Single-cup profitability: Which way is it headed?

This year’s Automatic Merchandiser State of the Coffee Service Industry Report presents one of the strongest forecasts for the OCS industry ever, with one caveat. As noted on page 23, the average price for single-serve coffee posted a decline from the prior year, indicating profitability has fallen for the fastest growing OCS product.

The culprit, most veteran OCS operators will agree, is the Green Mountain Coffee Roasters Inc. (GMCR) K Cup pack, the undisputed market leader of the single-serve segment. If OCS operators cannot sell the market leading products profitably, what does that say about the future of OCS?

The K Cup pack has built the demand for single-cup by being one of the first reliable OCS cartridge-based systems introduced and the first to establish a dominant presence in the homeowner market. As explained in the State of the Industry Report, the K Cup pack’s presence in the homeowner market has helped drive the OCS market, but at the same time it has delivered a host of alternative sources for buying K Cup packs, thereby creating more price competition.

Alternative cups emerge

These market forces have taken several years to establish. This past year, some of these forces came to a head with the introduction of alternative cartridges that OCS operators can use in Keurig brewers. Some of these products were displayed at the last National Automatic Merchandising Association OneShow in Las Vegas.

Earlier this summer, two supermarket chains, Kroger and Safeway, announced plans to launch private label coffee packs compatible with Keurig machines. The news sent GMCR shares down as much as 10 percent to a two-and-a-half-year low, according to reports. Some investors and analysts indicated that private-label brands will be able to undercut GMCR on price and erode its dominant market share in the U.S. market.

Meanwhile, Keurig has sued two manufacturers of coffee packs advertised as compatible with Keurig brewers. The company has indicated more legal challenges could be coming. While the lawsuits as of this report remain unsettled, OCS operators wonder what impact unauthorized cups will have on single-cup coffee pricing and on their own profitability.

The profitability challenge to OCS operators varies by geographic region and by company size. Price competition is fiercest in the Northeast, where K Cup packs are most established. Larger OCS operators have more purchasing clout with suppliers to begin with and are therefore less alarmed by the pricing issue than smaller operators.

OCS operators cautious

Few OCS operators interviewed by Automatic Merchandiser said they plan to offer the unauthorized cups. Some acknowledged that doing so violates the terms of their Keurig sales agreement.

Several OCS operators, however, hope that the unauthorized cups bring some relief in K Cup pack prices. At the time of this writing, some operators said GMCR is becoming more flexible in its K Cup pricing.

Some operators also expressed hope that Keurig’s legal action against alternative cartridge producers will fail, thereby maintaining pricing pressure on GMCR.

Complicating the situation further in the minds of some OCS operators is the fact that two K Cup patents are scheduled to expire in September of 2012.

Mike Tompkins, who operates Coffee Products Associates, a Bloomingdale, Ill.-based beverage consultancy, said some OCS operators worry that while they don’t want to sell unauthorized products, they fear that OCS competitors will use these products to undersell them in the market. “Potential exists for a competitor to gain an advantage (using an unauthorized product),” Tompkins said. “You want to protect yourself.”

A random survey of OCS operators by Automatic Merchandiser found this sentiment not widespread. Only a few operators said they expect the unauthorized cups to play a significant role in the near future, due mainly to GMCR’s market dominance. Most operators were skeptical that the providers of these products would be able to match the K Cup product quality at a competitive price over the long term.