The Keurig 2.0 Comes With A Bevy Of Risks For Keurig Green Mountain

Aug.22.14 | About: Keurig Green (GMCR)

Summary

Keurig 2.0 carries with it several risks to the company.

Cost increase to consumer and gross margin impact malign the product launch.

Has the company learned anything significant from the Vue product cycle.

The Keurig 2.0 and its respective 2.0 K-cups represent the next forecasted stage of growth for Keurig Green Mountain (NASDAQ:GMCR) as outlined by company officers. While I believe the product is a great product and the company has already reaped rewards from the pending product launch, I do have concerns that surround this latest product line from the company and investors may need to consider them as well.

With the launch of the Keurig 2.0 just around the corner and pre-orders already taking place at Bed Bath & Beyond, (NASDAQ:BBBY) Target (NYSE:TGT) and Wal-Mart (NYSE:WMT), we think Keurig Green Mountain has successfully positioned itself to continue eliminating Keurig 1.0 brewers from its system-wide sales channels. Additionally, with the "threat" of the Keurig 2.0 coming to market the company has lured private label single-serve coffee pod manufactures into the Keurig family of licensed brands. These additional licensed brands are already benefiting the company's total market share position within the single-serve coffee category. On its most recent conference call with analysts, the company notated the following:

The second driver of accelerated revenue in Q4 is a more meaningful revenue contribution from a number of new Keurig system partner brands both, announced and unannounced. The brands we have announced include Target and its Archer Farms brand, BJ's Wholesale Club and its Wellsley Farms brand, Harris Teeter and its store brand as well as Nestlé coffee-mate K-Cup packs. We are now seeing unlicensed share flattened out and begin to decline as we have started shipping newly licensed packs including, Peet's and Archer Farms among others.

Presently, my biggest concerns regarding the Keurig 2.0 are the following:

  1. Impending margin impact
  2. The closed system format of the product line
  3. Cost increase per unit to consumer
  4. Total functionality of the Keurig 2.0.

Margin Impact

The first concern regarding margin may prove to be more impactful for the company next year and as it laps strong gross margin comparisons from fiscal 2014. In each quarter of 2014, Keurig Green Mountain has shown sequential slowing of gross margin improvement. I'm aware that this sounds contradictory, but to be clear, the trend is for less gross margin improvement, which may lead to gross margin contraction next year. Much of this possible outcome could come from both the Keurig 2.0 and deployment of the Keurig Cold system late in 2015. The following is from the company's latest conference call transcript:

We are already working to reduce the cost of our Keurig 2.0 brewers, but in the short-term we expect to experience some gross margin and inventory headwinds as a result of our added investment in the system. Specifically for the introduction, we've included a K-carafe and sample starter carafe packs in every brewer box.

Obviously, with all the inclusions/starter kit for the Keurig 2.0, the cost associated with the production of the unit is higher than the Keurig 1.0 units. This production cost for the Keurig 2.0 starter kit is mitigated by a $20-$30 price increase for the unit over its predecessors. Additionally, the margin impact could be measurably higher depending on the adoption rate for the Keurig 2.0 at said price increases to the consumer. Any meaningful increase in the A&P budget designated for the product launch could meaningfully affect the forecasted gross margins for the total system and quarterly results. For example: If the Keurig 2.0 gets off to a slower than expected start in the coming months, with respect to consumers failing to trade-up to the new brewer platform, Keurig Green Mountain may have to institute pricing promotions or issue credits to retailers down the road. It is something to consider and especially in a tempered consumer spending environment. While the argument could be made that current guidance is encompassing of this exampled consideration, I would argue it is not. The company has already taken steps to eliminate its older brewer platforms indicating it is betting the price increase per system and per K-cup will not impact sales and or net profitability. In my opinion, all-in bets rarely work out the way they are intended. There are usually fits and starts as well as reexaminations of objectives and means for which to achieve those objectives.

Williams Capital recently weighed in with their revised gross margin consideration for Keurig Green Mountain's FY14. The investment firm sees operating margin expansion of 216 bps in FY14, down from a prior estimate. Revenue growth is forecast at 7.0% vs. 7.5% prior. It seems as though Williams Capital is becoming more cautious with their estimates given the potential impact of the Keurig 2.0 on the total system. With all that said, Keurig will likely see strong sell-in for the Keurig 2.0 platforms, but the key item to watch is the sell-through or take-away by the consumer. Capital Ladder Advisory Group will keep investors informed on the sell-through rate throughout the back half of 2014.

Increased Cost To Consumer

The Keurig 2.0 is entering the market with trade-offs in functionality and later than other platforms with similar advances in functionality. Hamilton Beach already has a brewer platform called the FlexBrew that can deliver a single-cup or a full carafe at the touch of a button. The FlexBrew is at least $40 cheaper than the proposed pricing of the Keurig 2.0 which will range in price from $149.99-$199.99. Pricing for the Keurig 2.0 might be $10 cheaper per unit at Wal-Mart stores. Keurig Green Mountain will be implementing a price hike of roughly 17% from the Keurig 1.0 to the Keurig 2.0 brewer system. This brewer price increase will coincide with a price increase for its K-cups of up to 9 percent per the company's most recent press release. This price increase will be effective beginning November 3, 2014. It certainly seems a risky proposition that Keurig Green Mountain is embarking on with these price increases.

As a consumer and a Keurig brewer user, I might be able to stomach a K-cup price increase, but upgrading my brewer from the Keurig 1.0 to the Keurig 2.0 might be prolonged given the cost increase of the brewers. In a sense, you won't get me "coming and going", especially when I know I can get a brewer that is compatible with Keurig 2.0 K-cups for substantially less money.

Closed System Format

The closed system format of the Keurig 2.0 also needs to be considered. It's not often that limiting the consumer to a particular system or functionality ends well for a wholesaler/producer. Essentially, the Keurig 2.0 embodies a "read only" K-cup software system which does not permit the use of unlicensed Keurig K-cups. There are still a great many Keurig 1.0 brewer users who don't use licensed K-cups and these users may not be inclined to purchase the Keurig 2.0 should their existing brewers fail and because of this issue related to unlicensed brand compatibility with the Keurig 2.0. There has been some backlash in the single-serve community already over this issue. Most of the backlash is coming from TreeHouse Foods (NYSE:THS), which believes Keurig is attempting to create an illegal monopoly in the single-serve coffee market. TreeHouse Foods brought forth a lawsuit against Keurig Green Mountain earlier this year regarding the lockout technology being used by GMCR to create an anticompetitive marketplace. The fact of the matter is that the claim is justifiable and does seem to fit some criteria of monopolistic behaviors defined and governed by the FTC.

It is unlawful for a company to monopolize or attempt to monopolize trade, meaning a firm with market power cannot act to maintain or acquire a dominant position by excluding competitors or preventing new entry. It is important to note that it is not illegal for a company to have a monopoly, to charge "high prices," or to try to achieve a monopoly position by aggressive methods. A company violates the law only if it tries to maintain or acquire a monopoly through unreasonable methods.

Regardless of the validity of the suit and claim/s against Keurig Green Mountain, this will take several years to conclude and any potential ruling against the firm may amount to a slap on the wrist.

Total Functionality of Keurig 2.0

The next issue of concern I have with the Keurig 2.0 is that other than the ability to serve a full carafe with the brewer system, there is little added benefit that would warrant the increased price to the consumer. With that said, the biggest obstacle for the Keurig 2.0 leaves this Keurig user befuddled. Unlike its predecessors, the Keurig 2.0 will not accept fresh grounds for brewing in the system. There are obviously millions of people who have used the Keurig 1.0 systems not for K-cups, but with grounds they prefer with the application of a My K-cup or replica filter. No longer will these consumers be able to perform this function with the Keurig 2.0 brewer. The photograph below is an example of this issue in which the Keurig brewer is being used with coffee grounds.

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The Keurig 2.0 does not permit anything other than Keurig 2.0 K-cups to be used with the brewer. This leads me toward other concerns including the following:

  1. How does Keurig inform the consumer of this reduced functionality through its packaging?
  2. Will the consumer even read the package or just assume, if they go to purchase a Keurig 2.0, it will perform exactly as their old Keurig brewer performed?
  3. What will be the impact to the brand should consumers become confused or disgruntled due to this reduced functionality from the Keurig 2.0, and at a higher price?
  4. If the feedback from the launch is poor and somewhat related to issues of compatibility, does the company implement a second marketing campaign inclusive of commercial advertisements?

I simply believe this may not have been the best upgrade or "lock-out" employed by Keurig Green Mountain. I've witnessed the company fail to successfully innovate and deploy their innovations into the market in the past. The most recent failed innovation cycle came from the Vue brewer platform that, oddly enough, carried similar traits that we now find in the Keurig 2.0. The Vue failed for a variety of reasons, but mainly due to the substantial price increase above that of the Keurig 1.0 brewer systems still available to the consumer and shelved at retailers alongside the Vue. Additionally, your K-cup choices were limited in the Vue system as retailers found it difficult to maintain shelf space for a slow selling brewer platform and its complimentary V-cups. The V-cups were also considerably more expensive than traditional K-cups. Moreover, when we look back at the issues surrounding the Vue brewer platform, at least it did allow the consumer to use their own grounds and still the consumer didn't find it appealing enough to upgrade to the platform.

Unlike the Vue platform, there is a lot more riding on the Keurig 2.0 platform as Keurig Green Mountain has already spent millions on developing the platform and has initiated distribution of the Keurig 2.0 K-cups. Additionally, the company has convinced several private label coffee pod providers to join the Keurig family under the guise of a successful Keurig 2.0 position for years to come.

It won't take very long to conclude whether or not the Keurig 2.0 will be successful or not. The rate of sale for the Keurig 2.0 brewer, when adjusted to include available Keurig 1.0 brewers available, should be consistent with the Keurig 1.0 brewer sales from the past years and quarters. Any significant slow-down will be visible in the first few months of the Keurig 2.0 launch. As indicated in the photograph below, retailers are already trying to eliminate Keurig 1.0 brewer systems in preparation for the arrival of the Keurig 2.0 brewers.

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Higher prices to the consumer, trade-offs in functionality, closed system format and margin impact from this latest Keurig Green Mountain product line make this a very interesting time in the company's business cycle. Investors would be wise to consider all the aforementioned subject matter when developing their investment strategy in shares of GMCR.

Disclosure: The author is long BBBY.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.