Description

Why am I pitching long on a company that most of you remember as a fraud? Because in my latest trip to China, I was shocked to discover that Luckin not only has survived the covid lockdown and legal challenges but also has grown to become the leading coffee brand in China. Tens of millions of Chinese consumers consider Luckin Coffee as a reputable brand with good products. This presents an under-the-radar opportunity to invest in a company with a checkered history but very promising prospects. Please skip this idea if you avoid stocks traded solely on OTC due to low liquidity.

The potential of China’s coffee market is massive

With SBUX opening stores at a rapid pace, one would think that China’s coffee market is quickly maturing. Yet the reality is the contrary: the coffee market in China remains vastly untapped. A Chinese person on average consumes about 12 cups per year(SBUX 2022 Investor Day est), a stark contrast to the 2 cups per day average consumption number in the U.S. Average coffee consumption goes up even higher to more than 3 per day in some European countries. Even compared to other places in Asia, China’s consumption number severely lags: Korea 367/yr, Japan 200/yr, Hong Kong 250/yr, and Taiwan 104. Evidently, there's about 10-20X growth potential to just reach the current Asian average, which is also growing faster than RoW.  There’s an astounding 60X expansion if Chinese drink as much coffee as Americans do. 

Furthermore, according to this research done by iResearch China(https://pdf.dfcfw.com/pdf/H3_AP202207221576448813_1.pdf?1658500284000.pdf),freshly brewed coffee made by companies such as Luckin and SBUX, only commands 35.5% of market share in China whereas in the U.S., freshly brewed coffee has 87.0% market share and in Japan 63%. Further penetration of freshly brewed coffee towards 70% would give another 2X multiplier effect on Luckin’s TAM. Another multiplier effect is the faster than industry average growth in the coffee takeout segment, Luckin coffee’s main distribution channel. Recent data (https://m.canyin88.com/zhuanlan/CBNDataxiaofeizhan/2023/0712/91638.html) reveals over 20% CAGR in the last 3 years for the 5 biggest cities with the growth in 2023 being the fastest for take-out coffee. The accelerating growth in 2023 suggests that the growth in take-out is a structural trend beyond temporary COVID-related boosts. Moreover, Luckin’s overseas ambition adds to its growth equation – the company just opened 7 stores in Singapore this year.

Product and User Experience

Luckin serves affordable,delicious, and innovative coffee with speed and convenience.. Luckin’s drinks, after ever-occurring discounts, cost about 10-15RMB a cup. Luckin’s price severely undercuts Starbucks’ average price of 35-40 RMB and even McDonald’s and KFC’s 15-18 RMB. Luckin’s coffee price is cheaper than most of its competitors’ and on par with tapioca tea. Luckin’s coffee is too light to any regular coffee drinker. Even their topline black coffee with their best coffee beans still comes off as too bland: they probably only use half a shot of beans for all their drinks. With only a hint of bitterness and a bit less sweeter than tapioca tea, Luckin coffee gets easily adopted by the young crowd who are Luckin’s core customers. Young Chinese, accustomed to very sweet and milky tapioca tea, love Luckin Coffee. Luckin’s coconut milk based coffee series is such a huge phenomenon that all other competitors had to come out with their own versions or risk losing market share. I tried the mint version during this hot summer in China and I have to say for the price of 14 RMB($2) it’s unbeatable. And they are NOT burning cash doing it this time– Luckin’s GAAP operating margin in Q2 23 just surpassed that of SBUX.

The stores I visited are in bustling locales like subway stations and shopping malls. However, they adopt a more subtle stance, often nestled in distant corners, yielding premium spots to brands like Starbucks that emphasize in-store experiences. Upon arrival at a Luckin store, an immediate realization dawns – the absence of a physical point-of-sale machine precludes traditional in-person ordering. Instead, the ritual unfolds digitally, exclusively through Luckin's app or the two superapps, Alipay and WeChat. Inside, the ambiance is modest and uninviting, featuring 2 small round coffee tables each with a duo of chairs, all within a snug space one-fifth the expanse of a typical Chinese Starbucks.Sitting on the not so comfortable chair waiting for your order to be made, you will witness a tireless crew making a long list of drinks. There are constantly 10-20 drinks ready for pick-up sitting on the counter to be picked up either by the customers or the delivery people. Your drink is usually done within 10 mins. You pick it up and get it on your way.  99% of Luckin Coffee 10K stores do not offer a third place to chill, to socialize, or work - they are more like ghost kitchens.

History and development post fraud allegations

Two of Luckin’s co-founders committed one of the biggest frauds in the history of Chinese ADRs, leading to their termination. The old management was purged and a new slate was brought in to run the coffee chain with the exception of the current CEO Dr Jinyi Guo, another co-founder of the company. I initially questioned the wisdom of selecting yet another co-founder for the top job as his resume leans heavily towards academia. The reason is because an outsider CEO is considered almost a taboo in the business culture of China - almost all privately owned companies in China are run by its founders.  However, Dr. Guo is more of a symbolic figurehead to hold the company together, given that he only holds 1.3% stake of the company. In fact, the entire management only holds 3.4% of the company. The real boss is a Chinese PE firm called Centurium Capital(https://www.centurium.com/). It invested in the company via convertible senior preferred shares in 2021 and bought out the disgraced founders’ entire stake in 2022. As a controlling shareholder, Centurium now controls about 33% of the total diluted shares and 55.7% of voting power. Fast forward to 2023, Luckin has resolved all security litigations and paid out the vast majority of the fines. Legal fees associated with litigations dropped to 0.6mil USD in the latest Q, signaling an end to Luckin’s darkest period of company history.

Although Luckin lost the trust of investors, its brand did not endure significant damage in the eyes of the consumer. The new management pruned its unprofitable locations and opened new profitable stores at a blistering pace. Net store count reached more than 10K at the end of Q2, doubling within a difficult 3-year span in China characterised by periodic extensive lockdowns. Its monthly transacting users soared to 43 mil in Q2 this year from 6.6mil in 2020. Revenue in 2022 tripled compared to 2020 and H1 2023 revenue grew more than 80% compared to H1 22.Same store sales growth for the last 6 quarters has been consistently at 20%+ with the exception of Q4 ‘22. When the whole nation was going through the longest and strictest lockdown in Q4 ‘22, Luckin still managed a nearly 10% growth. This is a growth machine. And this time, their approach is sound: store level operating margin reached almost 30% in Q2 and GAAP net-income margin is at 18.7%.

Competition

Starbucks is not a major competitor to Luckin. Luckin positions 48% of its stores in office buildings and 12% on campuses while Starbucks stores are mainly in high-traffic shopping areas. Luckin focuses on to-go coffee while Starbucks caters to customers drawn to its third-place experience. The real competition arises from other coffee chains focusing on take-out and tapioca tea.

Scale brings tremendous competitive advantage within the budget take-out coffee sector. Volume-based discounts on materials and equipment empowers Luckin to maintain a strong price competitiveness against rival brands. Arabica coffee beans are highly sought-after global commodities. To reduce coffee beans cost from import, China has grown its own Arabica coffee beans in Yunan province. Luckin, along with other big coffee players like Starbucks, is able to source directly from Yunam coffee farms at favorable rates. Luckin is also building its second state-of-the-art coffee roastery in order to fully roast all its beans in-house.This sets Luckin apart as one of the very few brands, aside from Starbucks, equipped with such a significant roasting facility. This vertical integration not only eliminates intermediary costs but also safeguards consistent flavor and quality across their coffee offerings. Lastly, Luckin’s massive delivery volume allows the company to get a much cheaper rate on delivery compared to its smaller competitors because small chains have no leverage against the delivery duopoly controlled by Meituan and Alibaba’s Eleme.Notably, Luckin coffee only charges a 3 RMB delivery fee per cup compares to Starbucks’ 6 RMB(almost a dollar).    

If scale is crucial for Luckin's success, surpassing its scale seems unlikely for any competitor. Let's examine the rapidly expanding competitor, Cotti Coffee. Created by the same disgraced co-founder from Luckin, at the end of July, Cotti had amassed 5,000 stores, many of them franchised. Cotti mimics Luckin's strategies, except their coffee is notably subpar. While Luckin retains a hint of coffee flavor, Cotti's brew tastes just like water diluted sweet milk. Cotti tried to undercut Luckin on price but Luckin matched Cotti so now coffee prices from these two brands are about the same. Yet while Luckin is running its stores very profitably in this price war, many Cotti franchisees’ are complaining that they are losing money selling Cotti. Cotti’s store closing rate is alarmingly high, already reaching the hundreds per month. So while a competitor can try to open stores as fast as they can, to run stores profitably against Luckin proves to be much harder. 

On the other hand, Luckin is adding stores in a very thoughtful way. For tier 1 and tier 2 cities where coffee is proven to be a great business, Luckin opens self-operated stores. For the rest of the country, an unproven yet high potential growth market, Luckin opts for a franchise model. It sells all the equipment,software, and materials needed to run the franchised store, train the store employees,and charges a fee based on gross revenue. Luckin is leveraging its brand to penetrate the lower tier city market in a very low risk and capital light manner. 

Luckin’s main competition is from tapioca tea. In 2020 it was estimated that the consumption of bubble tea was 5 times that of coffee in recent years according to WikiPedia. A bet on Luckin is also a bet on the continued high growth of coffee and defending or even taking share away from tapioca tea. Bubble tea is typically made from tea (often black tea), milk, syrup, and a special ingredient called tapioca pearls. Its consumption is very high among young people in their 10-30s but drops off precipitously among older people who feel the drink is too sweet and unhealthy. Coffee, on the other hand, is a drink that can be enjoyed by a much wider audience. Before Luckin introduced affordable coffee to China, coffee had a smaller customer base than tapioca tea due to its higher price point. Usually, tapioca tea costs 10-15 RMB in tier 1-2 cities and 5-7 in the rest of the country, which is only a fraction of the cost of Starbucks coffee. But Luckin made coffee very price competitive against tapioca tea. Based on a recent Bloomberg article on IPOs of Chinese tapioca tea brands, Luckin has grown to be the second biggest chain across coffee and tapioca tea brands within a very short amount of time based on store count.

Valuation

Lack of analyst coverage and limited queries during the call make estimating Luckin's EPS challenging. However, considering it earned 0.48/ADR during Q2 ‘23, I think a conservative projection points to at least $2/ADR for the next twelve months. This assumes growth, from 1K - 1.5K net new store opening per Q and 10% SSSG(Luckin’s average SSSG for the last 6 months is over 20%), will be partially offset by the current promotional environment and less profitable colder seasons. An optimistic scenario could put Luckin’s NTM EPS at $2.5/share. This assumes, based on a 5K store addition and 20% SSSG, EPS double to around $1 in Q2 24. The hot weather in Q3 23 will help Luckin sell its high-margin signature icy drinks, pushing EPS to be somewhere between 0.6-0.8/EPS. Then we have 2 colder seasons with lower volume, partially offset by growth in store count and SSSG. The company also has about $2.4/ADR net cash. Given the current stock price, we are looking at 15X TTM EPS. This is exceptionally cheap for a company with a rapid revenue and profit growth for the foreseeable future. 

It’s clear that Luckin’s majority holder,being a profit-driven PE fund, wants to cash out. I believe the best way for them to exit is to re-list Luckin on the HK stock exchange.I think it is only a matter of time for Luckin to pursue a HK listing. 

Catalyst

Rev and EPS Growth

Listing in HK