They Highly Caffeinated Luckin Coffee

Luckin Coffee (NASDAQ: LK) aims to be “the number 1 coffee company in China” and their staggering growth suggests they will get there. But will it be a pyrrhic victory?

Some Positive Points

Rapid Expansion: The pace of expansion at Luckin is hard to compare to what you might find outside of China. For instance in Boston it takes months to *renovate* a small retail location and re-open. Delays are common and measured in months. In China some locations have been reported to open up over the course of a weekend – you leave work on Friday and when you come back there is a Luckin Coffee open and operating in your lobby.

During the past year Luckin has managed to growth from almost nothing to over 2,000 stores. Now to be fair they have an easier time since these are really more like coffee kiosks in many cases. More on that below.

Delivery drives store expansion: In a simple but effective innovation Luckin starts with delivery in a new area. This requires some subsidies and promotions but after delivering they can easily see “hot spots” where there is strong demand for the product. That’s where the next store goes. We know that Starbucks uses lots of data to pick locations ranging from GIS, changes in road traffic, income growth by area and so on.

Initially delivery is the majority of the business in these new areas but then it drops off dramatically in favor of “pick up” as their store network begins to serve the local demand instead.

All digital sales model: Because Luckin relies on their mobile application for all ordering they have every bit of data. It’s why some refer to Luckin as a kind of “Uber for coffee” story. Customers also have more control over timing their pickup and knowing when their order is ready.

All this data plus direct customer relationships give Luckin insights and opportunities to leverage with additional offerings like other types of drinks, snacks, and meals. The company is rapidly expanding these offerings.

Structurally lower costs: The entire strategy of the company is built around offering a lower-cost cup of coffee in a market where people don’t drink a lot of coffee (yet) and are very price sensitive. Even Americans blanch at a $5 cup cost at Starbucks from time to time. By not spending on building out fancy shops and skipping cashiers Luckin can offer lower prices and more promotions to get people to try their coffee and get “hooked” on a new habit like many Western consumers.

Potential Grinds in the Brew:

Diminishing returns: The investment case is based on rapid growth followed by “returns to scale” as costs decline while the company continues to gain share in a growing market. So far they have demonstrated an ability to do this. The question though is how much more they can do to reduce costs further. For example per cup costs seem to be reaching a point where further reductions will be limited.Because this is a price-sensitive market it’s unlikely that the company will be able to effectively raise prices much if they can’t lower there per-cup costs much further.

To make matters on the cost front a bit worse the st0re-level profit margins are still solidly negative and after improving dramatically appear to have leveled off – at least in the most recent period. We’re not even going to go into the current overall company operating losses because unless the per-store profit margins improve dramatically there is no way to “make this up on volume” at scale.

The store-level profit curve is consistent with the per-cup costs. In order to improve store-level profits the company plans to offer a much broader array of products which will help increase same-store sales as customers rely on Luckin for snacks and meals throughout the day. Indeed the management vision is that Luckin will be a part of their clients today from the moment they get up and leave for work until they get home in the evening.
More menu, more problems: Management has made it clear they are aiming to provide a broad array of offerings beyond coffee. That may well help drive store-level profitability but how will that impact the “lowest cost” strategy? The complexity of configuring orders and managing inventory goes up dramatically as the menu of offerings expands. It’s already been reported by some that mistakes in orders are already showing up. These are small things like a missing condiment or straw for a cold drink but these problems get bigger with variety and scale, not smaller.

Parting Thoughts

Luckin is certainly a company to watch closely as a potentially dominant player in China which is a huge market. But it’s too soon to tell if this strategy is going to work out for investors.

It’s been noted that Blackrock just led the most recent $150M financing round at a $2.9B valuation and they are no dummies. But this is also chump change for Blackrock and the inside information they get about the Chinese market alone will generate strong returns for them whether Luckin works out or not.

The future of retail seems to rely to some degree on eliminating the need for expensive and often unreliable human beings. Why even have baristas? Can the whole thing be automated? Do consumers want what feels like a vending machine to be the source of their beverages and snacks? This is true to a large extent in some places like Japan and it makes sense that it may evolve that way in China too.

For these reasons some have said that Starbucks isn’t the real competition there but convenience stores like 7-Eleven.

As we wrap this note the trade tensions between China and the US remain elevated. Maybe the Chinese will embrace a “national champion” like Luckin for their coffee and snack purchases over western companies like Starbucks.

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