Monday, April 26, 2010

GMCR: Why I Worry Little About the Patent Expiration

Update 9/28/2010: I have been getting a lot of hits today from a number of prominent asset managers after the SEC announced inquiry into GMCR's dealings with a "fulfillment vendor", most likely M Block and Sons. There have been allegation about channel stuffing for a while, as I note in the last paragraph, because a number of the short theses that I had seen question the relationship. This article has very little to do with the allegations: I refer to them only in the last paragraph+comments.

Original article. 

There is a lot of noise about the expiration of the k-cup patent protection in 2012, and its impact on Green Mountain Coffee Roasters (GMCR). Of all the possible problems with GMCR, this one is not a priority, in my view. (I have no position in GMCR but this can change at any time.)

Let's talk about patents first. Patents provide protection for inventions and are good for a certain number of years. Patent protection is crucial to human progress as it provides incentives for people and companies to go out and develop new things, as the inventors can reap the benefits of their efforts. There are certain industries in which patent protection is of paramount importance: pharmaceuticals for example. A patent-protected drug is a gold mine, de facto a monopoly. This is why one of the crucial metrics in valuing the large pharma companies is how many drugs they have that are coming off protection in the next few years. Patents are also important with tech companies and some industrials for the same reasons.

Enter GMCR. GMCR's spectacular performance is due to the success of its Keurig brewer system. The company sells the machines at cost, and then sells really expensive "k-cups" (vacuum-packed roasted ground coffee) that work with the machines. The company describes the model as "razor-razor blade". I prefer calling it a Trojan horse (but this is good from a shareholder perspective). A bit of history, the company did not invent Keurig. They had a relationship with them that culminated in GMCR acquiring Keurig a few years ago. Keurig had licensed out the production of the k-cups to several roasters, including GMCR. GMCR has been working at bringing the k-cup production under its roof by acquiring the licensees, most notably the pending DDRX deal. It has been dragging but once done, GMCR will have only one licensee outstanding, a private company up in Montreal. 

So the fear is that once the k-cup production patent expires in 2012, everyone will start making k-cups, suppressing GMCR's margins. I think that the importance of this expiration is overstated, and drawing parallels between a patent expiration event in pharma to this is misplaced. Here's why.

Look at the consumable products that you use in your daily life (including coffee) and think whether patent protection plays a major role. Are there cheaper cognacs than Hennessey? Sure. Do you drink them? No. Are there cheaper cigarettes than Marlboros? Sure. Are there cheaper chocolates than Lindt? Are there cheaper sodas than Coke? You get the picture. Very simply, you do not make consumption choices guided by price alone. What is the common thread in these examples?

Bingo. It's brands. None of the brands mentioned above are patent-protected and, yet, somehow, they are doing more than OK. This- in my view- means that it will be difficult for a non-major coffee brand to compete with GMCR for shelf space in the stores and for mindshare with the consumers. People who would buy a Keurig machine are already (1) higher income (paid $100+ for a machine vs. $10 Mr Coffee drip brewer), and (2) bought the machine precisely because they like good coffee. So I think that this eliminates the non-brand competition.

Now let's look at the potential major brand competition. What are the major coffee brands? Store: Folgers (SJM), Maxwell House (KFT), Taster's Choice (Nestle); Retail: Dunkin, Starbucks, Seattle's Best (also SBUX), Caribou (CBOU); Office: Flavia (Mars). There are a lot more brands at the regional and local level, however, to be a threat by 2012, the brand should have national visibility and distribution at this stage.

You may not know it, but Kraft, Sara Lee, Mars and Nestle have their own machine systems in existence for years: Tassimo, Senseo, Flavia and Nespresso, respectively. So the competition has been around for a long time. Of the major brands that I list above, Folgers (and related, like Millstone) and Caribou are aligned with Keurig, Starbucks is aligned with Sara Lee, and, obviously, the Kraft (Maxwell, Gevalia) and Nestle brands are with their own. This leaves only Dunkin out to the best of my knowledge. So, even with an expired patent, I do not see a major threat to the k-cup system from the branded competition either. Sara Lee is trying to do something like that with the Nespresso capsules in France but there they have major brand presence compared to the US.

Finally, you have the game theory bit. Even if you have a well-capitalized, popular brand enter the space, this does not mean that they will compete on price. If you look at instant coffee, for example, the only major new entrant (SBUX) is more expensive than Nestle, even though the margins are good. Players understand that competing on price simply shrinks the profit pool for the manufacturers. Further, an entry into the space by a well-known brand might even be beneficial to the wider adoption of the machines, which does help GMCR (a network effect of sorts).

So the patent expiration is not high on my worry list. If I were a GMCR shareholder, I would be a lot more worried about (1) compression of the earnings multiple, (2) dilution, (3) input costs, (4) integration issues, (5) the DDRX tender offer, (6) alleged channel stuffing, (7) the ongoing drop in average kcup usage per machine, (8) office market penetration, (9) growth/maturity issues, and so on. ***PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US


Lumpy Investor said...

nice post. quick question - you mention that investors should be concerned by potential channel stuffing? Can you please elaborate on that point? Are you alluding to their near exclusive relationship with M. Block & Sons?


Barbarian Capital said...

Thanks for the note. I have read at a few places (notably, on SumZero) that GMCR is a bit aggressive with machine shipments, implying that the distribution agreement with Block helps them look better. I have no way of verifying it personally so I wrote "alleged". The concern comes, in my view, in the disparate growth rates of machine shipments vs. cup shipments. Machines had been growing faster than cups for a while, which might be a red flag. I personally explain it with pulling in marginal consumers rather than something nefarious.

seanchile said...

"People who would buy a Keurig machine are already (1) higher income (paid $100+ for a machine vs. $10 Mr Coffee drip brewer), and (2) bought the machine precisely because they like good coffee."

This is true of the current user-base of ~4.5m (I know that total sold historically is 5m+, but I'm assuming that about 15% have been taken out of service for various reasons - broken, forgotten about, gifted and not used, upgraded and thrown away, etc.).

However, there are only so many wealthy brand-conscious baby boomers who have a desire for a single-serve coffeemaker. I am not sure how far away GMCR is from reaching some kind of "saturation point" where most of the low-hanging fruit already has a machine. It may be closer than the high EBIT multiple implies though.

"Bingo. It's brands. None of the brands mentioned above are patent-protected and, yet, somehow, they are doing more than OK."

Yeah, but Coke, LVMH, Altria/Philip Morris Int'l, and Lindt & Sprungli OWN the rights to those respective brands. On the other hand, GMCR has Green Mountain (owned) in the East, Tully's (owned) in the West, Caribou (licensed) in the Midwest, and Newman's Own (licensed) all over the U.S. If you look in the K, Newman's Own, in addition to the Green Mountain Fair Trade sublabel, is 30% of volume.

At any rate, a substantial amount of GMCR's brand "power" actually belongs to another company. The terms of the Folgers deal with Smucker - where Folgers roasts the beans, sends them to GMCR which packs them into K-Cups and ships them back to Folgers to be distributed to retail stores - underlines this.

There's nothing terrible about this business model, but at some point (when the important patents have expired and licenses come up for renegotiation) it seems that Caribou, Smucker, and Newman's Own will be in a position to skim off more of GMCR's margin than they do now.

Also, if the patent issue were really "no big deal," why get in a bidding war with Peet's and buy DDRX at such a rich multiple? In the half to March 2010, DDRX EBIT was $3.65m. Being generous and doubling high season EBIT to get a yearly EBIT, we get $7.3m. GMCR paid $313m, or 43x EBIT.

Finally, Adam on Davian letter made a good point about Kraft, Sara Lee, etc. giving up on proprietary-brewer designs and simply making self-branded K-Cups once the patent expires. Surely a brand like Maxwell House would have the scale to merit investment in production lines and technology, given current gross margins on K-cups? It's definitely not a death knell for GMCR but a real possibility that could slow down GMCR's K-cup growth rate (though if it spurred brewer adoption, could be good in the long run as you mentioned).

Barbarian Capital said...

Valid points. The only comment on DDRX is that they gave away the store with the original contract, and paid up to get it back.

Otherwise, there is considerable uncertainty how other players will behave post expiration.

Barbarian Capital said...

Sean-- also posted some thoughts on davian.