Analysis: Green Mountain faces mounting pressure from store brands

NEW YORK Sun Jun 17, 2012 12:19pm EDT

Green Mountain Coffee single-serve K-Cups are pictured in New York, May 3, 2012. REUTERS/Brendan McDermid

Green Mountain Coffee single-serve K-Cups are pictured in New York, May 3, 2012.

Credit: Reuters/Brendan McDermid

NEW YORK (Reuters) - Green Mountain Coffee Roasters Inc (GMCR.O) is facing new competitors in the U.S. single-serve coffee market even before some of its patents expire in September, suggesting pricing pressures could come earlier than analysts had expected.

U.S. supermarket chain Safeway Inc (SWY.N) last week said it began to sell its own brand of filtered coffee pods that are compatible with Green Mountain's Keurig brewers, but at prices below Green Mountain's own K-Cups.

Kroger Co (KR.N), the largest U.S. grocer, also plans to launch its own private-label coffee pods, news that sent Green Mountain shares down as much as 10 percent to a 2 1/2-year low on Monday.

"It just punches a giant hole in the business plan of Green Mountain. The margins in this business are going to change. They cannot continue to be as profitable as they were," said Bevmark Consulting CEO Tom Pirko.

Green Mountain's business model is often referred to as the razor/razorblade model - like makers of shavers, it sells Keurig brewers virtually at cost to drive consumer adoption, and makes most of its profit from the patented K-Cup refills.

Investors and analysts had been expecting an onslaught of competition in the fall, since two of Green Mountain's patents governing cup design will expire in September.

But the much earlier arrival of Safeway, and news of Kroger, means that Green Mountain could feel pressure on its prices and profit margins sooner than expected, analysts said.

So far, Safeway is selling 12-packs of Safeway Select cups at $6.99, or 58 cents apiece, compared with 12-packs of Green Mountain K-Cups for $8.99, or 75 cents each.

Safeway Select cups are manufactured by Rogers Family Co, a privately held company based in California that has been sued by Green Mountain for patent violation for selling its San Francisco Bay OneCups, which work with Keurig brewers.

At some Costco Wholesale Corp (COST.O) stores, those OneCups have sold for as little as 32 cents each - a sign of how low prices could ultimately go.

"We anticipate competition will pressure K-Cup pricing, increase promotional activity and result in share loss for Green Mountain, negatively impacting the company's long-term earnings power," Stifel Nicolaus analyst Mark Astrachan wrote after seeing that Rogers' OneCups had achieved "material shelf space" in select grocery stores and West Coast Costco's.

Shares of Green Mountain, which is estimated to control some three-quarters of the U.S. market for single-serve coffee, have tanked 83 percent since September amid questions about its business, management team and accounting practices.

In the latest quarter, its gross margin fell to 35.4 percent from 37.5 percent a year earlier, hurt by higher coffee costs and lower-than-expected K-Cup demand. Sales of K-Cup coffee refills rose 59 percent, though this represented a sharp fall from the 115 percent growth seen in the previous quarter.

LEGAL CHALLENGES

Green Mountain spokeswoman Suzanne DuLong declined to comment specifically on the news from Kroger and Safeway or on how the quick private label entry might affect the company's performance in the current quarter.

Green Mountain has said it expects to continue to benefit from its scale and expertise in manufacturing K-Cups, and that it will "aggressively defend" its intellectual property.

Green Mountain has dozens of patents governing the brewers, the K-Cups and the interaction between the brewers and cups. The company has already sued Rogers and Sturm Foods, a unit of TreeHouse Foods (THS.N), for selling Keurig-compatible cups that allegedly infringe its patents.

Rogers' president, Jon Rogers, told Reuters he was confident that he would prevail in the patent fight, saying his cup is as different from the K-Cup as "apples and oranges" - the K-Cup is made of plastic, while the Rogers cup is made of mesh.

He said Safeway was Rogers' first private-label client but the company has been approached by others and was being careful about how much business it takes on at once.

Michael McCoy, an intellectual property lawyer at Alston & Bird, said Safeway's use of the Rogers cup may be seen as an endorsement for the family run coffee company, though it would not surprise him if Green Mountain tried to sue Safeway or other brands that sell unlicensed Keurig cups.

"It's fairly safe to presume that a company like Safeway, which is a reputable company, is going to be well-advised," McCoy said. "They're going to know the risks and they will have taken reasonable steps to either avoid infringement or at least minimize their risk."

McCoy noted that Rogers could have a hard time proving that it worked around Green Mountain's patents governing the interface of brewer and cup, since the Rogers cup works with the Keurig brewer. But he said Green Mountain might be less inclined to sue a customer like Safeway for fear of poisoning their relationship.

Safeway did not return calls and emails requesting a comment.

PRIVATE LABEL GROWING

Private label, or store brand, products are in most aisles of the supermarket. Since they require much less marketing, it is not unusual for them to cost 20 percent less than national brands, according to Bevmark's Pirko.

Their relative market share varies. For products like soda, cosmetics, candy and laundry detergent, where brands usually matter, private label amounts to less than 10 percent of the market, according to Bain & Co. But for more commoditized items like milk and cheese, it can be north of 30 percent. For coffee, it is about 10 percent, Bain said.

In the case of single-serve coffee, which Euromonitor International says makes up about 10 percent of the overall U.S. coffee market, private label is still undeveloped.

Rick Haffner, Euromonitor's head of global beverages research, said it may be some time before private label makes a big dent since Green Mountain has licensing deals with premium brands like Starbucks (SBUX.O), Folgers (SJM.N), Caribou Coffee CBOU.O and Dunkin' Donuts (DNKN.O).

But given the category's expected growth - about 75 percent over the next five years, according to Haffner - many companies want in.

"Pretty much anybody who's anybody, whether you're a food company or a retailer, you probably want to have some level of exposure to it," said Marc Riddick, an analyst at The Williams Capital Group, who follows Green Mountain. (Reporting by Martinne Geller in New York; Editing by Bernard Orr and Maureen Bavdek)

A couple walks along the rough surf during sunset at Oahu's North Shore, December 26, 2013. REUTERS/Kevin Lamarque

Find your dream retirement town

Florida? Hawaii? Reuters has teamed up with Zillow to give you the power to customize a list of your best places to retire.  Video | Full Article