Bad News for Keurig Green Mountain Investors: TreeHouse Foods Says Keurig 2.0 Technology Can Be Cracked

Keurig Green Mountain (NASDAQ: GMCR  ) shareholders may want to lower their expectations for Keurig 2.0. At an investor conference two weeks ago, TreeHouse Foods (NYSE: THS  ) CEO Sam Reed said his company could replicate the next-generation K-Cup technology in less than one year. If Reed is correct, Keurig may encounter stiffer competition from unlicensed brands in the years ahead. Reduced profitability would lead to big losses for Keurig shareholders, but the fight is far from settled. Investors need to know the true implications of TreeHouse's threat before deciding to ditch the stock.

Photo courtesy of Keurig Green Mountain.

TreeHouse hanging on by a limb
TreeHouse, a private-label food and beverage manufacturer, is doing everything it can to salvage its K-Cup business. The company is one of a handful of white-label manufacturers that capture 14% of the $3.7 billion K-Cup market. Earlier this year, TreeHouse sued Keurig on grounds that Keurig 2.0's patented technology was designed to lock out competitors' products. No dispute there; one of Keurig 2.0's biggest selling points for investors is its potential to keep unlicensed brands from using its platform.

I'll leave the legal debate to lawyers, but Reed's latest comment suggests that even he knows that the lawsuit has little chance of success. Reed told investors and analysts at last month's Citi Global Consumer Conference that his analysis "indicates that, under any circumstance, it will be a matter of months -- not years -- before we replicate the technology for the [new K-Cups]." In other words, Keurig 2.0 will not be able to shut out competitors for any meaningful length of time.

Given Keurig's limited description of its next-generation technology -- the company has only said that next-generation brewers will have "interactive readability" that only works with licensed K-Cups -- skepticism is warranted about TreeHouse's ability to know how quickly it can replicate the technology. Reed developed his estimate based on "our own research, as well as analysis of public statements." However, as a private-label manufacturer, TreeHouse's core competency is making knock-offs of branded food and beverage products. Keurig shareholders should assume that the technology will be cracked well before its patent expires.

Should shareholders be concerned?
TreeHouse's ability to fool Keurig 2.0 into brewing unlicensed K-Cups is not a good development, but it may not be devastating. Two years since the company lost its original patents -- opening the K-Cup market to TreeHouse and other private-label manufacturers -- Keurig is still extremely profitable and maintains a commanding share of the market.

Keurig actually increased its gross margin from 34% in fiscal 2011 to 37% in fiscal 2013, though that was partially due to higher-margin K-Cups accounting for a greater proportion of sales in 2013. Keurig also has an 86% share of the K-Cup market, a position that has held up better than some critics imagined it would two years ago.

However, Keurig's pricing power will be kept in check if unlicensed brands can circumvent Keurig 2.0's safeguards. If Keurig were to raise K-Cup prices, unlicensed competitors could keep prices low and steal market share. Moreover, Keurig's beverage partners would have greater bargaining power in negotiations since they have the option to go to a third-party manufacturer, leaving Keurig out of the process altogether.

Keurig 2.0 will probably be cracked and opened to unlicensed pods, but that does not mean it is worthless. In addition to the traditional single-serve pods, Keurig 2.0 enables consumers to brew an entire pot of coffee. This addresses the No. 1 non-price reason that consumers do not yet own a Keurig brewer, or own a Keurig brewer and a drip coffee maker. Keurig 2.0's new brew sizes will make more consumers use K-Cups more often, growing the overall K-Cup market. This could work out in Keurig's favor, even if it has to share the market with unlicensed pods.

Foolish takeaway
TreeHouse Foods is intent on breaking up Keurig's monopolization efforts and will probably succeed. Although the presence of third-party manufacturers acts as an anchor on K-Cup prices and reduces bargaining power with licensed brands, Keurig's ability to maintain a dominant market position and high profitability two years after its original patents expired should reassure shareholders that the company is not doomed.

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