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Luckin Coffee - The Starbucks of China?

Recently, Luckin Coffee (NASDAQ:LK) has caught investors' attention because the stock has risen big time, with some even calling it the Starbucks of China. Although I am not an expert on coffee, I've been asked by some friends to share some thoughts on the company from what I've observed in China.

Luckin Coffee (NASDAQ:LK) was founded in June 2017. It has since become the second largest coffee chain in China with more than 3000 stores. It's tempting to compare Luckin Coffee to Starbucks (NASDAQ:SBUX). However, Luckin and Starbucks have vastly different business models, and Luckin's future growth and profitability in China are perhaps less uncertain compared to Starbucks, in my opinion.


Luckin Coffee targets a different market

While Starbucks (NASDAQ:SBUX) has grown rapidly since it entered China's fast-growing coffee market, it has only served a small portion of China's coffee drinks due to two main reasons:

1. Starbucks, with an average cost of about 30 yuan ($4.30) per cup, targets the wealthier customers in China.

2. There are only 3000 Starbucks stores in China but almost 15,000 in the U.S. According to Luckin, Beijing has a population of 29 million but less than 300 Starbucks. New York City has a population of less than 9 million but more than 300 Starbucks.

Therefore, there's still a huge and under-served coffee market in China. Luckin Coffee, with an average cost of about 10-11 yuan per cup ($1.50), targets the masses rather than a smaller group of wealthier coffee lovers with more disposable income. It also offers more convenient locations than Starbucks in many cases due to its more flexible store formats.

Luckin's niche

China's coffee market can be broken down into a few distinct markets:

Based on price:

  • Low end
  • Mid-tier
  • High end



Based on delivery methods:

  • Pick up
  • Delivery
  • In-store



The low end market is still the largest market in China. According to Frees Fund, a famous Chinese Venture Capital Fund, instant coffee takes up 65-70% of China's coffee market. This market is dominated by Western brands such as Nestle and Maxwell.

In the mid-tier market, Luckin mainly competes convenient stores such as 7-Eleven or Family Mart. Family Mart has run a huge promotion in 2019 with its buy one get one free coupon. For a medium cup of Americano, with the promotion, it only costs 5 yuan ($0.70) at Family Mart. This is a very compelling value proposition for many consumers. However, one issue with the Family Mart model is the long wait time. Peak coffee hours often coincide with peak breakfast and lunch hours, and since consumers can't pre-order coffee using Family Mart's mobile app, they have to wait in store to place the order and wait in line. This is where Luckin has an edge against the convenience stores. You can place an order on Luckin's app and pick up the coffee in 3 minutes in a nearby store. This is very appealing to many coffee drinkers who don't want to wait.

In the high-end market, Starbucks (NASDAQ:SBUX) and other emerging coffee chains are the main players. Starbucks also offers flexible delivery methods - consumers can choose in-store pick up, delivery or dine-in.

Investors should question Luckin's growth and profitability

While Luckin has had explosive growth since its founding and it appears its profitability has improved, investors should still be skeptical about the sustainability of Luckin's business model.

  • Luckin's ASP per cup has increased to more than 11 yuan ($1.60). Given consumers' perception of the brand, it would be very hard to increase the ASP at the previous rate.
  • Many low-hanging fruits locations have been picked and rental and labor costs can only increase.
  • Competition has picked up in China. More capital is entering the coffee market.
  • Luckin's expansion into tea and other businesses is a sign of management's effort of diversifying from the coffee business.



Conclusion

Luckin Coffee has carved out a niche market in China's fast growing coffee market and has become the second largest coffee chain in China. Luckin's management team is obviously aware of the type of stories Western investors want to hear. However, Luckin's business model is still unproven as the business continues to burn cash. Investors should remain skeptical with the sustainability of the business model of the company.

Disclosure: No position in LK.

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This article first appeared on GuruFocus.