Confessions of a Green Mountain Skeptic: Why I Could Be Wrong About Green Mountain Coffee Roasters

I have been and continue to be a skeptic of Green Mountain Coffee Roasters' ability to maintain outsized profits. Here's why I could be wrong.

Feb 26, 2014 at 10:53AM

I am a Green Mountain Coffee Roasters (NASDAQ:GMCR) skeptic, but I could be wrong. Bulls and bears generally agree that Green Mountain must successfully transition to the next generation of brewers in order to keep earning outsized profits. Where we disagree is whether or not that transition will go smoothly. There is a strong chance that the introductions of Keurig 2.0 and Keurig Cold do not go as well as they need to in order to solidify Green Mountain's competitive advantages.

However, there is also evidence that suggests Green Mountain's profits will continue to climb upward for years into the future. That evidence is the focus of this article.

Historically, a great business
Green Mountain has historically earned outsized profits. According to Morningstar, the company averaged a 10.5% return on invested capital over the last 10 years; for every dollar invested in operations, Green Mountain earned more than $0.10 per year in profit. That is pretty good to begin with, but even more impressive is that return on invested capital has increased in the years since the K-Cup patent expired. Instead of having its profits stolen away by competitors, Green Mountain has increased its profitability.

Off-patent K-Cups
Unlicensed K-Cups captured a 14% share of the market in Green Mountain's fiscal first quarter, which includes October, November, and December. Unlicensed K-Cups are compatible with the current generation of Keurig brewers, but Green Mountain is not compensated at all by unlicensed brands. As a result, Green Mountain is diligently licensing as many unlicensed brands as it can.

I am skeptical about Green Mountain's licensing deals, especially those with coffee heavyweights Starbucks and Dunkin' Brands. These companies are large enough to extract favorable terms out of any white-label manufacturer; it does not make sense for them to sign a deal with Green Mountain except on terms more favorable than they can get from any other manufacturer. Sturm Foods -- a subsidiary of TreeHouse Foods -- and Rogers Family Co. are just two examples of companies that manufacture their own Keurig-compatible single-serve portion packs. Starbucks and Dunkin' Brands could do the same or outsource manufacturing to a third party.

However, my skepticism may be misplaced. Green Mountain CEO Brian Kelley says licensed brands benefit from Green Mountain's superior manufacturing, which leads to a perfectly brewed cup of coffee.

For companies like Starbucks, quality is even more important than price. In addition, manufacturing is a capital-intensive activity in which Starbucks may be unwilling to invest as long as the grocery channel represents a small portion of its overall sales. The purported quality of Green Mountain's manufacturing process, in addition to the capital intensity and specialized knowledge required to manufacture K-Cups, could be reason enough for major brands to team up with Green Mountain.

Next-generation brewers
Even if unlicensed K-Cups do not make a large dent in Green Mountain's profitability, reclosing the system with the next generation of brewers would provide a boost to the company's profitability. Keurig 2.0 utilizes patented technology that only brews licensed K-Cups. The newly patented K-Cups are already making their way into stores in time for the Keurig 2.0 rollout. The new technology should cause K-Cup prices to rise and allow Green Mountain to earn a higher profit per K-Cup.

In order to secure a wide moat for another decade, Green Mountain must get Keurig 2.0 into as many homes as possible. It must convince a large portion of the 18 million households that have a Keurig 1.0 to upgrade to Keurig 2.0. In order to do that, the Keurig 2.0 must have innovative functionality that compels consumers to upgrade.

Keurig 2.0's single biggest enhancement is its ability to brew both single-serve and entire pots of coffee. This hardly sounds like the kind of game-changing functionality that Keurig 1.0 owners will rush out to get, but Green Mountain's data suggest it may be just that.

According to a recent company presentation, 72% of Keurig 1.0 owners who also use a drip coffee maker do so because they want larger brew sizes than are available on the Keurig. Moreover, the No. 1 non-price reason that consumers who do not own a Keurig refuse to buy one is that it does not brew an entire pot of coffee. The new brew size may be the key to mass-market penetration after all.

In addition to offering innovative functionality, Green Mountain could rapidly expand its Keurig 2.0 user base by selling the brewers at a steep loss -- essentially paying customers to adopt the closed system.

However the company intends to get Keurig 2.0 into millions of homes, competitors are starting to believe that Green Mountain can pull it off. TreeHouse Foods -- a manufacturer of unlicensed K-Cups, mentioned previously -- announced a lawsuit earlier this month charging Green Mountain with "anticompetitive acts to unlawfully maintain a monopoly over the cups used in single-serve brewers."

There is perhaps no greater indication that a company is destined for greatness than the quivering lips of its competitors. Maybe Green Mountain will pull it off after all.

Foolish takeaway
There are many ways that the transition to next-generation brewers could go right and many ways it could go wrong. I want a clearer picture of Green Mountain's future before I invest, but that does not mean that the stock will not continue its ascent. One of The Motley Fool's newsletters recommends Green Mountain -- a recommendation that has served subscribers fantastically. I do not mind watching this pitch go by -- it is not in my wheelhouse -- but that does not mean that it will not be a home run for those who do take a swing at it.

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Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Green Mountain Coffee Roasters. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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