Here's Why Green Mountain Has to Ban Unlicensed K-Cups

The Keurig maker hit the headlines over plans to lock out unlicensed K-cups. But here's why Green Mountain has to try this strategy.

Mar 10, 2014 at 5:30PM

K Cups

Source: Michael Dorausch

Green Mountain Coffee Roasters (NASDAQ:GMCR) made headlines last week due to the fact that its future Keurig brewers won't work with unlicensed K-cups -- the store and generic brands that hit the market when the K-cup patent expired in 2012. Green Mountain is accused of employing digital-rights management, or DRM, an unpopular anti-piracy measure usually found in digital media products. And a lawsuit from Treehouse Foods (NYSE:THS) alleges the new Keurigs essentially force competitors to sign licensing agreements or leave the market.

But the aspect that's often overlooked is that Green Mountain itself is forced to at least try this route to keep its business alive. Why does Green Mountain need to maintain a firm grip on the K-cup market? 

The rise of unlicensed K-cups
Green Mountain operates under what's known as the razor-and-blades model. The company sells its brewing systems at minimal profits in order to reap the sales of K-cups. In the first-quarter report, K-cups -- or the packs segment -- accounted for more than 67% of total revenue.

Green Mountain has signed exclusive partnerships with a long list of big-name brands, including Starbucks and Dunkin' Donuts. The early licensees had no choice but to sign up because Green Mountain had the K-cup patent. But latecomers continue to sign agreements to take advantage of Green Mountain's well-positioned distribution services. 

But now Green Mountain plans to release new Keurig machines this year that won't work with any unlicensed pods.  That has ticked off competitors that justifiably feel bullied into signing up for agreements. In its lawsuit, Treehouse Foods accused Green Mountain of "...abus[ing] its dominance in the brewer market by coercing business partners at every level of the K-cup distribution system to enter into anticompetitive agreements intended to unlawfully maintain Green Mountain's monopoly."

And Treehouse Foods has a point. But there's two important factors to remember. Keurigs aren't the only single-pod brewing system on the market: Starbucks has the Verismo. Nestle has the Nespresso. And Brunn has the MyCafe, which stands out because it's compatible with any type of K-cups.  The second fact is that Green Mountain has to try and squash the unlicensed competition as much as possible. 

Green Mountain feels the pinch
In the first-quarter conference call last month, Green Mountain execs said that unlicensed packs accounted for about 14% of the K-cup pods used, and it expects that number to grow during the first half of 2014. That number would presumably grow even higher if Green Mountain wasn't releasing the Keurig 2.0 system within the next year.

Green Mountain needs K-cup sales to stay in business. If the company lost a significant share of the market, Green Mountain couldn't afford to create any more brewers. So the company has to try and earn more licensing agreements while staving off the competition -- at least until the Keurig Cold launches sometime next year. The Keurig Cold might bring along a new batch of patent protections, and has, at the very least, already attracted a superstar partner in Coca-Cola.

Is the Keurig lockout DRM?
DRM typically applies to electronic media, where copyright owners use methods such as encryption or watermarks to ensure that the material isn't copied and distributed illegally.  So there's a spirit of DRM in the planned Keurig 2.0 lockout. 

But the reasoning remains closer to that razor-and-blades model. The name refers to how personal-grooming companies sell the razor at cost and the replacement blades at a stiff markup. But the model also includes the fact that the brand's razors will usually only fit with the brand's own replacement blades. 

Foolish final thoughts
Some customers won't buy any more Keurig-related products in the future, either from protest of the lockout or just because they prefer the off-brand K-cups. But plenty of customers will carry on with Keurig. The forcing of licensing agreements is a bit shady, but Green Mountain has to try something to keep its K-cup market share from eroding to a fatal point. 

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Brandy Betz 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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