Green Mountain Coffee Roasters (NASDAQ:GMCR) files a trademark for a product widely believed to be a new soda making machine and the crowd goes wild for GMCR. That's not exactly the reaction the SodaStream (NASDAQ:SODA) crowd of investors exhibited upon the news however. Now on the day the trademark was more publicly recognized and talked about in the media, shares of SODA actually finished positive, but the following day was anything but positive with shares finishing down greater than 5% and even reaching $55 a share intraday and on heavy volume.
What I think investors are failing to understand are the realities or fundamentals at play with this supposed Green Mountain trademark and patent development. See, Capital Ladder Advisory Group has long since been aware of the Green Mountain carbonated beverage maker patent. In fact, we've talked about the filing with both GMCR and SODA over the last two years. When we're approached by hedge fund clients and they ask us why the SODA short position remains ever present in spite of the phenomenal growth the company is achieving alongside the company's consistent business model execution, we tell them the shorts think they know something that will eventual hinder SODA's success. What they think they know is the GMCR carbonating beverage machine patent.
This article will definitively demonstrate that the GMCR trademark is nothing for SODA investors to fear. With a more careful understanding of the GMCR trademark and an understanding of the incredibly high barrier to entry in this product category investors will recognize why CLAG is reiterating its Buy rating on shares of SODA. With regards to GMCR, our investment thesis has not changed, the lack of patent protection in an ever-increasing competitive environment does not encourage us to offer a Buy rating at this time. If GMCR further develops various sales channels in a profitable way which drives greater earnings production, we would be inclined to adjust our current rating on shares of GMCR from Hold to Buy.
So the infamous shorts think they have been holding onto a SODA destructive diamond piece of information by way of the GMCR patent which outlines the form, fit and function of what would be a carbonating beverage machine. This article will take aim at the GMCR patent so we can all better understand and dissect the future possibilities for GMCR. Understand that this patent originated in 2010, not 2011, but that is a minute detail so let's move on. Below is an excerpt from the patent filing outlining the functionality of the system and its use of a carbon dioxide cartridge:
- Aspects of the invention relate to carbonating a precursor liquid, such as water, to form a beverage. In some embodiments, a carbon dioxide source can be provided in a cartridge which is used to generate carbon dioxide gas that is dissolved into the precursor liquid. A beverage medium, such as a powdered drink mix or liquid syrup, may be provided in the same, or a separate cartridge as the carbon dioxide source and mixed with the precursor liquid (either before or after carbonation) to form a beverage.
Houston, we have a problem, please advise kindly! Sorry, just a little humor as we educate ourselves on how the at-home carbonated soft drink system has come to work over the years. So what is the problem we see in the very first paragraph of this patent filing and is easily identifiable by anybody who knows anything about the soda business? It's really quite simple if you have ever used a soda maker. If you have you would know why the syrup is delivered to the carbonated water outside of the mechanism and poured directly into the bottle. That's right, overflow or fizzing up if you will. Every paragraph, every sentence, every word and every design dimension associated with this patent assumes that the carbonation and syrup mixing occurs within the device. This is not coffee folks, this is a carbonated beverage. You are dealing with a combustible element.
Now I won't go so far as to say this can't be done. Why not? Well because I've seen single-serve soda makers before. Primo Water Inc. (NASDAQ:PRMW) had developed one and brought it to market in 2012. It was a rather large unit, about the size of a commercial grade espresso/cappuccino maker. It was so large because you have to have a water reservoir and a CO2 canister compartment all in the same machine. It weighed a good 13 pounds as well, not exactly easy to maneuver. So what happened with the Primo Water single-serve CSD machine? The functionality of the machine was quite poor and frankly speaking it just didn't work. Due to the simultaneous mixing of the CO2, water and syrup, you can only deliver so much CO2 into the mix without it exploding inside the machine; therefore what it produced was a very flat- tasting carbonated soft drink. The product never made it onto retail store shelves and Primo Water scrapped its venture in 2012. Essentially, the patent filing by GMCR which dates back to 2010, suggests the very same design and functionality. Ever used a SodaStream soda maker; you wonder why each of their devices invites the user to add the syrup themselves outside of the machine? I think we can move on to the next problem with our GMCR patent now as we have clearly outlined the patent was never intended to see production in its current form. Below is yet another except from the patent filing where we will find our next problem:
- The carbon dioxide source may include a charged molecular sieve, such as a zeolite that is in solid form (e.g., pellets) and has adsorbed carbon dioxide, that releases carbon dioxide in the presence of water.
So the source of carbon is suggested to be in the form of either a cartridge as mentioned in the earlier excerpt or pellets as mentioned in the latter excerpt. Well, for those who have used a soda maker which uses pellets or disposable cartridges you probably didn't use it twice. They are far too ineffective as they don't deliver the appropriate amount of carbonation to the water and most mainstream soda maker manufacturers have long since moved to cylinder-based CO2 delivery like that which is found with SodaStream, Wassermax and Cuisinart soda makers. Again, these carbon dioxide sources don't work and haven't been used in this application for years.
A cylinder-based CO2 delivery system optimizes the CO2 output. As a point of reference, the soon-to-be-released soda makers from Hamilton Beach, Whirlpool (NYSE:WHR) and Breville will all utilize SodaStream's CO2 cylinders. The Samsung refrigerator is an advanced partnership outlining where the industry of at-home CSD is moving and this refrigerator also is licensed and designed to use SodaStream's CO2 cylinders. There is a theme here as it pertains to partnerships I believe. One last thing, with the at-home CSD category, one of the system features is the eco-friendliness of the products, those cartridges and/or pellets are anything but eco-friendly. Does GMCR want to be that company which has billions of empty k-cups and un-recycled aluminum pellets and cartridges adding to our landfills?
Ok, I think that is enough about the patent as this machine design is clearly outdated and renders itself obsolete and possibly dysfunctional. Even that doesn't matter though as all patents which have been approved and published are easily amended and/or updated. So the very patent we see published may have already been updated for form, fit and function. No, I'm not wasting your time, just developing the points of analysis surrounding this trademark and patent news.
The truth is that the patent doesn't matter. GMCR doesn't need a patent for this machine or any soda maker machine; SodaStream doesn't either. Machines are easily replicated without patent infringement with slight design changes. The barrier to entering the at-home CSD market after all isn't the machine. I know we have said this a few hundred times, but the barrier to entry is the CO2. There are hundreds of coffee makers, there are hundreds of toasters and there will someday be hundreds of soda makers. However, there is only one CO2 exchange existing on a global scale and that patented CO2 doesn't expire until 2023 which is owned by SodaStream.
We've seen soda maker manufacturers come and go over the last decade because they simply can't compete with SodaStream's vast network of CO2 exchanges. It's not even that SodaStream doesn't want the competition. They repeatedly invite the competition into the fold, but overtime, the competition simply can't get the retailers to adopt a second or third CO2 exchange process. Primo Water tried to enter the market with simple soda maker devices in 2011 and did manage to land an account with Lowe's (NYSE:LOW), but with only one retailer for which consumers had to do their respective CO2 exchange, there was little to no convenience for the consumer. They couldn't go to a Bed Bath and Beyond (NASDAQ:BBBY) to do the exchange; BBBY was already locked into the SodaStream exchange. Ok, locked into is strong verbiage, but let me tell you why it is probably the most accurate depiction of the CO2 exchange process.
The CO2 exchange process is the heart of the at-home CSD system, without it, the system doesn't work. Let's be clear on this, if you are selling a soda maker you have to sell CO2 and have a vast network of CO2 exchanges to refill the consumers CO2 cylinder. This is not optional; no CO2 = no soda maker. The retailers are quite reluctant to perform the CO2 exchange process as it is not the normal retail operation. Essentially what the soda manufacturer is asking the retailer to do is to provide the consumer a service and a product while providing the manufacturer a service at the same time. Here is how the process works:
Step 1. The consumer brings the empty CO2 to a participating CO2 exchange retailer. (Each CO2 cylinder has a serial number for tracking purposes as they have a shelf life)
Step 2. The retail associate logs the empty CO2 cylinder from the consumer and rings up the new CO2 cylinder which is full.
Step 3. The retail associate places the empty CO2 cylinder in the empty CO2 cylinder box with the rest of the empties.
Step 4. When the empty CO2 cylinder box is full of exchanged cylinders, it is sent to the reverse logistics area for shipping back to the soda maker manufacturer's refilling facility (this is the part of the process that is a service to the manufacturer). That's right; a separate refilling facility needs to be operational as determined by federal regulators.
Step 5: The reverse logistics associate or warehouse manager has to log all shipments in and out. CO2 is an entirely separate shipment due to HAZMAT regulations which entails further steps associated with the process.
As one can see, there are a number of steps that need to be followed and record keeping to boot. The record keeping ensures proper processing of the CO2 cylinders in a timely manner and consistent with the manufacturers processes for billing and shipping. Unfortunately what has happened in the past when a retailer operated two independent manufacturer CO2 exchange processes is that retail associates handling the transactions would put the wrong CO2 cylinder in the wrong manufacturer's box and the retailer is left on the hook for the payment of the misplaced CO2 cylinder. For all of the stated process steps, record keeping and liability, the retailers generally, as is evidenced by SodaStream's dominant position in the marketplace, don't like to adopt more than one CO2 exchange process. They don't have the space behind the counter and the liability is simply unnecessary. Another point of reference; SodaStream boasts a near 90% gross margin on CO2 cylinders sold to retailers. After all, it is just air right?
So now GMCR might want to get into the at-home CSD market? I can assure you that SodaStream would welcome them with open arms as they view competition as quite healthy. Competition breeds innovation, growth of the category through product awareness and overall it solidifies the product category as relevant and here to stay. SodaStream and the at-home CSD category is no fad. Just ask Bed Bath and Beyond who just began the 130 liter CO2 exchange to compliment the 60 liter gas exchange. Or ask the executives at Office Depot (NASDAQ:ODP) who signed a deal with SodaStream to roll out products in 500 of their stores with the 60 liter and 130 liter gas exchange. I'd like to also point out that the prime retail real estate end-cap space which was once enjoyed by Keurig products has been replaced with SodaStream products. SodaStream is growing by leaps and bounds and has been for roughly 10 years in Europe and the last three years in the U.S and the Asia-Pacific region. Now, GMCR might be exploring an entrance into this product category with other well-recognized, global brands; I think the fad label was clearly misplaced?
Finally, we are going to dive into the possibilities for GMCR in this product category and discover what the implications, if any, are for SODA. SODA has already well-defined the pricing structure and the product specifications that work for the category. A well-positioned soda maker can sell reasonably well at a price point at or below one hundred dollars. Anything more than this and the value proposition of making your own CSD at-home begins to lose its efficacy at the onset of consumer adoption and thus your addressable market is curtailed greatly. Remember, you are not just competing with other soda makers; you are competing with ready-to drink beverage producers. GMCR can't expect to make a $200 soda maker after investing some $100-$150 million into the production of this system and expect to compete profitably with a can of Coca-Cola that is regularly on sale for roughly $.35 a can. As it pertains to the cost of investment, yes, that is about what it will take to successfully launch a product system; this cost assumption does not include the full benefit of a CO2 network. If you want a CO2 network which needs a refilling station, that's going to cost you extra of course. Does GMCR have that kind of money to throw around and start from the bottom? Yes it does, but not if it is going to crimp margins for the overall business and without a CO2 partner to provide sales of its machines. GMCR investors have to consider these implications and I would assert this is just one logical reason the GMCR patent has sat for this long.
GMCR can "go it alone" as they say, but the at-home CSD landscape is littered with failed competitors who tried to do so in the past. Let's put it into a greater perspective to see things more clearly: Whirlpool is going to generate some $16 billion in revenues this year alone and has manufacturing, distribution and points of retail all over the world and they chose to partner with SodaStream rather than spend the necessary monies to build out an expensive, competitive CO2 product and exchange pipeline. GMCR is going to generate roughly $4 billion in revenues this year; ¼ that of Whirlpool's revenues. What Whirlpool already recognizes is that just because they build it, that doesn't necessarily mean they will come. Remember, the retailers have a hard time operating a single CO2 exchange program, so even if Whirlpool manufactured its own CO2 that doesn't mean the retailers would adopt it and that leaves you with a soda maker that doesn't have a CO2 exchange network for the end consumer to utilize. Entering this product category alone assumes great risk to the capital investment for the soda makers, your risk then doubles if you choose to embark on an independent CO2 network. I don't think "going it alone" is in GMCR's best interest and the proof is in the pudding as they say.
I've heard a lot of talk surrounding GMCR's ability to leverage its partnership with Starbux (NASDAQ:SBUX) for CO2 distribution. Hate to burst bubbles again, but let's look at this logically. If you tell the consumer that if they buy this Karbon soda maker by GMCR they have to perform the CO2 exchange at SBUX, well I think this is going to be an epic failure. As evidenced in the 80s, the 90s, most recently with Primo Water and even with Soda Club in Europe during the 90s, the consumer needs convenience and isolating one point of CO2 exchange doesn't exactly accomplish this feat. A side-by-side comparison of CO2 exchanges would undoubtedly tell you that SodaStream's multiple points of CO2 exchange retailers are a much more attractive proposition for the consumer. This point of analysis is also evidenced in the sales of Cuisinart's soda maker system. The evidence really is indisputable. One could contend all they want but they would have little more to go on than hubris and/or false understanding of the at-home CSD business.
So let's really get down to GMCR's recognizable problem. SodaStream has built out a global network of CO2 exchanges which include roughly 13,000 participating retailers in North America, and that's just North America investors. They have several refilling stations around the world and are adding a second refilling station in the U.S. in the near future. SODA has built itself into a widely recognizable global brand and is known to be the leader in quality at-home CSD systems. SodaStream is selling in excess of 11,000 soda maker systems a day. So what does all this equate to in the end? Do you remember when GMCR lowered its prices on the Vue brewer as Starbucks and Nespresso came out with competing brewers last year? That's right, pricing power! SodaStream has all the pricing power in the product category. So if investors think for a second, that there are any drawbacks for SodaStream with GMCR contemplating entering the at-home CSD market, you might want to read this a second time and commit it to memory.
The facts are all here in black and white; these are not opinions as Capital Ladder Advisory Group has spoken with countless retail executives and even our executive friends at Primo Water Incorporated and Cuisnart, a division of Conair.
Let's do the math. It's been some 10 years and SodaStream hasn't found a viable, long-lasting competitor. Cuisinart is unduly suffering and has had to go back to the drawing board and spend even more money to compete with SodaStream and the numbers simply haven't changed for them as evidenced in the following link . Major tier-one appliance manufacturers from around the world have partnered with SODA for the CO2. SodaStream now boasts licensed partnerships with Kraft Foods (NASDAQ:KRFT), Campbell (NYSE:CPB), Ocean Spray and Eboost. SodaStream has locked up some 90% of the major retailers when it comes to the CO2 exchange process. SodaStream holds all the pricing power for the product category. Now I'm not saying GMCR can't "go it alone", but I will say, "It wouldn't be prudent and it is highly unlikely". You have to imagine yourself in the shoes of SODA and GMCR executives. I would imagine the conversation going something like the following:
GMCR Exec: "No, I think we can manage on our own. We plan to start with a $79.99 machine".
SODA Exec: "I completely understand and wish you the best of luck. You would be well- informed that in light of this development we will be reducing our price for soda machines to $69.99. Have a great day"!
SodaStream has the user base, they have the high profit margin consumables coming in every day; they can afford to competitively price their competition out of the market if need be. GMCR effectively used this strategy against the Starbucks Versimo and Nespresso's U and Pixie brewers. It's just business folks; it's just business and this is how the at-home CSD business works.
Disclosure: I am long SODA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.