How Keurig Green Mountain Fall Through the ICE

Like razors that use disposable blades, Keurig coffeemakers from Green Mountain Coffee Roasters (“GMCR”) operate by consuming disposable, single-use pods of ground coffee. Once upon a time the company’s “K-Cups” were patent protected and like makers of razor blades GMCR earned high margins on each coffee pod they sold. To its credit, GMCR since 2006 has thrived by partnering, and then acquiring, the coffee businesses of Tully’s, Timothy’s, Diedrich and Van Houtte, and by licensing its pod technology to numerous partners, including Dunkin Donuts, Swiss Miss, Folgers, Millstone, and Starbucks.

In September 2012, however, two key K-Cup U.S. patents expired. More than 20 companies have since started marketing unlicensed portion packs at lower price points, threatening GMCR’s revenue growth in pod sales. The result? The share price of Keurig Green Mountain has fallen dramatically, dropping almost 30% today alone.

In announcing its new, next-gen Keurig system last year, the company made clear its intention to prevent consumers from using unauthorized, off-brand coffee pods with Keurig brewers. This strategy of “locking-out” unlicensed vendors—what engineering types would call “non-interoperability”—is a fundamental error committed by the company because it doesn’t understand—and, so, can’t take advantage of—the “ICE principle.”

This critical economic concept—“internalizing complementary efficiencies,” or, “ICE,”—holds that firms have a strong incentive to implement modularity voluntarily when modularity enhances consumer value. In other words, GMCR should have opened its installed base of coffee brewers (numbering into the millions) to any and all comers who think they can make a buck selling Keurig-compatible coffee pods.

The logic of the ICE principle is lucidly described by Joseph Farrell and Philip J. Weiser, writing in the Harvard Journal of Law & Technology (Volume 17, Number 1, Fall 2003) in an article called, “Modularity, Vertical Integration, and Open Access Policies: Towards a Convergence of Antitrust and Regulation in the Internet Age.” Farrell and Weiser explain that:

ICE maintains that the platform monopolist cannot increase its overall profit by monopolizing the applications market, because it could always have charged consumers a higher platform price in the first place; it has no incentive to take profits or inefficiently hamper or exclude rivals in the applications market because it can appropriate the benefits of cheap and attractive applications in its pricing of the platform. To the contrary, ICE claims that a platform monopolist has an incentive to innovate and push for improvements in its system —including better applications — in order to profit from a more valuable platform.

The bottom line is this: the more coffee companies offer their product in Keurig-compatible pods, the greater the penetration of the GMCR system and the more money the company makes in the long run as consumers begin to accept the brewers as useful, modular, high-quality appliances from which every coffee/tea-drinking home or office could benefit.

Instead, in a misguided attempt to capture illusory profits from supra-competitively priced branded coffee pods, GMCR has “broken the ICE,” and in the process alienated its customer base with unfriendly incompatibilities that limit the usefulness of their platform and spread FUD among potential purchasers considering a Keurig brewer.

GMCR might take a lesson from Microsoft—which seems of late to have learned the lessons of ICE (at least compared to the bad-old-monopoly days when it attempted futilely to control every important application that ran on their platform).

A fundamental change in GMCR’s strategy—particularly, respect for the ICE principle—might go a long way to rehabilitating GMCR’s stock price and instill some confidence in the company’s management to boot.

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