Luckin Coffee Stock: Bullish Prospects In China’s Coffee Surge (OTCMKTS:LKNCY)

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Luckin Coffee (OTCPK:LKNCY) remains underpriced and overlooked, even in light of its impressive financial performance in 2023. Coffee, the staple beverage for white-collared workers globally, is set for an exponential surge in demand as China continues its journey to become a developed nation. This growth, however, has been stunted primarily due to China’s historic preference for tea. Yet, with Luckin Coffee’s strategic emphasis on beveraged coffee and its efforts to cultivate brand loyalty among the middle-income demographic, the company stands at the cusp of breaking this mold, paving the way for a robust coffee culture in China.

Company Overview

Luckin Coffee is the largest coffee chain in China by outlets. It operates both self-run stores and partnership stores throughout China. Leveraging a technology-driven new retail model, the stores primarily serve as collection points for coffee deliveries made through their proprietary mobile application and third-party platforms like Meituan (OTCPK:MPNGF)(OTCPK:MPNGY) and Ele.me (ELEME).

Franchised Stores (new retail partnership)

Franchised stores account for approximately ~33% of the total number of stores Luckin operates in China. A recent publicity drive to attract franchisees highlighted a trend: Luckin is focusing on opening franchised stores in the tier 2 and tier 3 markets in China. This aggressive expansion aims to further establish its brand presence and reinforce its brand power.

Luckin’s franchise agreement with its partners is structured around a tiered profit-sharing model. Partners aren’t required to pay any initial fees. 100% of the gross profit from sales is returned to its franchisees on a tiered basis; e.g., if the gross profit exceeds 20,000 RMB a month, the returned percentage decreases incrementally. Beyond 80,000 RMB, the profit share caps at 80%.

The franchise model demonstrates Luckin’s commitment to longevity, contrasting with many other chains that prioritize quick revenue through charging initial franchise fees.

Industry Tailwind

Luckin Coffee competes in the fresh ground coffee market, alongside other players such as Starbucks (SBUX), Manner Coffee, and Costa Coffee. Unlike supermarket coffee, fresh ground coffee offers a fresher taste and the flexibility to innovate new flavors. China’s market penetration for fresh ground coffee remains low compared to developed countries. However, with a rising Compound Annual Growth Rate tied to China’s development trajectory, the coffee industry in China is projected to grow at an estimated CAGR of 27.2%.

Product Innovation In Beverage Coffee Attracts A Larger Audience

Coffee offers a unique value proposition: it boosts productivity through caffeine, which is both stimulating and addictive, ensuring repeat sales. Although China is historically a tea-consuming nation, its caffeine intake via coffee has been slow to rise. Many Chinese consumers find coffee’s bitterness a barrier. Luckin Coffee’s innovative beveraged coffee – blending coffee with flavors like coconut and fruit juice – can potentially diminish this resistance. An example of this is Luckin Coffee’s Coconut Latte, which sold more than 300 million cups in 2 years. By introducing a diverse product line with seasonally rotated offerings, Luckin can attract and retain more customers.

The above image is a summary of the product line-up of Luckin Coffee. Apart from the classic Latte, various beveraged coffee options are available, such as Grape Latte, Watermelon Latte, Coconut Latte, Orange Coldbrew etc.

The effect of the beveraged coffee strategy bears 2 benefits for Luckin. Firstly, consumers are introduced to coffee via their special lattes, which do not have as strong taste like Americano. Even non-coffee consumers can try these lattes and get hooked onto coffee products. These consumers then become repeat customers of Luckin. Secondly, beveraged coffee opens up a whole new market for Luckin. These special lattes now serve as alternatives to popular new tea beverages like HeyTea, etc. This means that Luckin Coffee can also be an impulsive purchase for consumers, thereby opening up its potential target audience market.

Strategic Store Locations Foster Long-Term Customer Loyalty

Luckin Coffee’s stores are placed in strategic locations to breed customer loyalty. In many universities in China, Luckin Coffee has a store within the campus. This helps them to secure brand loyalty from these university students who would later go on into the workforce. The second most popular location for Luckin Coffee stores is near office buildings to cater to working adults, who are the biggest consumer of coffee.

Luckin’s franchise strategy is also part of its long-term plan to establish Luckin as a long-term coffee brand. The sinking market of China is a key market that cannot be overlooked due to its large population. The success of Pinduoduo (PDD) has shown that consumer brands in China should also focus on the tier 2 and tier 3 cities, which are more sensitive to price changes. Luckin Coffee has an advantage compared to competitors like Starbucks due to its cheaper pricing, which is more acceptable for the sinking market. Thus, Luckin is poised to gain the first-mover advantage in the sinking market and establish itself as the prominent coffee brand in China.

Risk

The most obvious and biggest risk with regard to Luckin would be its fraud investigation.

In terms of accounting impact, it reached settlement with the SEC and the Chinese State Administration for Market Regulations and paid its fines already, so its accounting reports would not be affected. It is still pending outcome from the US DOJ as well as the Ministry of Finance of PRC, however, I think the impact of this would be minimal on its operations.

In terms of internal control, in Jan 2022, former management Lu Zhengyao and Qian Zhiya no longer have any interest in Luckin. Centurium Capital, who was the pre-IPO investor, is now the controlling shareholder of the company. The renewed directorship and management could mean a move away from its past. With this change, the new ownership also appointed new auditor BDO China to replace Centurion ZD. However, between 2020 – 2021 under the old ownership, there were frequent changes in auditors for Luckin, hinting at disagreements and a lack of confidence from the auditors in Luckin. Under the new management, if such a trend continues, it would be a clear red flag to stay away from Luckin stocks.

Valuation

DCF

Next, we derive an appropriate valuation of Luckin by using a Discounted Cash Flow Model approach.

We first calculate the Weight Average Cost of Capital for Luckin.

For its cost of debt, because it does not have any long term liabilities in its financials, we take the weight average interest rate of the outstanding liabilities (right of use lease), which is at 4.36%.

For the cost of equity, the risk-free rate taken is China’s 10-yr government bond, and we take the 2-year beta of Luckin against the S&P 500. This brings us to a total WACC of 7.16 %

For the assumptions, we assume that sales growth increases by 80% in 2023, with a decline of 10% in each subsequent year. This is consistent with Luckin’s Q1 and Q2 2023 revenue growth at 80+%.

Next, we assume a COGS of 40%, which is a conservative estimate, as Luckin is likely to attain larger economies of scale in the future with more stores.

SG&A expenses are estimated to be around 40%, which is again conservative given the potential economies of scale effect.

CapEx, related to Luckin’s store expansion plans, and Luckin’s Q1 and Q2 2023 earnings has shown that store expansion is double that of 2022. Given the assumed sales growth of 50%, the CapEx would increase to 9% per year.

Assuming a terminal growth rate of 2%, which is much lower than China’s current GDP growth estimate of 4.6%, we arrive at an implied equity value of 66 USD.

Multiples

For multiples evaluation, I chose EV/sales, EV/EBITDA and EV/EBIT as well as P/E ratio for comparison. Similar companies to Luckin Coffee would include Starbucks, Dutch Bros (BROS) as well as Restaurant Brands International (QSR), which operates Tim Hortons. Nayuki Holdings, a Fresh brewed tea company in China, as well as Helens International (OTCPK:HNIHY) which produce craft beer, milk beer beverages in China were also considered in the mix, due to Luckin Coffee’s beveraged coffee play. Luckin Coffee is trading at the lower end of the valuation multiples, especially when compared to the 2 other coffee companies in Dutch Bros and Starbucks, who are more mature Fresh ground coffee companies. This implies a good margin of safety for investment into Luckin Coffee now.

Conclusion

Luckin Coffee has emerged as the dominant coffee chain in China, with its innovative beveraged coffee play and potential to establish widespread brand loyalty. An anecdote that captures Luckin’s popularity: on a hot summer day at 11:30 AM, the Luckin store on the Tsinghua campus ran out of ice. Despite its controversial past, Luckin’s product strength and brand power remain intact, essential for thriving in China’s competitive consumer market. Thus, Luckin Coffee shows promise in charting a fresh course forward.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.