Keurig Plans to Lock Out Third-Party K-Cups From its New Coffee Makers, But Is it Legal?

Keurig plans to add technology to its new line of brewers that would make them not work with unlicensed coffee pods.

Mar 12, 2014 at 10:26AM

Keurig Green Mountain  (NASDAQ:GMCR) wants to keep companies from selling unlicensed coffee pods for its popular line of K-Cup brewers. 

The company, which changed its name from Green Mountain Coffee Roasters March 10, plans to include interactive readers in its new Keurig 2.0 machines being released this fall that are programmed to work only with Keurig-licensed pods, Geekwire reported. The company makes most of its money from sales of the pods, a revenue stream that has been threatened by non-partners creating and selling cheaper pods without cutting Keurig in on the action.

Keurig gets sued

TreeHouse foods, which makes unlicensed K-Cups that generally sell for less than the ones from Keurig and its partners, has filed a lawsuit to stop the inclusion of the lockout technology in the new machines. In the lawsuit, TreeHouse acknowledges that until 2012, Keurig had patents that allowed it to keep competitors out. Since those patents have expired, the company alleges Keurig is using technology to improperly keep competitors from making K-Cup alternatives.

The key complaint can be found in this excerpt from the lawsuit.

"Green Mountain has announced a new anticompetitive plan to maintain its monopoly by redesigning its brewers to lock out competitors' products. Such lock-out technology cannot be justified based on any purported consumer benefit, and Green Mountain itself has admitted that the lock-out technology is not essential for the new brewers' function. Like its exclusionary agreements, this lock-out technology is intended to serve anticompetitive and unlawful ends."

Keurig has not issued a formal comment on the lawsuit but did take to Twitter to discuss its technology. "Our Keurig 2.0 brewer will deliver new interactive-enabled benefits which will require it to identify the inserted pack," said a Tweet from the @Keurig account.

Keurig CEO Brian P. Kelley did speak about the technology at a February conference in Florida, Scott Kirsner of The Boston Globe reported.

"We are a technology company in the beverage business," Kelley told the audience.

Keurig is following a path popular with technology companies, Kirsner wrote, "using software as a way to lock customers into a particular set of high-margin products. Microsoft (NASDAQ: MSFT), Apple (NASDAQ: AAPL), and the printer-maker Lexmark (NYSE: LXK) have all waged legal battles to control their 'ecosystems,' which in Lexmark's case has meant trying to keep refurbished ink cartridges out of their printers."

Is what Keurig is doing legal?

Treehouse faces a difficult legal fight in its battle with Keurig -- in addition to the precedents in other industries cited by Kirsner, the law may be on the side of the manufacturer of the popular brewers. Intellectual property attorney Jacob Koering, a partner at Freeborn & Peters LLP in Chicago, told the Fool he believes Keurig has the right to keep other companies of its platform. In an email interview, he wrote:

"Treehouse Foods sued GMCR under the Sherman and Clayton Antitrust Acts based on allegations that it is improperly using its monopoly power in various ways. One of the allegations by Treehouse was that the introduction of a "new" Keurig single cup brewer, called Keurig 2.0, is an antitrust violation because the new brewer will deliberately not be backwards compatible. In other words, GMCR is making an affirmative decision not to allow the old-style "K-Cups" to be used on its new brewer. The purpose of antitrust law is to prevent a company with monopoly power from improperly using that power to the detriment of consumers and other competitors. But, GMCR's decision to limit the functionality of its Kuerig 2.0 brewer can hardly be considered a negative decision for its competitors. In fact, it opens up a huge market opportunity for a new single-cup manufacturer (or existing manufacturers like Nestle and Starbucks) to step in and fill that void."   

According to Koering, "the complaint filed by Treehouse Foods does not appear to have a strong likelihood of success." There is a possibility however that TreeHouse could win based on another argument, Koering wrote. 

The one potential caveat here is that Treehouse has made allegations that Keurig/GMCR has entered into supplier agreements that make it essentially impossible to sell single-use cups for any other kind of brewer than Keurig. Without seeing the particulars of the supplier agreements, it is difficult to measure the veracity of that claim. That being said, if indeed Keurig's supplier agreements make the single-server pod supplier market captive to the brewer products sold by Keurig, Treehouse may have a strong claim. Essentially, the nature of that claim would be that Keurig is illegally extending its patent monopoly (for the now-expired K-cup patent) by entering into agreements that would prevent others from entering and competing in that now-expired patent market.

How big is the K-Cup market?

In the first quarter of 2014 Keurig sold $931 million worth of coffee packs (which would primarily be K-Cups, but would also include packs for its less-successful Vue brewing system). That number was an 8% increase over the $863 million in packs it sold during the same quarter the previous year.

The company expects that growth to continue, though it acknowledged the impact of unlicensed packs in its first quarter earnings report. The company said it expects "net sales growth of low-to-mid single digits over the second quarter of fiscal year 2013 due to year-over-year pack sales comparisons; the impact of unlicensed packs; and the currency headwind in Canada."

Should Keurig do this?

Even if Keurig loses it's probably worth it for the company to show its partners (who pay for the right make licensed K-Cups) that it will vigorously fight to keep non-licensed brands out. If it loses, Keurig also loses negotiating power with its biggest partners. Smaller companies may benefit from being an official Keurig partner but major players including Dunkin' Donuts (NASDAQ:DNKN) and Starbucks (NASDAQ:SBUX) likely don't need the affiliation if they could sell packs that work on K-Cup machines without paying Keurig.

Keurig does not break down how much revenue it makes from licensed K-Cups versus the ones sold under its own name in its quarterly reports, but the company is partners with nearly every major player in the coffee world. In its 2013 annual report, Keurig acknowledged that failure to maintain its partnerships could adversely impact the business.  

Since coffee pack sales have increased since Keurig's patents expired it's reasonable to predict that non-licensed K-Cups won't crush Keurig. The company should be worried about its partners deciding there is no reason to pay a licensing fee. Keurig may not win the legal right to lockout competitors but it should fight aggressively to keep the legal question open in order to keep its partners from becoming competitors.

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Daniel Kline has no position in any stocks mentioned. He owns a Keurig brewer. The Motley Fool recommends Green Mountain Coffee Roasters and Starbucks. The Motley Fool owns shares of Starbucks. 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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