Luckin Coffee: looking forward

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But times change just as tastes change. As generation Z begins to impact China’s culture, and local brands begin to emerge as competition to global brands, the launch of Luckin Coffee in 2017 marked another major milestone in China’s coffee consumption.

Coffee still feels like an indulgence to many Chinese, but it’s an accessible luxury, and, increasingly, one that they have grown up around. Luckin is meeting this need with a lower price offering and a model based on scale and efficiency. If convenience is a cornerstone of most new coffee shops, then Luckin leads in convenience. So much so, that it now has 62m monthly transacting customers and more than double the stores that Starbucks has in China.

Its online-to-offline model is built upon its mobile app and store network. The mobile app and presence on other third-party platforms, cover the entire customer purchase process, offering customers a cashierless experience.

The operating efficiency differs from its traditional peers, allowing it to stay connected and engaged with customers anytime, anywhere.

Its store network comprises pick-up stores, relax stores, and delivery kitchens, enabling the company to maximize convenience for its customers, improve its brand recognition, and achieve broader delivery coverage.

It is a data business; an internet company that sells good coffee at reasonable prices with huge scale. This model has allowed it to grow rapidly despite a background of weak consumer confidence in China, by offering an efficient solution for busy office workers where coffee is growing into a daily routine, as well as being a very affordable option for customers in lower tier cities with new and growing demand for ‘trendy’ drinks.

The opportunity here is clearly that it is mispriced relative to its opportunity. The reason for the mispricing is obvious too.

Luckin was delisted in 2020 following a discovery that they’d fraudulently inflated revenue1. It filed for bankruptcy in 2021. Since then, a lot has changed. Most significantly, the founder is long gone as part of the restructuring. A Beijing-based private equity white knight stepped in to ensure the company remained solvent and operational when the liquidators were brought in. The company defaulted on its debt, was fined by a number of regulatory bodies, settled class action lawsuits and was forced to deal with challenges to the existing business model.

As a result, the stock currently trades over-the-counter in the US, albeit with ample liquidity to support its purchase. When looked at in the rearview mirror, it can make for uncomfortable viewing. But if everyone around us is looking in that same mirror, there is opportunity in adjusting our perspective. The release of accruals relating to the costs of dealing with the historic fraud in Q4 2023 should signal the end of these issues. We must listen and learn from past events but focus on what matters looking forward: a profitable and growing consumer brand with strong operating efficiencies, supply chains and scale in a fast-growing market.

We think it is already one of those rare and attractive businesses in China that has good unit economics despite the intensity of competition. As it expands, scale efficiencies and various forms of brand loyalty will represent an increasing moat to competition. A good example here is the tie up with China’s leading consumer brand, launching a ‘Moutai coffee’ in September 2023 and selling 45m cups by the year end!

While Luckin’s reputation in the investment community may have been tarnished, there appears to have been no damage to the brand among consumers. Management have been replaced and the company has emerged from this experience stronger. Without a relisting, with limited information and no sell-side coverage, we proceed with an additional element of caution. The company continues to meet all Securities and Exchange Commission (SEC) requirements and is considering a full listing in the US or Hong Kong in future. And the valuation multiple2 seemingly accounts for much of the risk and little of the opportunity.

Our recent trip to meet management in China helped build our confidence in the company’s strategy and alignment. As investment manager, Ben Durrant, noted after his trip, there’s not much of an overlap between budding Chinese coffee drinkers and Nasdaq investors. Despite store numbers up 7 times since initial public offering (IPO) in 2019, monthly transactions up 14 times and revenues up 54 times (and now profitable), Luckin’s share price has barely changed.

From today’s starting point, we believe revenues can grow 40 per cent a year as they continue to open stores, deepen customer traction and raise prices, with the exciting prospect of margin expansion3 leading to even faster earnings growth4. Our research note suggests that “the addressable market is potentially so large that eight-fold growth from here is plausible”.

So, while Luckin’s history may make for some uncomfortable discussions, its future brings with it a significant opportunity not only for operational growth, but for a possible rerating as more people begin to look forward and not back. At 10 times price-to-earnings5, despite all the tea in China, perhaps it’s time to wake up and smell the coffee.

1Revenue/s: the total amount of income by the sale of goods or services related to the company's operations.

2Vaulation multiple: to evaluate one financial metric as a ratio of another, in order to make different companies more comparable.

3Margin expansion: an increase in the rate of profit a company makes on a product.

4Earnings growth: the annual compound annual growth rate of earnings from investments.

5Price-to-earnings: a company's share price relative to its earnings per share.

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