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.

Some welcome competition

There were exceptions. Some operators claimed they have been able to sell unauthorized cups to customers. They claim these cups save the customer money and deliver a better profit. Such operators said they owe no loyalty to GMCR since the company failed to maintain its loyalty to them by not sustaining profitable pricing.

John Conti, owner of john conti Coffee Co. in Louisville, Ky., thinks the expiring K Cup patents are driving the alternate K Cup products, which will force GMCR to lower K Cup pack prices. “GMCR had a lock on the market and were able to raise their price at will, before their patents expired. Other companies will produce K Cups at a much cheaper price. The same thing happened in Europe with Nespresso. Another company produced a like product and sold it for half the price on supermarket shelves. Our K Cup price is going to drop a bunch,” he said. Conti himself is testing his own home-made cups for Keurig brewers.

Mike Klassen, owner of Blue Tiger Coffee Service Inc. in Seattle, Wash., a third generation OCS operator, plans to offer alternative cartridges in addition to K Cup packs. He believes that if he does not offer the alternative cups, some of his competitors will offer them, placing him at a disadvantage.

Klassen doesn’t know what role the alternative cups will play long term, but he thinks other single-cup systems will deliver as good a cup of coffee as the K Cup pack. He is currently also offering “soft” pod single-cup systems in addition to K Cup packs.

Klassen said he wants to protect his profitability while remaining competitive and helping his customers stay within their own budgets.

Most operators, even in the Northeast, said the unauthorized cups are not yet a competitive factor. Most don’t expect they will be a factor, even if the lawsuits fail to stop the unauthorized products.

New cup players unproven

Chris Nachtrieb, owner of Chris Coffee Service Inc. in Albany, N.Y., doesn’t think existing Keurig distributors will want to jeopardize their relations with GMCR over unproven competitors. Nachtrieb, a Keurig distributor, believes GMCR already has a battle plan in place.

“They (GMCR) are ready,” Nachtrieb said. “Don’t think that Green Mountain is going to sit back and let the violators pick them to death. They have a plan.”

As for the unauthorized cups he’s seen to date, Nachtrieb said: “They’re no great shakes on price. Let them go ahead and spend all that money.”

Nachtrieb, for his part, doesn’t even object to the homeowner K Cup market. It has created a new source of customers for him. He claims he does about $6,000 a week delivering K Cup packs earmarked for home use to existing OCS customers. Nachtrieb doesn’t deny there is pricing pressure on K Cup packs from office supply companies selling the products as loss leaders. But for his OCS customers, the service he provides that other channels can’t deliver has value.

Many operators, meanwhile, are awaiting the outcome of GMCR’s lawsuits against Sturm Foods Inc. and Rogers Family Co. GMCR claims the two companies’ products infringe upon multiple patents. (See sidebar above.)

Two early design K Cup pack patents are scheduled to end this month, September, 2012. However, Suzanne DuLong, a GMCR spokesperson, told Automatic Merchandiser the patents cited in both of these suits are not scheduled to expire any time soon.

GMCR to police the market

DuLong said GMCR will police its intellectual property going forward. “We expect to continue to aggressively defend our intellectual property portfolio,” she said. “We fully anticipated as we neared patent expiration we would see competitors emerge.”

Coffee market analysts have noted that because the expiring patents do not apply to the newer K Cup packs, competitive producers aren’t likely to gain any advantage from the intellectual property protected by those patents. The expiring patents apply to products that are not currently being marketed in any significant way.

Asked why GMCR has not taken legal action against the supermarkets that have publicly announced private label cups designed to work with Keurig brewers, DuLong said GMCR has taken action against the manufacturers of the single-serve packs, not the resellers.

GMCR has not discontinued supplying those supermarket chains with GMCR K Cup packs.

DuLong said the company is taking a “tiered approach to brands and pricing” going forward to protect the profitability of OCS and other “wholesalers.”

She pointed to the new Keurig Vuebrewers which are designed to give customers control over the strength, size, and temperature of their beverages. An away-from-home Vuewill be available to Keurig authorized distributors in the fall of 2012.

The OCS Vuepack will work with the Vuehomeowner brewer, and vice versa, DuLong said. However, the OCS Vuepacks will incorporate RFID technology which will recommend brewer settings for specific beverages. This interactive-driven functionality will not be possible in homeowner brewers.

Starbucks Coffee Co. and GMCR announced the expansion of their relationship for the manufacturing, marketing, distribution and sale of Starbucks-branded Vue packs for use in the GMCR’s Keurig® Vue brewer.

Some OCS operators believe some new soft pod brewers will emerge as an effective alternative to Keurig and other cartridge-based single-cup systems. As noted in the State of the Coffee Service Industry Report, soft pod systems have had a difficult start due to mechanical issues, but some OCS operators believe the newer models are much better and some will give the cartridge systems new competition.

The introduction of unauthorized products for the Keurig brewer has created some concerns among OCS operators who want to maintain their K Cup pack market share.

But coffee suppliers seeking to infringe upon the established K Cup market face a difficult challenge, given the K Cup pack’s dominant market position.

At the same time, the single-serve market continues to evolve, with competing single-cup systems offering alternatives to Keurig. GMCR has recognized the changing market and has responded with new offerings of its own.