Green Mountain Coffee Roasters Inc. (GMCR): Will the K-Cup Falter in the Face of Knockoffs?

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.

GMCR Revenue TTM Chart

Green Mountain Coffee Roasters TTM Revenue, data by YCharts.

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.