Is a piece of cellophane tape enough to bring Keurig Green Mountain (NASDAQ:GMCR) to its knees?
The at-home coffee maker company invested a lot of money in the development and marketing of its new 2.0 coffee machine that is loaded with DRM-like technology to rebuild its patent protection moat. But a simple 10-second hack might have already rendered the machine's protective technology obsolete.
Moreover, with white-label pod maker TreeHouse Foods (NYSE:THS) saying it has already cracked the technology behind the new system and will be ready to run with discounted pods as soon as allowed, how long can Keurig Green Mountain's comeback survive?
A hill of (coffee) beans
Keurig created the new machine as a means of regaining its preeminent position in the coffee brewing business. Its original system still dominates the landscape, with 10.9 million units sold in the last year alone. But after patent protection expired and third-party coffee pod makers were able to manufacture the consumables, Keurig's business plunged.
In a typical razor-and-blades business model, Keurig essentially gives away its brewers (the razors) at cost and racks up sales and profit on the consumable coffee pods (the blades). So long as it had patent protection, it thrived, but once the protection expired, it saw sales damaged by the likes of TreeHouse Foods and others that moved into the pod production business.
The empire strikes back
To reclaim its leadership position -- and the profit margin that came with it -- Keurig built into the new 2.0 brew system technology that used only the company's own K-Cups and was again protected by patents. The hope was the introduction of a new machine that allowed coffee drinkers to brew more than a single serving of coffee would cause them to ditch their old coffeemakers. And since the machine required the company's own pods, Keurig could regain its patent moat behind which it could rebuild its empire.
TreeHouse Foods realized the threat to its own business and actually sued Keurig over the "lock-out" technology, claiming it and other third-party manufacturers should have unfettered access to the saying there was no guarantee consumers would buy the new machine and that they still had access to plenty of 1.0 systems, in which TreeHouse pods could be used. There was no fear Keurig would monopolize the market, according to the ruling.
But this past summer, TreeHouse claimed it cracked the code to Keurig's 2.0 brewing system. And now, as several simple hacks float around the Internet showing all that is needed is a bit of tape, the question arises, just what did Keurig spend all that money on?
Duct tape and baling wire
The Keurig 2.0 Beverage System features a sensor that reads a chip built into the cover of a pod and signals whether it's OK to brew the coffee. Without the chip, the machine doesn't work. But last week, CNN aired a video that showed how just taping the edge of a new pod to the brewer defeated Keurig's reader as it reads the bit from the licensed pod regardless of the pod being used.
Other videos have made the rounds showing users sticking a new label on an old pod to beat the system or permanently taping the pods' colored dot to the sensor itself to defeat the DRM technology and allow the use of the old, cheaper K-Cups.
Therein lies Keurig's risk. Last quarter it sold 2.4 million brewers, up 7% from a year ago when adjusting for returns of some 1.0 systems. Sales of portion packs rose 13% for the year, but surged 22% in the fourth quarter on a 28% spike in volume following the introduction of the new system. The Keurig 2.0 launched in August and the least expansive one is advertised on Keurig's site for $149.99.
To date in 2014, Keurig has sold 9.8 billion pods representing 76% of total net sales. It also enjoyed a 23% jump in operating income primarily because of the rise in pod sales. But with coffee drinkers able to bypass the Keurig pods, have sales already peaked?
Trusting in the goodness of people
Perhaps only a relative handful of people will hack their new brew systems. Yet Keurig announced a big increase of up to 9% in pod prices, effective Nov. 3, to offset rising coffee costs, giving coffee drinkers more incentive to circumvent the technology and continue using cheaper white-label pods.
For investors, the relative ease with which the technology and safeguards were defeated calls into question the amount management spent on developing the system. Research and development spending reached $76.5 million in 2014, up 33% from the $58 million the company spent the year before and nearly 63% higher than what it spent in 2012. It seems incomprehensible that Keurig should allow its moat to be defeated (and its money wasted) by a little bit of tape. No wonder TreeHouse Foods was able to readily figure out a work-around.
Countdown to obsolescence?
Keurig Green Mountain probably won't crumble as a result of these hacks. But if investors put their faith in the 2.0 system to rebuild the company's preeminent position in the coffee market, they have to be sorely disappointed.
It's clear the coffee brewer is living on borrowed time. The clock is ticking on Keurig's patent expiration again and on the value of its stock as an investment.
Rich Duprey has no position in any stocks mentioned. The Motley Fool recommends Keurig Green Mountain. 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.