Math on Green Mountain’s Razor/Razor Blade Model: Dull Edges after Patent Expires

The old razor/razor blade business model has been kind to Green Mountain Coffee Roasters (GMCR). The sale of millions of its Keurig coffee machines in recent years, at no profit or even at a small loss, brings customers back for gazillions of the company’s K-cups, the little coffee portion one snaps into the brewer.

The set-up appeals to our gadget-obsessed culture and, at anywhere from 50 cents-to-80 cents per cup, one can always tell oneself, well, it’s cheaper than a $2 for a Tall at Starbucks.

By virtue of a patent, Green Mountain has enjoyed a monopoly on selling the K-cup coffee portions. It’s just coffee – and not always great coffee – in a little plastic cup. But Green Mountain has been able to raise prices – the commodity price of coffee has been increasing, so that was a factor, with the company passing through two price increases in 2011 – and expand margins.

Green Mountain Coffee Roasters Operating Margin TTM Chart

Green Mountain Coffee Roasters Operating Margin TTM Chart by YCharts

Coffee Arabica Price  Chart

Coffee Arabica Price Chart by YCharts

This era of monopoly pricing is about to end. The question is just how hard competition will hit Green Mountain’s revenues and margins. The patent expires this year and coffee drinkers can expect a flood of lower-priced K-cup knockoffs to hit the marketplace.

The unprofitable Keurig machines aside, this is just a coffee wholesaling and retailing operations. Green Mountain roasted and sold 136 million pounds of coffee last year. That includes coffee it sells by the pound and such, but the great majority of it was apparently K-cups. We’ll pretend the bulk coffee sales don’t exist. So with that caveat, in 2011, for example, Green Mountain made $12.52 in revenue per pound of coffee, based on the $1.70 billion in K-cups revenue over the volume of coffee it sold. That's up from $11.92 per pound in 2010 and $10.26 in 2009.

(Since much of that coffee is sold through retailers online and at stores, Keurig users pay quite a bit more than $12 a pound.)

Green Mountain enjoys a cost advantage – for now, at least – because it’s already scaled up its K-cup business. But stuffing coffee grounds into little cups isn’t brain surgery. And among the competitors is Starbucks (SBUX), which said it's getting into the hardware game with plans to sell its own single-serve coffee machines, called Verismo (Italian for knockoff, we think), later this year. Starbucks coffee also is sold by Green Mountain in K-cups.

It won’t be as bloody for Green Mountain as it was for Pfizer’s (PFE) Lipitor losing patent protection and going generic. But the business is fundamentally changed and not for the better, if you’re an investor (coffee drinking Keurig owners will enjoy lower prices).

Green Mountain Coffee Roasters PE Ratio Chart

Green Mountain Coffee Roasters PE Ratio Chart by YCharts

With Green Mountain’s PE at 26 times trailing earnings, you’d be buying into a company that gives away its gizmo – Apple (AAPL) gets Verizon (VZ), AT&T (T) and Spring (S) to give away the iPhone after paying top dollar for the thing – and is facing daunting competition in selling its K-cups. Goodbye, razor/razor blade, hello razor-thin margins.

Michael McHugh is an editor for the YCharts Pro Investor Service which includes professional stock charts, stock ratings, stock screener and portfolio strategies.

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