Starbucks, Kellogg plot cereal killing

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Starbucks can't lure the latte-swilling masses into buying breakfast with their morning coffee. Kellogg can't persuade consumers to pay top dollar for a premium cereal. But together, they could be invincible.

At least that's what Kellogg's head of new ventures, Doug Van de Velde, and Starbucks' director-new food concepts, Lani Lindsey-Sordello, are staking two years of work on. The pair today unveils Grani-Starbucks cups filled with Kellogg's Low-Fat Granola and customized with steamed milk and various add-ins from fruit to caramel sauce-in 12 Indianapolis Starbucks locations.

The potential payoff could be huge. Industry analysts conservatively estimate that Grani could rake in $85 million to $150 million in incremental sales annually for Starbucks-if the brand makes it through the operations test. And that's just the beginning. If Grani is successful, Kellogg will quickly move the product into supermarkets, with a payoff that could reach into the hundreds of millions. And, of course, for Starbucks there's the potential to change consumer behavior in terms of where people buy their breakfast.

The partnership is widely seen by analysts and observers as nothing short of brilliant, combining as it does "two of the most valuable names in the a.m. space," said Gary Stibel, founder and principal of The New England Consulting Group.

The seemingly simple concept could allow Starbucks to finally crack the code on a signature hot breakfast item and lift its check average to boot. Kellogg gets the benefit of the Starbucks halo, a big margin boost and the holy grail that's so far eluded it: a single-serve cereal that consumers are willing to pay a premium for.

What's in a name?

Grani, Italian for grain, will not be co-branded with the Kellogg name in Starbucks but could include the cereal leader's moniker down the road if it expands into more traditional grocery channels, a move tentatively slated for 2007.

As Kraft Foods, PepsiCo and others well know, the Starbucks name can lend incredible assistance building premium platforms at retail. Kraft's licensing agreement with Starbucks to market and distribute its ground and whole-bean coffee in grocery and mass merchandisers last year gave the struggling food marketer a big lift: Sales for the line grew double-digits to roughly $300 million, according to Information Resources. PepsiCo, likewise, has seen success with its Starbucks joint venture, which includes among other offerings the ready-to-drink Frappuccino line, sales for which shot up 20% last year to $157 million, according to IRI.

Kellogg on its own has failed to find a way to get consumers to move beyond what one executive close to the company calls "the magic ceiling of, at most, $5.50 per box." Certainly consumers balked at the premium prices Kellogg hoped to command for its now-defunct Breakfast Mates single-serve cereal-and-milk kits in the late `90s. But the Starbucks name, which clearly commands a premium, is expected to help open up "a new pricing frontier," potentially as much as $2 to $3 per cup, the executive said.

Kellogg's results have been strong-it posted a 6% gain in net sales last year to $10.2 billion-and for the sixth straight year it has grown its share, now at 34%, in the $6 billion ready-to-eat category. While its competitors in the food industry have suffered severe margin deterioration, Kellogg has avoided such a fate through a combination of efficient management and innovation by taking chances with products like Grani.

Even if the product does not move to grocery, it can still offer Kellogg a great opportunity for expansion by taking it into Starbucks locations, said Lehman Bros. analyst Andrew Lazar. "I like the fact that they're thinking out of the cereal box and looking for alternative ways to build demand and usage occasions [for cereal] and to reach the more on-the-go consumer," he said.

For Starbucks, Grani is likewise expected to help it with its long-time Achilles' heel. "Food is [Starbucks'] biggest challenge and biggest opportunity," said an executive with knowledge of the venture, who noted that only about 20% of transactions at Starbucks include a food purchase.

Starbucks in fiscal 2005 reported that food sales at its company-operated retail stores drew only 15%, or $810 million, of its $5.4 billion in revenue. Moreover, Starbucks has a big motivation to get consumers buying more, since it's admitted to analysts its heady 8%-plus same-store sales gains of the past few years are unsustainable.

Past attempts at non-coffee items beyond an array of muffins and doughnuts-among them everything from scrambled eggs to hummus-have been hampered by how the food smells overpower the coffee aroma and by difficulties its baristas face in preparing the food. But Starbucks has much to lose to competitive chains in not offering breakfast, especially at the drive-thru, so it keeps on trying.

Last week Starbucks announced plans to expand the warm breakfast-sandwich lineup it launched in late 2002 to a total of 600 stores, insisting that the program has not slowed down service, a crucial factor in food offerings for the chain. Grani will likewise be looked at in the Indianapolis test for whether or not it slows service or complicates baristas' jobs, as well as for how the cereal holds up against steamed milk.

According to a Starbucks spokesman, the next step for Grani is an advertising-supported test in two or three markets. Grani is particularly intriguing to Starbucks executives because it fits well with the customization aspect its business has been built on, an aspect that has been missing from other food offerings.

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