When Green Mountain Coffee Roasters (UNKNOWN:GMCR.DL) released its first-quarter earnings on Wednesday, it was supposed to be a routine affair. It turned out to be anything but.
Bulls and bears are anxiously trying to determine how successful the next generation of Keurig brewers will be; the company's future profitability rests on its ability to keep unlicensed K-Cups from using its system. Signing a wide variety of major brands to licensing deals is the most crucial part in closing its system. So, when Green Mountain announced a partnership with Coca-Cola (NYSE:KO) for its Keurig Cold brewer, Green Mountain's stock price jumped an incredible 41%.
What the Coca-Cola deal means for Green Mountain
The agreement is notable in that Coca-Cola is buying a 10% stake in Green Mountain for $1.2 billion, giving Coca-Cola a long-term incentive to do business with the company. Green Mountain's previous deals, with companies like Starbucks and Dunkin' Brands Group, did not involve equity commitments from its counterparties.
Keurig Cold, the system for which Coca-Cola signed the deal, is a product in Green Mountain's lineup of next-generation brewers that uses patented reader technology to distinguish between licensed and unlicensed brands. Keurig Cold is part of Green Mountain's strategy to provide "a beverage for every occasion." It is designed to dispense carbonated beverages, energy drinks, teas, sports drinks, enhanced waters, and more.
Coca-Cola is the holy grail for Keurig Cold. As the world's largest beverage company, Coca-Cola's has a vast portfolio of beverages that includes many of the kinds of beverages that Keurig Cold is designed to make. As a former Coca-Cola executive, Green Mountain CEO Brian Kelley's ties to the beverage giant may have provided the impetus to get a deal done.
An urgency to make Keurig 2.0 a success
The Coca-Cola deal is a giant step forward for Green Mountain in its quest to secure its future. The company's current line of brewers works with unlicensed K-Cups for which Green Mountain is not compensated. The company estimates unlicensed share to be 14% at the end of the first quarter, up from 12% at the end of the fourth quarter.
The growing share of unlicensed K-Cups on the old system creates an urgency to roll out the new system; Keurig 2.0 brewers are expected to hit the market in fiscal 2014 and fiscal 2015. Since only licensed K-Cups will work on the new brewing system, Green Mountain needs to have licensed several major brands by launch date so that it can offer consumers a wide variety of beverages. Presumably, the company's deals with Starbucks, Dunkin' Brands, and other brands on its Keurig Hot system extend to the next generation of brewers, enabling the company to offer a strong selection of beverages on its new system.
Of course, the new system will need to be rapidly adopted by consumers. The company announced that a record 5.1 million Keurig brewers -- the ones that can use unlicensed K-Cups -- were sold in the first quarter. It will be a challenge for the company to ask consumers who have already bought Keurig brewers to upgrade to the next generation.
However, it is absolutely crucial that Green Mountain convince consumers to upgrade. During the first quarter, dollar sales of portion packs increased 8% versus the year-ago quarter due to strong volume increases, but growth would have been 25% higher if not for lower portion-pack prices.
The price decline is exactly what the bears predicted; as long as unlicensed K-Cups are compatible with brewers, prices will continue to decline due to price competition. Green Mountain needs to eliminate unlicensed players so that it can control K-Cup prices. This is why it is vital that Keurig 2.0 replaces the original system in as many American homes as possible.
In order to build a durable competitive advantage, Green Mountain needs to do two things: (1) sign up a wide variety of respected brands for use on its next generation of brewers, and (2) get the next generation of brewers into as many homes as possible. The company's deal with Coca-Cola -- and its existing agreements with Starbucks and other major coffee and tea brands -- goes a long way toward accomplishing the first half of its task. Now, investors just need to watch for indications of how the second half will turn out; the company's future depends on it.