Restaurant Analysis Series Part 1: Luckin Coffee (LKNCY)

Once disgraced market darling turned survivor turned behemoth prime for rapid expansion

Introduction

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Welcome to the first part of my Chinese restaurant stock analysis series and I shall be commencing with perhaps the most controversial company out of all the ones that I shall be covering in this series- Luckin Coffee. Let’s first address why I’m covering the restaurant sector. I noticed that a lot of the largest compounders of the last fifty to sixty years in the U.S. have been restaurant stocks because I mean obviously food is a necessity to survive and is thus given preference as compared to all the other discretionary expenditure that one could engage in. Combine that with their mostly resilient nature relative to other discretionary stocks and you have a recipe for some long term consistent compounding. Restaurants have gone through their fair share of innovation because of humans’ desire for value and convenience which has institutionalized fast food. Let’s look at a few examples, shall we?. McDonald’s actually grew its revenues and profits during the Great Recession, which is probably one of the worst macro situations that the U.S. economy has ever gone through; Domino’s Pizza eclipsed even the U.S.’s most prized darling, Apple, in terms of total compounded returns from 2008 to 2020; then there’s obviously the meteoric rise of Chipotle Mexican Grill from being an E.Coli disgraced chain to now trading at 8 times sales and selling 40 dollar burritos. There are countless other such examples including one of Luckin Coffee’s main rivals.

The question you may be asking me now is- Mr. Dragon why are you looking at restaurant stocks in China? when all the success stories that you’ve mentioned are from the U.S. which has a more consumerist population, higher per capita income, and has higher brand loyalty as compared to the Chinese who are notoriously value obsessed. Well the answer to that question as with most other questions lies in one simple word: valuations. Starbucks, which has been having declining revenues and profits for two years now, recently fired their Indian McKinsey poached CEO after he gave one of the most embarrassing interviews in public CEO history with Jim Cramer and hired a new work from home CEO poached from Chipotle still trades at 28 times earnings. Meanwhile Luckin Coffee, its main Chinese rival that grew revenues by 41.4% trades at only 25 times earnings. Yum Brands, the global arm of Yum, which operates KFC, Pizza Hut, and Taco Bell stores in the U.S. and globally hasn’t grown profits at all in the last three years but still trades at 23 times earnings while Yum China, the Chinese arm of Yum, has been growing profits considerably after a strict COVID lockdown still trades at 19.81 times earnings. The difference is even more astounding when looking at the international arm of Chinese hotpot giant Haidilao; Haidilao’s international arm SuperHi International has the same revenue growth rate as its Chinese equivalent with it burning cash to expand internationally but trades at an egregious valuation multiple of 77 times while its Chinese arm only trades at a multiple of 17 times.

I think i’ve established the following points:-

• Chinese restaurant chains trade at a cheaper valuation multiple as compared to their U.S. and global equivalents relative to their business growth.

• Restaurant chains perform relatively well during tough macro.

• Chinese consumers who are becoming wealthier every year devote a large proportion of their income towards food as evidenced by this chart that someone kindly posted on X.

  

  These points serve as the foundation of my investment thesis on Chinese restaurant stocks. Now let’s finally get into the nitty gritties of Luckin Coffee shall we?

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China’s Coffee Market

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Let’s start by. looking into the history of coffee in China; coffee was brought to China by French missionaries in the 19th century to China’s Yunnan province. But Chinese coffee production remained quite low until the 1980s when the Chinese government partnered with the World Bank and IMF to boost coffee production in Yunnan province. However, tea remained the preferred beverage of choice until Western fast food brands initially KFC and McDonald’s began their foray into the Chinese market. Starbucks was the first major coffee chain to begin its foray into China, followed by Dunkin, Costa, and Tim Hortons. Starbucks has a whopping 7,000 stores in China but international players control only 20% of the coffee market in China with 80% of the market being held by domestic players, the largest of them being Luckin’ Coffee. In December 2023, World Coffee Portal released a report saying that the Chinese coffee market had become the largest coffee market and that 90% of the people they surveyed stated that they drink coffee daily, and 89% said that they visited a coffee shop once weekly with a fifth doing so daily. Meituan stated in 2022 that there were 8000 coffee shops in Shanghai along making it one of the most densely populated cities in terms of coffee shops.

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Founding of Luckin Coffee

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Until 2017, Starbucks held 60% of the Chinese coffee market but a new competitor would emerge soon. Luckin Coffee was founded in 2017 by Qian Zhiya in Beijing. Starbucks’ strategy when it was founded was built upon providing customers with a luxurious offering and gentrifying coffee into a premium beverage from a beverage usually consumed by the blue collar working class looking for their hit of caffeine to power them through the day. They echoed the same strategy in China opening large restaurants with lavish interiors in premium locations. Luckin’ inverted this exact strategy by instead operating a small store format about the same size as a mom and pop fruit juice outlet while prioritizing food delivery orders and targeting a more price sensitive demographic of university students, blue collar workers, and office goers on their lunch break looking for a quick and cheap hit of caffeine. Couple this with a digital only ordering model which alleviated long queues at peak hours, optimized for efficiency, and required less staff as a cashier was no longer needed meant that they could serve customers at faster speeds and cheaper prices-two things which Chinese consumers love. To build its brand, Luckin hired two world renowned award winning baristas to curate its menu and burnt a lot of cash in running advertisement programs and discount promotions. Its small store format highly efficient operating structure allowed it to rapidly expand reaching 4500 stores in 2019, eclipsing Starbucks as the largest coffee chain in China in its first year of operations.

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Accounting scandal

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In 2019, Luckin sold a whopping 90 million beverages and while they earnt $1.30 per cup, they lost $2.57 per cup. However there was an irregularity, while they were burning cash to expand and running steep discount programs they reported lower net losses in Q2 and Q3 2019 while claiming that their stores on average were more profitable than Starbucks stores despite having lower order values. Short seller firm Muddy Lake Waters and a Chinese investment fund released a short seller report claiming with proof that Luckin’s financial statement numbers were fabricated to the tune of $400 million. In 2020, Luckin came clean on the allegations pinning the blame of the fraud on COO Liu Jian. It was fined $120 million by the SEC, settled a lawsuit worth $180 million to set up a shareholder compensation fund, and also had its stock delisted from the NASDAQ. Disgraced Luckin executives left the board and started their second coffee venture, Cotti Coffee, which became Luckin’s main competitor that we shall discuss later. Most companies would’ve declared in Luckin’s situation but Luckin miraculously survived.

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Survival

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Luckin underwent a complete overhaul of its management and organizational structure. With most institutional investors selling out, the situation seemed very dire, they ended up being bailed out by Centurean Capital - a Chinese private equity firm that injected $240 million dollars of investment into Luckin. The new management team led by Gu Jinyin began its process of regaining credibility. An investigation team was formed to expel the individuals involved in the previous accounting fraud and the company fully complied with regulators to demonstrate accountability. Focus for the time being shifted to becoming profitable and sustaining operations. The company also begun a franchise model like fast food chains to expand more rapidly at a lower cost to the company.

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Resurgence

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Luckin has 21,000 + stores as of Q3 24 and has now legitimately overtaken Starbucks China in terms of both revenue and store count. Luckin has democratized coffee drinking in China from being a hobby of the rich in Tier 1 and Tier 2 cities to something that everyone can afford on a daily basis. Starbucks prices its lattes at about 33 RMB while Luckin prices its lattes at RMB 8-10 while the taste is 95% the same. Due to the Luckin revolution the average price of a latte in China has fallen 70%. A fellow publication and I’m proud to say subscriber-The Great Wall Street- recently posted about the immense opportunity that lies in the development of lower tier Chinese cities and rural areas and I think Luckin coffee with its small store format, low prices, digital format, and easy to expand franchise model will benefit massively from this.

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Competition

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Luckin was the pioneer who introduced the value-convenience model to Chinese coffee consumers but now has to face intense competition itself from a company started by its defrauding former executives- Cotti Coffee- which has rapidly expanded to 6500 stores in China, 10,000 globally and plans to open 40,000 more new stores in 2025. This is quite reminiscent of the strategy that the same management used when they managed Luckin. Needless to say, the strategy went completely haywire and I fear that the same will happen to their latest venture Cotti. Cotti attempts to undercut Luckin’s prices by about 1 RMB. It first cut prices to 9.9 RMB which Luckin agreed to price match for two years and then Cotti cut prices by a further 1 RMB. Cotti’s strategy is very risky and I believe that its impossible for them to be sustainably profitable using this model. This model has already failed once and will probably fail again as they can’t continue pressuring their suppliers and franchisees to suffer continuous losses. Even if Cotti expands rapidly to become larger than Luckin in China in terms of store count, I still think that Luckin has a better business model with a proven track record of profitability even in the tough macro situation and intense competition environment that they’ve been operating in. Cotti also risks going insolvent because I cannot foresee them raising large amounts of institutional capital due to their management’s past while Luckin with a completely new management team and backing from one of China’s largest private equity funds and raise further capital if it needs to. Starbucks, Manner, and M Stand are significantly more premium offerings than Luckin so I don't consider them to be direct competitors. Starbucks has been declining considerably with them being stubborn about their prices, having a worse offering than all their Chinese competitors, and Chinese consumers wanting to support local brands over American and other foreign ones. I would personally stay miles away from investing in their overvalued stock.

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What Chinese consumers want, how Luckin delivers, and why the model can scale

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Chinese consumers are famous all over the world for constantly demanding quality at the best possible price and they’ve spearheaded the migration towards value by all brands operating there. As Chinese brands expand globally whether they are technology brands, automobile brands, or now consumer brands they carry the same principle of providing value with them that led them to defeat Western competition in the Mainland. I had a conversation about Luckin with one of my subscribers, Apprentice Alpha, and according to him Singaporean consumers loved the value that Chinese consumer brands like Mixue and Luckin provide as compared to their Western equivalents.

Luckin is also known for constantly tailoring its menu to changing consumer trends and trying to innovate through brand collaborations. The Kweichow Moutai collaboration was such a commercial success that Luckin managed to sell 100 million cups of it in just the first day of its launch. This can be scaled up internationally to great effect as well, imagine a durian coffee in Malaysia where they are planning to expand to next. Similarly a Jack Daniel's coffee for example in the US where they are rumored to expand to priced at $4-5 would sell like hotcakes as well. If Luckin can scale internationally and maintain the same prices and margins as they do in mainland China then the sky’s truly the limit for them. Markets like India,Thailand, Indonesia, markets as notoriously value obsessed as China which have limited coffee chains but high demand, can be key markets for Luckin as well and they are rumored to expand there soon.

The world is undergoing a cost of living crisis like never before and if Luckin can continue democratizing coffee as they’ve done in China internationally then we might see their overseas business in the future grow to eclipse their China business in the next 10 years maybe. Luckin’s overseas expansion strategy is also very astute with them partnering with local players in a 50/50 joint venture to mitigate risk as evidenced by their partnership with Hextar Industries Berhad in Malaysia.

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Valuations and expected returns

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Coming to the most important part, valuations, that I consider to be my only parameter and hedge. I’ll value Luckin using a price to sales multiple because they might artificially keep their profits low in the medium term until it can properly expand in China and internationally and until competition pressures from Cotti Coffee subside. The Chinese coffee market is expected to grow by a CAGR of roughly 11% according to World Coffee portal and while Luckin is likely to grow revenues by around 35% in 2024 I’ll be more conservative in my estimates. I have come up with three scenarios:-

• Bear Case: Significant slowdown from current growth rate; sales growth rate assumed only at 15% for five years while the entire market itself is growing at 11% CAGR. Valued at 2x times sales, the future market cap comes to $14 billion giving us a CAGR return of 14%.

• Base Case: Moderation in growth rate again; sales growth rate assumed at 20% for the next 5 years and a price to sales multiple of 2 times gives us a future market cap of 19 billion dollars and expected CAGR return of 20.54%.

• Bull Case: Assuming international expansion goes really well; sales growth rate assumed at 25% for the next 5 years and a price to sales multiple of 2 times gives a future expected market cap of 21.28 billion and an expected CAGR return of 24%.

I’ve assumed a price to sales multiple of 2x because that’s what growing restaurant businesses have been historically valued at in the US.

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Conclusion

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Thank you for your overwhelmingly positive feedback on my first two posts and to everyone who’s subscribed. I didn’t expect to get so many subscribers in just my first 5 days or so. I believe Luckin Coffee presents an overwhelmingly positive risk to reward scenario if you want exposure to what I believe is a high quality F&B business which in the future can become almost McDonald’s esque in regards to its international as well as domestic expansion. Stay tuned for part two of the series releasing very shortly.

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