Hack Attack: Will Unlicensed K-Cups Hurt Keurig 2.0 Sales?

When Keurig (GMCR.DL) introduced its 2.0 brewers earlier this fall, the company attempted to quietly add digital rights management technology to the machines making it so only licensed K-Cups would work in them.

This move, which sparked a lawsuit from TreeHouse Foods, a maker of unlicensed K-Cups, charging that Keurig violated antitrust and unfair competition statutes in a number of states. It also led to immediate efforts by hackers to find ways to get around the technology. 

Those efforts were quickly successful and a simple Internet search will reveal an easy method to bypass the DRM protection in order to use whatever K-Cup you want in the next generation brewer. Without going into full details, hacking the machine requires little more than a single licensed K-Cup and a piece of tape. It's something an uncoordinated schoolkid using safety scissors could accomplish and it's actually a little shocking that Keurig bothered to include DRM technology -- which brought it some negative publicity and a bit of a consumer backlash -- without making it at least somewhat difficult to get around.

Instead, Keurig now has the worst of both worlds -- a system which is effectively open and a user base which is keenly aware the company attempted to remove the option of using unlicensed K-Cups, which are almost always cheaper. And whether you consider it botched technology or a poor public relations decision, Keurig may have put itself in position to not only sell less Keurig 2.0 brewers, but to cut into the lifeblood of its business -- coffee portion pack (K-Cup) sales.

K-Cups produce a majority of Keurig's revenue. Source: Author

How important are K-Cups for Keurig?

Keurig needs to sell brewers in order to create demand for its portion packs which are its main revenue driver. In the company's fiscal 2014, it had $4.7 billion in sales, $3.6 billion of which came from portion packs (both its own and from royalties paid by licensees). The vast majority of the portion pack revenue, which the company does not break down, comes from K-Cups as its other brewing systems have failed to connect with users.

The company's current brewers allow for unlicensed K-Cups. The attempt to include DRM technology in the 2.0 is an effort to force customers opting for cheaper, unlicensed pods to use authorized ones. It's also a way to shrink the market for those companies, making it less enticing for them to offer K-Cups to a potentially shrinking user base. If people buy the 2.0 and if Keurig had DRM tech that was not easy to defeat, the company might increase its revenue by taking audience away from the brands making K-Cups without paying a royalty.

Legal unlicensed pods have been on the market since 2012 when two key Keurig patents expired and BusinessWeek reported in August, 2013 that Keurig said that generic pods had captured 11% of the total market. Given that the company had $3.18 billion in portion pack sales (not all of which were K-Cups) in fiscal 2013, that's roughly a $300 million hit. It's important to note however that despite the increasing availability of unlicensed pods, Keurig's portion pack sales have steadily increased.

Keurig portion pack sales year-over year

Source: Keurig 

While the percentage of growth has slowed down since the patents expired, that might be explained by the company reaching a level of market saturation. It's likely that only a certain amount of people want single-serve coffee brewers and those people will only drink so much coffee. Keurig won't be able to post the large growth numbers it did in 2012, but it looks likely to keep growing steadily despite the prevalence of unlicensed pods.  

Will the hack hurt sales? 

Keurig has licenses with nearly every major coffee brand including high profile rivals Starbucks (SBUX 1.00%) and Dunkin' Donuts (DNKN). In most cases, if you want premium coffee -- or at least the most heavily marketed brands -- they come in licensed K-Cups. The existence of unlicensed pods which work fine without any sort of hack on pre-2.0 Keurig brewers, has perhaps contributed to Keurig's decreasing growth rate, but as mentioned above, that may also be a natural occurrence as the company runs out of new audience.  

K-Cup machines are themselves more expensive than a basic traditional full pot coffee brewer and the amount of people who buy a premium brewer, but are looking for cut-rate pods to use with it, is likely not big enough to do much more sales damage.

Even with the easiness of the hack, the number of unlicensed pods sold should decline if the 2.0. which brews full carafes of coffee as well as single servings, catches on, because many people won't bother trying to beat the technology, they'll just spend more and buy licensed pods. 

What the unlicensed pods and to a lesser extent the ability to get around DRM on the 2.0 do is keep Keurig honest. They serve as a price check creating a line that places a cap on just how much Keurig can charge for K-Cups. You could argue that plain old coffee markers did the same thing since at a certain price the convenience of brewing a single cup no longer outweighs the much cheaper cost per cup of brewing an old school pot of coffee.

The presence of the DRM technology might make some potential 2.0 buyers stick with Keurig's earlier line of brewers, which is still being sold. But, in the long run, unless Keurig pushes its prices too high or major brands opt to forego a license in favor of lower pricing, unlicensed pods have likely already done as much damage as they will ever do to the single-serve leader's bottom line.