Why the Starbucks-Kraft Dispute Likely Comes Down to Instant Coffee

Since 1998, Starbucks (SBUX) has contracted with savvy packaged-goods company Kraft Foods (KFT) to distribute its bagged coffee through grocery stores. Today, in letters released to The Wall Street Journal and Reuters, Kraft fired yet another salvo in its bid to hold together this deal, which Starbucks now wants to undo. Kraft's letter said: "the success of the business and its performance over the last 12 years are clear," and it insists that there has been no breach.

However, a breach of certain terms of the agreement is just what letters sent from Starbucks' attorney have accused Kraft of, beginning with one dated Oct. 5. The Journal says Starbucks thinks Kraft has been "failing to properly market packaged-coffee products," and Reuters describes it as Starbucks accusing Kraft of "bungling sales of its packaged coffee in grocery stores."

At What Cost?

At the center of the argument is a contract that has no end date, unless material terms of the contract have been breached. In order to dissolve the agreement, both parties have to agree to do so. But Kraft says this will come only with "sufficient time to execute an orderly transition" and compensation "for the fair market value of the business, plus a premium." The cost, Edward Aaron of RBC Capital Markets estimates in comments to the WSJ, could be $1.5 billion, based on $500 million in annual sales with an estimated 15% to 20% EBITDA and a 12-times multiple.

Why any corporate attorney would sign an agreement that had no end is unclear. While so-called evergreen contracts are run of the mill in American business, they typically have an annual or biannual termination date. If one party gives appropriate notice, usually between 30 and 90 days, the contract will end, and both parties can walk away (leaving the usual nondisclosure and anticompetitive clauses intact for a period of time).

In 1998, however, Starbucks was growing like crazy, adding 30% to 40% more stores each year and getting serious about global expansion, entering the U.K., Thailand, New Zealand and Taiwan. Coincident with its purchase of the Tazo tea company, it needed to work with grocery stores, a huge potential source of revenue for its coffee beans and the main point of purchase for tea bags.

An Instant Coffee, 20 Years in the Making

Kraft seemed like a sensible partner: It's an influential giant in grocery aisles, and it had little concern for Starbucks' pricey gourmet beans. Kraft's main coffee brand was, after all, Maxwell House -- famous for its popular "smooth" instant coffee and an entirely different target consumer from Starbucks' snooty and "overroasted" beans. (Other major Kraft coffee brands include Sanka, Yuban, General Foods International Coffees and Gevalia.)

If Starbucks CEO Howard Schultz was thinking about the potential for competition back in 1998, perhaps his mind was elsewhere (he would step down as CEO in 2000 for an eight-year hiatus). According to Starbucks' story about the development of its own VIA instant coffee brand, someone on the management team should have foreseen this. The coffee, they say, was in development for two decades prior to its 2009 release.

VIA, Schultz has said repeatedly in analyst conference calls and other public statements, is a huge part of Starbucks' future growth. And that growth won't come just in company-owned stores but in the grocery channel as well.

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Schultz has mentioned this specifically each quarter as he brushes off analyst questions about how big, exactly, are VIA sales. But Starbucks distributor Kraft must now place Starbucks' Via -- described by consumers as better than Maxwell House in taste tests -- next to its own cash cow on grocery shelves. Eleven percent of Kraft's North American revenues come from its North American Beverages unit, led by Maxwell House.

Whether or not Kraft has done a bad job up until now with its Starbucks distribution deal is immaterial. What's more relevant now is that Kraft likely harbors fears about the upstart instant coffee beverage. A conflict of interest is unavoidable: Kraft's century-old flagship Maxwell House versus Starbucks' great hope for future growth, VIA. And everyone knows that the new kid gets all the attention.

Editor's note:
On Nov. 29, a Starbucks representative wrote to tell us that Kraft does not distribute its VIA coffee: "We work with Acosta Sales & Marketing as our broker for Starbucks VIA and directly manage the Starbucks VIA business ourselves." Therefore, we removed a sentence in the second paragraph implying that VIA was the likely subject of Starbucks' contractual concern. This does not, of course, remove the competitive threat to Kraft from Starbucks-branded coffee.

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