When Keurig Green Mountain (NASDAQ:GMCR) designed the new models of its popular K-Cup brewing machines, it added digital rights management technology that was supposed to make it so unlicensed pods would not work in the new brewers.
This would force the companies making K-Cups without paying a royalty to Keurig to either become an official partner and pay up or to stop manufacturing their pods altogether Either solution would be fine by the Vermont-based coffee company because royalties from K-Cup sales are a huge part of its business model.
But the new DRM technology that was supposed to make using unlicensed K-Cups impossible has not worked and one company is already touting that is has cracked the code and that its knockoff K-Cups will work with the 2.0 brewers, which went on sale a couple of weeks ago.
What is Keurig trying to do?
Although the company has attempted to position its new brewers as being all about delivering the best coffee experience possible -- and that's certainly part of it -- it's hard to see the consumer benefit for including DRM technology. An argument could be made that locking out unlicensed pods allows Keurig to keep standards high for the coffee pods, but the real plus in keeping a closed platform for the company is forcing everyone to pay or leave the market.
Unlicensed pods that work with pre-Keurig 2.0 brewers are currently sold by a number of companies including Treehouse Foods (NYSE:THS), which filed a lawsuit against Keurig in March, according to Consumerist, in which the company claimed Keurig was unfairly monopolizing the market. The illicit coffee packs are also sold under the house brands of a number of supermarket chains.
In most cases the unlicensed pods are cheaper than the licensed ones they share shelf space with. It's likely that consumers have no idea that they are buying an unapproved product as nothing is mentioned on the packaging (though Keurig branding is limited to wording along the lines of "works with most K-Cup brewers").
There are no official sales totals for unlicensed K-Cups, but my fellow Fool Brandy Betz shared some numbers Keurig provided in its first quarter conference call in an article from March. "[Keurig] 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," she reported.
That's a big number when you consider just how many K-Cups the company sells.
How big is the K-Cup Market?
The sale of K-Cups, which are lumped into the "portion pack" section of the company's financials are incredibly important to Keurig as they represent the majority of its revenue. In the company's third quarter financial press release, which the company released Aug. 5, Keurig stated that $826.3 billion of its overall $1.02 billion in revenue came from portion pack sales. Those sales would include formats other than K-Cups and the company does not provide a specific breakdown, but Keurig's other line, the Vue, has struggled to catch on with consumers and has very little market penetration.
The company has been very successful getting high-profile partners to make K-Cups, including Dunkin Brands (NASDAQ:DNKN) and Starbucks (NASDAQ:SBUX), which signed on despite owning a rival single-cup brewer, the Verismo. Keurig claims to have deals with more than 50 brands offering nearly 300 varieties that include everything from coffee to hot chocolate, tea, and more.
Keurig makes its money selling portion packs -- specifically K-Cups -- and any unlicensed sales hit the company in the bottom line. Adding DRM protection in the 2.0 made sense, but if the brands that are not partners can get around it, it won't help.
What are the nonpartners doing?
As mentioned above, Treehouse has filed a lawsuit. The company has also said it is working on getting around the DRM technology, according to an article by fellow Fool Ted Cooper. In that June story, CEO Sam Reed said it would take the company less than a year to crack the code.
Another unlicensed K-Cup maker, Mother Parkers Tea & Coffee, which owns and manufactures the RealCup brand, did not even need that long. The company announced on Aug. 21 that its pods would work with the 2.0 brewers. Mother Parkers cracked the DRM code and while the company did not take a direct shot at Keurig's attempting to lock competitors out of its new brewers, comments by Vice President of Business Development Bill VandenBygaart were not very subtle.
We are very pleased that our focus on innovation, quality, and freedom of choice has led to new technology that will produce authentic tasting coffee and tea products in all K-Cup type single-serve brewers, both old and new styles. Standard size capsule brews, as well as larger carafe and multi-serve formats, will soon be available for independent brands of single-serve capsules. Consumers will be the ultimate winners by having the best tasting coffees and teas available.
Keurig wanted a closed system but it's clear it won't be able to get one.
Will Keurig win?
If one company found a workaround this quickly, it seems like others will have no trouble doing so. This will cost Keurig some sales, but ultimately, it's not a major headache since Keurig has deals with major players in the coffee space.
Yes Mother Parkers and TreeHouse, along with various store brands, would appeal to people buying portion packs solely based on price, but cost-conscious customers have never been the Keurig audience. It has always been cheaper on a per-cup basis to brew a pot of coffee the old-fashioned way. Keurig's K-Cup, however, offers choice, customization, and a premium experience. With nearly every major coffee maker on board as a licensed partner, including Dunkin', Starbucks, and Krispy Kreme (NYSE:KKD), it seems unlikely that most Keurig users will opt for cheaper, obscure brands.
Even if the 14% number reported above is true, that figure is unlikely to grow as Keurig expands its own offerings. A deal announced with Kraft (NASDAQ:KRFT) in August will, for example, bring a number of well-known coffee brands, at a variety of price points, to K-Cups. These include Maxwell House, Gevalia, Yuban, and even a Kraft-manufactured line branded to the McDonald's McCafe line.
If Keurig continues to bring all the well-known coffee brands to its platform -- especially ones that include some cheaper offerings -- then there will be little reason to buy unlicensed portion packs. That seems like a much more successful strategy than using technology to lock out competition.
If Starbucks or another major player decided to leave the fold that would be different. For now, though, while the failure of Keurig's DRM efforts is disappointing, unlicensed sales are likely to remain a nuisance -- albeit an expensive one -- more than a real threat to Keurig's business.
Daniel Kline has no position in any stocks mentioned. He owns a Keurig brewer and has used unlicensed k-Cups on a few occasions. The Motley Fool recommends Keurig Green Mountain 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.