How to Sell More Coffee

Question: What do iTunes, coffee and HP have to do with each other?

Answer: digital restrictions, digital rights management or DRM.

DRM is the attempt to control distribution of digital media - files, applications, music and movies. Apple's iTunes DRM was famously called FairPlay (which led many of its workarounds to be called, "PlayFair!"). While Apple removed it from music in early 2009, they continue to use it on movies. You paid for the movie from your laptop, and want to watch it on your iPad and Apple TV? Sure, no problem. As long as you don't then copy it to a flash drive and give it to 3 friends, each of whom watches it for free.

Similarly, HP, in an effort to control how you use their printers - they want you being only their (very profitable) refills - has been introducing digital technology that prevents their printers from working with any except HP-certified refills.

Two years ago, one of my professors at Duke published a paper showing that DRM actually increased piracy; my write-up is here. At heart, the issues are:

• Restriction: If it is hard for someone to use what they purchased legitimately, the person may just choose to download an easily played pirated copy.
• Availability: If an item is difficult to get legally in someone's area, they are more likely to pirate (see "movie availability windows").
• Bundling: If the item comes with other things the customer doesn't want, they are forced to pay more for what they do want, and are more likely to pirate.

Essentially, if you give people the freedom to buy just the product they want, in a convenient method, usable when and how they want, they will buy more, not less. While it seems rather obvious to you and me as consumers, it isn't always to sales and marketing executives pressured to make their numbers.

What does all that have to do with coffee?

One of the hottest segments of the coffee market nowadays is the single-serve maker, a.k.a. the Keurig (owned by Green Mountain Coffee) or Nespresso (owned by Nestle). Anyone who has been in an office (and many homes) in the last 5 years has seen one of these. Pop in a capsule of the type of coffee you want, push the button, get a single cup of fresh-brewed coffee. Sure, it costs a lot more than a pot for everyone, but it costs less than your local Starbucks. A quick check on Amazon will show that the average price for a K-Cup is between $0.50 and $1.00, depending on the bulk.

Despite the $100-175 average retail price of a Keurig machine, Keurig makes the overwhelming majority of its money off of selling the K-Cup refills (or licensing fees to others who do). For FY2013, Green Mountain made:

• $3.2BN of portion packs (a.k.a. K-Cups)
• $0.83BN of Keurig single brewing machines and accessories
• $0.34BN of packaged coffee and non-Keurig-related products

In short, Green Mountain invested in Keurig, bought the rest out for around $160MM, and now it is the lion's share of the company, over 90% of its revenues, and nearly 80% of those Keurig revenue is from the cups.

Unsurprisingly, Keurig is hungry (desperate?) to protect its refills from encroachment. And where there is this much money, and overall gross margins of 37.2%, alternative coffee "portion pack" providers will enter the market. These might be smaller companies, or known name-brands like Starbucks or Dunkin Donuts.

And this is where DRM comes in. Buried in that annual report (on page 4, under "Keurig 2.0") is the hint that Keurig plans to use technology to prevent competitive refills from being used. It is also referenced in a lawsuit, listed here.

The question is, will it work? In the short term, this will definitely hit alternative makers, as the large installed Keurig base has no choice but to buy Keurig-certified coffee.

In the long run, though, I suspect that it will hurt Keurig. Two spouses having a cup of coffee a day each is 700 cups a year. Even at $0.50/cup, that is $350/yr, or twice the cost of Keurig's highest-end machine. It may take 6 months or a year, but eventually families and businesses who either want the alternative coffees or alternate prices will spend the $100-175 to buy a machine that works with both K-cups and open providers.

In coffee, as in music, let people buy what they want, where they want, in the exact amount they want, and they will be happy to spend their money on you.