Green Mountain Coffee Roasters Inc. (NASDAQ:GMCR) has enjoyed tremendous growth in the past few years as its line of Keurig brewers and the associated K-Cup coffee pods have gone mainstream. Keurig is the hands-down leader in the rapidly growing single-serve coffee segment. Consumers have warmed to the concept, as single-cup brewers are less messy than traditional coffeemakers and the coffee stays fresher in sealed portion packs.
The beauty of the Keurig system is that it follows a razor/blades business model. Green Mountain Coffee Roasters Inc. (NASDAQ:GMCR) doesn’t make very much money selling Keurig brewers; but it makes very healthy profits selling the K-Cup portion packs. However, some key patents protecting the K-Cup expired last September. This allows competitors to legally market knockoff products (although Green Mountain still holds other unexpired patents that cover improvements made to the original K-Cup design). The key to predicting Green Mountain’s success or failure is understanding whether these knockoffs will become popular enough to cut into sales and/or margins for Green Mountain’s K-Cups.
The bull case
Green Mountain Coffee Roasters Inc. (NASDAQ:GMCR)‘s management seems unfazed by the issue. On the company’s most recent earnings call, executives predicted that customers will remain loyal to genuine K-Cups because of their high-quality standards. Only Green Mountain and its authorized partners can offer K-Cups with the state-of-the-art design. Furthermore, Green Mountain plans to invest in merchandising support for retail partners, in order to get better shelf placement for Green Mountain Coffee Roasters Inc. (NASDAQ:GMCR) K-Cups. Green Mountain executives therefore believe that knockoffs will represent at most 15% of the K-Cup market.
So far, the patent expiration has not hurt results much. In the fall quarter — the first full quarter after the patent expired — K-Cup unit sales grew 26% and K-Cup revenue grew 21%. The main reason that revenue growth trailed unit growth was a mix shift toward cheaper brands in the Keurig system, rather than broad-based price cuts. The company’s gross margin remained above 30%, which is particularly impressive because the fall quarter has a high proportion of low-margin brewer sales, relative to K-Cup sales .
The bear case
However, bears believe that the threat to Green Mountain Coffee Roasters Inc. (NASDAQ:GMCR)‘s K-Cup business will grow over time. Several supermarkets began selling private-label knockoffs soon after the patent expiration last fall, but Kraft Foods Group Inc (NASDAQ:KRFT)‘s Maxwell House brand recently became the first major brand to sell unauthorized K-Cups. Maxwell House attacks the low end of the K-Cup spectrum, and could take sales from authorized brands like Eight O’Clock Coffee, The J.M. Smucker Company (NYSE:SJM)‘s Folgers, or Dunkin Brands Group Inc (NASDAQ:DNKN)‘ Dunkin’ Donuts coffee. Green Mountain may be forced to lower prices for these “entry-level” brands or risk losing share to knockoffs. Furthermore, The J.M. Smucker Company (NYSE:SJM) or Dunkin Brands Group Inc (NASDAQ:DNKN) could decide to stop working with Green Mountain, if they think they can compete better on price by selling unauthorized K-Cups.