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Luckin Coffee’s bid to dethrone Starbucks as China’s #1: Hype or hope?

How do you create a coffee startup company, design a menu and arrange the layout in a country like China, with a tea-based culture, when your opponent is another global industry leader which has been in the market for more than 20 years?

This is undoubtedly the most worrying issue for Luckin Coffee: the 18-month-old startup that recently listed on NASDAQ, raising $561 million in the process. Luckin joins the ranks of cash-burning companies like Uber and Lyft that have recently gone public.

The market valuation of Luckin Coffee shows a clear polarisation. Proponents believe that Luckin is the breaker of industry barriers, fostering a coffee culture through an expensive discount policy, even arguably benefiting the entire coffee retail market. On the flipside, there are a lot of arguments challenging the sustainability of the cash-burning strategy and the company’s ability to retain customers once the “discount well” runs dry.

Big in China

Luckin coffee opened its first store in October 2017. In less than two years, Luckin has managed to become the second largest coffee chain in China in terms of coffee sales and number of stores. The speed at which Luckin Coffee has expanded is nothing short of impressive. As of March, Luckin owned 2,370 stores. Starbucks, which has been in China for almost two decades, has only opened 3,600 stores. If Luckin continues to grow at its current rate, it will comfortably overtake Starbucks in this respect by the end of 2019.

Image source: statista

This rapid growth hasn’t come cheap though. Luckin’s growth has been fuelled by aggressive promotions and coupons. The company posted a $475 million loss against revenues of $125 million in 2018, its only full year of business so far. The first quarter of 2019 was no different. Luckin generated $71.3 million in revenue and its losses totalled nearly $79 million. For the user, the most intuitive experience is the very high frequency of the offer, whether it is a new customer’s first cup of coffee for free, or a daily issued coupon, which has attracted a large number of new clients.

Changing the way we drink coffee

If we look closely, the biggest difference we can find between the new retail coffee chain and the traditional coffee shops is how the new retail model challenges the basic norm – from “people looking for coffee” to “coffee looking for people”. That is to say, the new retail of coffee is no longer based on the storefront of the business and providing a venue for the customer. Instead, the idea is to take the client to the core, sending goods door-to-door, and building a consumption scene around the user.

Starbucks creates a more welcoming ambience for its customers to sit and enjoy their beverage. Luckin Coffee, on the other hand, has positioned itself as an “on-the-go” chain. It is worth noting that more than 90 percent of Luckin stores offer limited seating. The only way to order a Luckin coffee is via their mobile app and customers can only use digital payments as Luckin does not accept cash. Luckin coffee has not only taken advantage of the “new retail” model, but also figured out its advantage: from accurate offline and online advertising to using the Internet to enhance customer service.

The key to understanding Luckin is understanding that the company is not trying to beat the old players at their own game, but rather, is completely changing the game. China’s domestic coffee industry had been pretty mundane for several years and Starbucks faced relatively no competition from other brands. Luckin’s entry has undoubtedly shaken up the industry and its market leader. Facing intense competition, Starbucks partnered with Alibaba’s ele.me platform for online delivery of its beverages.

Growth over revenue

Although Luckin’s growth is largely fuelled by discounted offers and a “growth at all costs” attitude, its threats are quite real. From a numbers perspective, Luckin Coffee’s revenue in 2019 Q1 grew 35.8 times as compared to the same period a year earlier. Luckin had more than 16.8 million cumulative trading customers, with a 54% repurchase rate in 2018. So, while doubters may question this cash-burning strategy, it is important to see that it has had a significant impact.

The cash-burning strategy is often questioned by investors and rightly so. With startups so obsessed with growth, profitability often takes a backseat. Looming uncertainty causes investors to associate one company with the next similar company. Recent IPO failures of some of the most valuable startups in the world, Uber and Lyft, have given investors a lot to think about. In China, Luckin has been associated often with bike-sharing businesses from a scale and frequency of financing perspective and sceptics believe Luckin may face the same end.

However, it is important to note that the intricacies of the two models are quite different. According to media reports, the single schedule fee for shared bicycles was around 3 yuan, far exceeding the income of 0.5 yuan. This means that every time a shared bicycle was used, the company lost 2.5 yuan. The larger the scale, and the more users, the greater the loss.

Luckin Coffee, however, can benefit from economies of scale.

The numbers show potential

According to industry data, the direct cost of raw materials and packaging for each cup of coffee is about 5 yuan. Even in 2018, when Luckin Coffee expanded its efforts to subsidise users, the prospectus showed that its average price for a single cup in 2018 was 8.74 yuan, a direct gross profit margin of about 4 yuan for each cup sold.

Considering that the coffee consumption unit price ceiling in the Chinese market is based on the average price of Starbucks 30 yuan/cup as the anchor price, quality is comparable to Starbucks and the distribution is more convenient; even at an average price of 24 yuan/cup, the price advantage will still be very obvious.

Proponents of Luckin Coffee are banking on the fact that China’s growing demand for coffee will further drive Luckin Coffee’s value. Having recently been listed, Luckin faces new challenges in the form of investor scrutiny. The company must really present a strong narrative on how it plans to turn a profit and dethrone Starbucks as the number one coffee chain in China.

* AFSL 491139. FCA 583263. CySEC 109/10.

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