

Green Mountain’s stock price now appears to factor in the possibility of expanding the partnership internationally, where Starbucks has nearly 6,000 additional outlets. The international singer-serve market is seven times as large as the U.S.

However, the Starbucks deal covers only the U.S. Starbucks appears to be taking a hardware-neutral strategy, and it is free to partner in other countries with regional market leaders. Any value currently ascribed to Green Mountain on account of the international potential could easily be transferred to a prospective partner in Europe such as Sara Lee Corp., which uses machines from NACCO Industries Inc.’s Hamilton Beach Brands.

Having risked a damages award to end the relationship with Kraft — damages some analysts estimate could run as high as $1 billion — Starbucks shareholders may fairly ask why management didn’t capture more of the $2 billion created for Green Mountain shareholders by the new partnership.