Luckin Coffee Inc (NASDAQ: LK) Stock Analysis || 瑞辛咖啡股票分析

Target Price

  • 2019/11/12: $30
  • 2021/02/10: $20

Investment Evaluation

2019/11/12: Luckin (NASDAQ: LK) will usurp Starbucks to become the largest coffee retail chain in terms of cups of coffee sold in the coming years. Its unique business model will allow higher-than-average margin levels; its strong management team and strong financial position will revolutionize China’s retail industry. It is worth between $16 and $31 on a conservative basis.

 

Table of Content

Background and Thesis

Luckin Coffee is a fast-expanding coffee chain that has caught the public’s attention with its execution prowess and speed of IPO. Lead by Jenny Qian Zhiya, Luckin has reached enormous scale, populating 40+ cities in China within just 1 year of expansion. The rate of money burning is also quite a sight. The public seems to be unsure of the company’s prospects and view its “new retail” business model as a hoax that is without a moat and easily copiable. I view the end game of Luckin coffee is to be a ubiquitous coffee/food chain inspired by the concentration of 7-11 (OTCMKTS: SVNDY), and a streamlined retail location inspired the unique operations of Southwest Airlines (NYSE: LUV). I think Luckin is quickly becoming what Clayton M. Christensen would call a “discontinuous disruptor”. With its unique business model, strong management, and an underserved Chinese coffee market, Luckin Coffee is worth somewhere between $20 and $60 a share.

Business Model

Operations

Luckin Coffee currently operates around 4000 stores across 40+ cities in China, serving coffee and food to over 6 million customers on average per month. It operates as a version cashierless store, where customers order their desired beverages and food via Luckin’s app and pay through the app rather than with cash. Cash based transaction are prohibited in all Luckin stores. Over 90% of its stores are pick-up stores, meaning that there is minimal sitting space, leading to less rent and higher customer turnover. The stores are situated near office buildings, catering to middle-class workers. With a price point between 20 and 30 (10 to 20 with discounts), it sells at a premium to convenience store coffee, and at a discount to the well-perceived social economic status symbol that is Starbucks. It already operates more stores than Starbucks currently does in China and is plan on expanding to 10000 stores by 2021. Luckin uses the “fission strategy” that was first coined by WeChat. It refers to the rapid growth through online social interaction. Luckin first manipulates the press by comparing itself to Starbucks, which garners the attention of potential users. It then issues free coffee vouchers for first time users. After customers have tried its coffee, Luckin continues to issue coupons through referral, where the old customers can now earn a free cup of coffee if they refer a new customer to download the Luckin app. The new customer gets a free coffee like all new users and gets an additional free coffee from the referral process as well. Rinse and repeat. This strategy allowed Luckin to reach massive scale in terms of word-of-mouth marketing, at the expense of lower average sale price (ASP) of items. Luckin then retains these customers with new product offerings, discounts, and online/offline collaborations like WeChat + Luckin Coffee, Marathon + Luckin Coffee, Beijing Car Show + Luckin Coffee. As a result, while Luckin’s revenue grew tremendously, it reported a net loss of $241 million in 2018.

The current moat that Luckin has built, is the massive retail chain that it is operating in tier 1 and tier 2 cities. Technology has enabled Luckin to collect an abundance of data from these consumers, tapping into an unknown and under-served market even to Starbucks (the rapidly emerging first-time coffee triers due to discounts and promotions). For a new company to enter into the market and compete at the 10-30 price range, you now must fight against a giant with 4000 stores optimally situated in tier 1 and tier 2 cities with an established brand, strong management, and almost limitless capital (public market).

Competition

As with any underserved market with growth potential, everyone is trying to enter into the market to get a piece of the action. The following table documents a list of coffee related startups that received funding from 2014 to 2018. The most notable competitor that is already at its B round financing is Coffee Box (連咖啡). Coffee Box chose the online route as they have determined that physical retail is suicide going against Starbucks. They pioneered the “pocket coffee” idea, much like the Facebook restaurant game that many of the 90’s generation remember. You set up your own shop, publish it to your friend group, and start selling virtual coffee. Once your friends buy the virtual coffee (which they pay actual money, and is delivered to their desired location), you gather points that can be used for future coffee purchases. This business model is certainly interesting, allowing gaming to become a value proposition to “coffee shop owners” where they can earn actual money, and to coffee buyers since they enjoy the process of buying coffee through an online game. However, there are several major problems that has rendered Coffee Box in a precarious situation.

First, Coffee Box used to rely on delivering Starbucks and Costa Coffee to its consumers. However, it quickly realized that the dependence on a third-party coffee seller will ultimately erode its margins since they are the reliant on the third party’s product but not vice versa (Starbucks has its own delivery service and recently partnered with Alibaba to enhance its delivery service). Therefore, it opened its own brand of coffee. However, without the grand marketing scheme, premium Arabica beans, and sophisticated supply chain like Luckin possesses, Coffee Box was only able to crank out subpar coffee that is reminiscent of the KFC alternative. Second, games are simply fads that is “the thing” today and gone the next. Third, Coffee Box also spread itself too thin, trying to branch out into different products (tea, mojitos, and other drinks). As a result, it had to close 30%-40% of its physical retail locations. Coffee Box is now stuck in a pickle and must decide whether it wants to establish an offline presence to secure its delivery channel or rely on third party coffee sellers since the coffee market is rather crowded with 4000+ stores of Luckin populating tier 1 and tier 2 cities’ prime locations.

Luckin will obviously also face competition as it ventures into the tea and juice business (through joint ventures and franchising). However, they remain in control of technology and store layout of these joint venture and franchising stores, meaning that they are still obtaining the much-needed data on its customers and providing consistency through its “new retail” business model.

Supply Chain

Supply chain is a crucial component to a business’s operation. Luckin has listed its supply chain as its strength in many of its presentation, as well as in the risk section of the company’s report, sending mix messages to the investors. Luckin originally sources its coffee beans from only one producer from Taiwan. According to the F-1 filings, Luckin “source premium Arabica coffee beans from renowned plantations in Guatemala, Brazil, Ethiopia and Colombia. We mainly procure roasted coffee beans from an affiliate of Yeuan Yeou Enterprise Co., Ltd., a well-known roasting company in Taiwan”. They have also “commenced cooperation with UCC Ueshima Coffee Co., Ltd.” that is yet to start. Furthermore, to further diversify their risk on relying too much on a single provider, they reached an agreement with Louis Dreyfus Company Asia Pte. Ltd. “to incorporate a joint venture for constructing and operating a coffee roasting plant in China” (F-1). Whether these endeavors actually bear fruit remains unknown, but it is reassuring to know that the company is attempting to strengthen its supply chain. As indicated by its presentation, they have business relationships with 300+ partners globally with regard to non-coffee-bean related operations, providing it with enough diversification to suppress any major supplier power.

Branding/Marketing

Ultimately, you cannot compete in the market if you do not have an adequate product. Taste, aroma, temperature (especially with delivery), waiting time (both in-store and delivery), and environment are all considerations for a coffee’s quality. An interesting thing I have observed is that a lot of people criticize Luckin’s coffee when comparing it with Starbucks. They usually compare across several different drinks, like Americano, Mocha, and Latte. First, I almost never see anyone comparing LK’s coffee to 7-11, KFC, or MCD. That’s a huge win on the marketing front. It’s already imprinted in people’s mind that Luckin is a major competitor of Starbucks. Second, many of the early criticizations of Luckin in 2018 have now been replaced by compliments in 2019. Taste is a very subjective thing, and if Luckin is able to remain in the same conversation as Starbucks, its price point and convenience will allow it to stay in competition.

Marketing is arguably the most controversial category, as Luckin has spent over 70% of its revenue in the past two quarters (1Q19 and 2Q19) on SG&A. The good news is that advertising, free promotion, and delivery have all decreased substantially as a percent of revenue from 4Q18. Delivery will likely continue to decrease as it is a non-core aspect of the business. Free promotions as well as general advertising will continue to be a substantial percentage of Luckin’s revenue as it solidifies its brand image through endorsements and continue to gain market share through free promotions. The management has executed very well on this front despite the public’s despise of the rate of cash burn, and I believe Luckin will remain in relevance for decades to come.

Discontinuous Innovation

First popularized by Clayton M. Christensen, discontinuous/disruptive (used interchangeably in this article) innovation can be perfectly described with the following excerpt: “process whereby a smaller company with fewer resources is able to successfully challenge established incumbent businesses. Specifically, as incumbents focus on improving their products and services for their most demanding (and usually most profitable) customers, they exceed the needs of some segments and ignore the needs of others. Entrants that prove disruptive begin by successfully targeting those overlooked segments, gaining a foothold by delivering more-suitable functionality—frequently at a lower price. Incumbents, chasing higher profitability in more-demanding segments, tend not to respond vigorously. Entrants then move upmarket, delivering the performance that incumbents’ mainstream customers require, while preserving the advantages that drove their early success. When mainstream customers start adopting the entrants’ offerings in volume, disruption has occurred” (https://hbr.org/2015/12/what-is-disruptive-innovation). It is often different from simply being a technological breakthrough. Southwest Airline is a perfect example of discontinuous innovation. Some differences between Southwest and other major airlines are:

  1. Reducing the number of cabin crew’s members to only three.
  2. Using only one type of aircraft.
  3. No in-flight meals.
  4. Tickets can only be bought at its own website.
  5. Flying point-to-point and only 25 minutes turn-around after landing.
  6. Having only one seating class choice.
  7. Cheaper prices.
  8. Effective on-land service and generous cancellation policies.
  9. Two free checked bags.

Rule (1) to (4) allowed Southwest to effectively lower its operating costs through lower training costs of its crew (one type of aircraft), better aircraft prices (bulk purchases with Boeing), and cheaper preparation costs (no meals). Rule (5) and (6) allowed Southwest to maximize its utilization of its aircrafts. Rule (7) through (9) provides a customer friendly environment. It is the optimal mode of transportation if the customer’s desire is solely to get from point A to point B.

Similarly, Luckin Coffee is the optimal coffee vendor if your sole desire is to purchase a quality cup of joe prior to beginning work or during lunch hours. Some unique attributes of Luckin include:

  1. Minimalistic design.
  2. Limited seating space in its pick-up stores (which constitutes over 90% of total stores).
  3. Cashierless (fewer employees).
  4. App only order.
  5. Rapid reward system and promotion.
  6. Lower price point.

Points (1) through (3) allows Luckin to operate at a lower cost, provide higher efficiency, and improve customer turnover rate that troubles all traditional coffee chains. Point (4) allow Luckin to retain important data on its customers that it can use to further expand its business into tea and juices. Point (5) and (6) provide customers significant value by lowering their expenses on coffee consumptions. Luckin is disruptive in nature because it utilizes its technological capabilities to streamline the pickup process. It then complements that with small changes to its stores to eliminate frictions of transactions that are present in every other coffee store. The purpose of being a disruptive innovation, suggested by Clayton Christensen, is to first target an underserved/unserved market at a low operating cost to slowly build up its market share. This presents a dilemma to the incumbent company because they don’t want to appeal to these customers with a lower priced product as it will erode its margin. The incumbent company also doesn’t have the low operating costs of the disruptor and shouldn’t dilute their brand image to venture into the lower tiered markets, therefore the RIGHT DECISION for the incumbent company is to stay in place and continue serving their customers. As the disrupter slowly creeps up on the incumbent company, the margins of the incumbent company start eroding anyways and it is slowly driven out of business or maintain a subpar margin level compared to its operating history. The powerful thing about disruptive/discontinuous innovation is that not a single wrong decision is involved. It is a natural process of better business operation taking away market share and margins. Luckin is simply doing what other disruptors have done, just at an unprecedented scale and pace. From the terrible reviews from 2018, to “slightly better tasting than Starbucks” in multiple double-blinded tests, Luckin has moved up-market in less than 1 year. Starbucks has been forced to act, but I believe Starbucks is already too late, and Luckin has already garnered the footsteps necessary to successfully disrupt the coffee (perhaps food and beverage in the future) industry.

Analogies

Southwest Airlines: Luckin is often compared with Starbucks or referred to as “Starbucks of China”. However, I think Luckin to the coffee industry, is more like Southwest to the airline industry. Southwest is the only airline that made profits for 46 years consecutively. How is it able to achieve this feat of strength in a highly competitive and asset heavy airline industry? For those that have not flown Southwest, have not heard the story before, or simply missed the previous section where I described Southwest’s disruptive abilities, here are some highlights of how Southwest operates as an airline: first two checked bags are free, no seat selection (you are divided into groups before entering seats are obtained on a first-come-first-serve basis), no free food offerings (purchased options only), often humorous crew, no tiered classes (only economy available), no cancellation fees, and only sells tickets through its own website.

7-11: I believe Luckin is also taking a page out of 7-11’s playbook. By being data intensive, 7-11 can provide significant value to its customers. In combination with low cost, convenience, consistency, and its hall mark 7 am to 11 pm operating hours. With a carefully thought out franchising model, 7-11 expanded quickly and soon became ubiquitous. Luckin plans on expanding its juice and tea business through franchising while retaining the technology that allowed them to operate at lower costs and obtain valuable data from its customers.

Amazon: I think cashierless operation (Amazon Fresh), humanless warehouses (FBA model), and future humanless freight (Amazon Freight) best characterize Jeff Bezo’s ideal utopia. It is a place where humans enjoy, and robots labor. Let’s set aside whether that situation is ideal or not, and focus on what Amazon is trying to accomplish, which is to minimize labor and maximize utility. I believe Luckin is on the same track. I wouldn’t be surprised if Luckin invented a preorder-able coffee vending machine that takes over the world.

Valuation

Calculations

If people in tier 1 & 2 cities of China consume on average 3.8 freshly brewed cups of coffee per year, and the CAGR is between 18% to 28% (Frost and Sullivan estimates 26% growth), the total cups of coffee consumption per person per year is between 9.3 and 15.2 cups in 2024. With an estimated population of 210 million inhabiting tier 1 & 2 cities of China, the total coffee consumption per year in the addressable market is between 2.1 to 3.5 billion cups.

If Luckin obtains between 15% and 19% of total freshly brewed coffee market share it will be able to sell between 406 million to 602 million cups of coffee. I believe the market share percentage is achievable since Starbucks controlled 58% of total market share in 2017 (https://asia.nikkei.com/Business/Companies/Starbucks-plans-ambitious-growth-in-China-amid-US-trade-tensions), and now Luckin has the same number of stores as Starbucks in 2019. Furthermore, Luckin only sold 2% of total freshly brewed coffee in 2018, and now sells around 10% of total freshly brewed coffee in 2019.

Assuming an average sale price (ASP) of 15.5 RMB for all coffee beverage for Luckin (currently around 10.5 RMB in 2019, 15.5 ASP in 2024 represents a 1 RMB increase per year in ASP), we arrive at 7 billion RMB in freshly brewed coffee revenue. A survey has been conducted on 2019/05/19 with a sample of 102 Luckin coffee consumers, and 76.5% of the participants are willing to pay 16 RMB or more for a cup of Luckin coffee (https://www.todayusstock.com/news/2100.html).

Percentages of total revenue are used to estimate costs of operation as shown on the left column. Delivery cost is estimated to be 3% in the future, it fell from 30% to less than 10% from 1Q18 to 2Q19 as it was a non-core part of the business. Advertising and promotions are pegged at 20%, representing a significant portion of total operating cost as Luckin will continue its strategy in acquiring new customers and maintaining brand image. Depreciation represents the cash spend on maintenance capex for the stores and is set at 4% of revenue. Many of the sales and marketing ex delivery costs will disappear due to their one-off nature of a company’s IPO. With the revenue assumptions made above, Luckin will need a CAGR of 23% for its total revenue, CAGR of 0 for its store level revenue (stay flat at 1.2 million RMB per store), and a CAGR of -7.6% for its coffee sold per store due to cannibalization. Price to sales calculation yields little value but is a worthy benchmark. FCF yield calculation assumes a 20x multiple on profits to calculate the market cap, an 8% to 12% stock dilution per year to calculate the total share count in 2024, and a 15% discount rate for the 5-year period.

Costs of Expansion

With 6 billion RMB cash on hand, Luckin could open between 6000 and 7000 stores at the current loss rate if it decides to open 1000 stores per year. On the other hand, it could open more than 7000 stores at the current loss rate if it decides to open 3000 stores per year. I personally don’t think the market can support 10000 Luckin stores in 2021 (management’s target), and that cannibalization would slow down Luckin’s store openings.

Rationale

The reason I didn’t attempt to calculate cost per cup and obtain projected break-even level is because I think the costs will fluctuate greatly as LK reach a higher level of scale and the number of stores Luckin will open is still up for debate. Furthermore, there is too much of a variability in the amount of promotions that the management intends to give out. It is very likely that the management will attempt to operate the company at a marginal level of breakeven on the books to avoid taxes through high levels of depreciation and amortization on its equipment. I simply believe that Luckin coffee will be cash flow positive before 2024 through the continuous decrease in unit operating cost as total cups of coffee per store increases and through the slowly rising ASP as brand image solidifies. I also think that the company will have enough capital to achieve its desired level of expansion and can easily issue shares (dilute shareholders) to remain solvent and finance cash if need be. Growth beyond year 5 should decrease substantially as stores saturate, markets stabilize, and margins plateau. As suggested by author Robert A. Haugen in his book The New Finance: The Case Against Efficient Markets, abnormal growth rarely sustains past year 5, and the level of accelerated expansion is certainly not sustainable in terms of available cash on hand. I use a 5% operating cash flow yield to calculate Luckin’s market cap, and I assume that coffee consumption will continue to grow faster than 5% and that Luckin will be able to grow operating cash flow faster than 5% in the foreseeable future, providing investors with at least 10% returns.

Risks
  • Sustaining brand image.
  • Lack of emotional attachment for employees working there, feel like autonomous workers that is doing part of the robotic job that will soon be replaced if possible. However, if Amazon can do it with its warehouse, Luckin should be able to do it with its baristas.
  • Coffee bean supplier reliance: Potential failure in joint ventures to diversify its coffee bean supply would result in a waste of time and money.
  • Failing franchising model and joint ventures failures.
  • Inherent risk of buying an ADR.
  • Growth of coffee industry in China (Luckin projected 26% in its prospectus).
  • Store rental costs.
  • Revenue recognition in regard to corporate (B2B) sales. Luckin lists “wallet revenue” (where customers prepay for coffee) as deferred revenue but does not mention any revenue through B2B channel.

Management

Jenny Qian Zhiya: The current Founder and CEO of Luckin coffee. She was the COO of Car, Inc. and UCAR, both companies were founded by Lu Zhen Yao.

Yang Fei: The CMO of Car, Inc. and UCAR and now Luckin Coffee. Also the author of the book《流量池》, a famous literature detailing his marketing philosophies.

Lu Zhen Yao: CEO of Car, Inc. and UCAR. The largest shareholder of Luckin Coffee and board director.

While the public is thinking about “why keep expanding when you aren’t even profitable yet?”, the management team is thinking “why stop expanding when we can continue to capture market share?”. This is the same management team that first IPOed a car rental company that dominated China’s car rental market, then IPOed a share-ride business that defeated UBER in China and is a major competitor to Tencent’s Didi Taxi, and has now IPOed a coffee business that opened more stores than Starbucks in just 2 years. While management competency is hard to quantify in a short period of time, these three important leaders of the company demonstrated that their strategy works, which is to: raise capital, rapidly expand (opening stores or buying cars in this case), lower prices, gain market share, IPO (raise additional capital), gain more market share, and finally raise prices.

How I am being Conservative
  • I assume that “COGS” remain 35% of the total revenue. Realistically, it should be much lower once the ASP rises, since net revenue represents the total sales after discounts. As discounts wane, the margin will likely start to expand.
  • I assume “SG&A ex Delivery Cost” to represent 18% of the total revenue in the pessimistic case. After brand name is established, theoretically it would cost much less to maintain brand image. SBUX’s SG&A cost is approximately 7% of its revenue for the latest quarter. DNKN’s SG&A cost is approximately 16% of its revenue for the latest quarter. According to 2019 Q2 financial report, most of G&A are driven by “business expansion, costs related to the company’s Initial Public Offering (“IPO”), and share-based compensation to senior management”. I am assuming that the business will start to slow its physical expansion once it reaches a certain level of cannibalization. Free coffees are not likely to be a reoccurring theme either once Luckin penetrates the market. IPO costs are one-time costs.
  • I assume an ASP of 15.5 when calculating fresh-brewed coffee revenue for 2024, which translates to 1 RMB increase per year. An ASP of 15.5 and a store count of 7000 in 2024 will require each store to sell an average of 175 cups of coffee each day, down from 263 cups of coffee each day in 2Q19, allowing room for cannibalization.
  • I assume A&P (advertisings and promotions) to be 20% of total revenue. The latest quarter’s data shows that A&P make up 14% of the revenue. Maintaining a strong brand presence requires significant investments, and 25% is a very adequate percentage. Many tech companies spend an average of 20% or less on their marketing, including Google and Microsoft.
  • I assume a 20% contribution to total revenue from other products. I do not account for the potential upside (and downside) from expanding into tea as well as other products. I also do not account for any B2B revenue that Luckin is likely to make in the future (see section “Business Model” for more information).
  • I assume that Luckin will obtain 17% of the total fresh brewed coffee in China’s tier 1 and tier 2 cities by 2024. Currently, Luckin already penetrates around 8% of the market, selling close to 400 million cups of coffee out of the total 5 billion cups (estimate) sold in FY 2019. Using 17% allows for cannibalization concerns as Luckin expand at its current rate.
  • I assume 230,000 RMB as the operating costs per store (for detailed calculations and items included, see section “Valuation” for more information). As Luckin reach scale and its technology matures, payroll, delivery (not a core focus of Luckin), and store preopening costs should all decrease significantly. Depreciation expense will likely exceed actual cash capex in the early years due to an aggressive depreciation schedule.
  • I assume that the total addressable market for coffee is confined within the total population of 49 tier 1 and tier 2 cities in China. Luckin already operates in 40+ cities and will likely reach more than just 49 cities by 2024.
  • I assume a 20x multiple on its operating profits, which translates to 5% yield and 5% growth for the business in the foreseeable future. The runway for growth for the coffee market in China may be much longer and faster than what’s assumed in the valuation.
  • My calculation only accounts for the core freshly brewed coffee and light snacks, as more SKUs and business ideas are introduced under the same retailing model, I think Luckin will generate a higher incremental return on invested capital in future ventures like pre-made coffee, coffee vending machines, juice, and tea.

Why Does This Opportunity Exist and Why am I Right?

Fear: The current IPO environment is very shaky, as many unicorns, including Uber and Lyft has decreased in price significantly. The recent failure of WeWork has only exacerbated the situation. The companies that Lu Zheng Yao founded (where Jenny Qian Zhi Ya served as COO) including CAR Inc (HKG: 0699) and UCAR (NEEQ: 838006) has performed poorly in terms of stock price. People are afraid that this is much of the same “get-rich-quick” scheme for the founders. However, people seem to forget that stock price is not indicative of underlying performance. The truth is, the stocks were overvalued in the first place of IPO, and even though the business has become better, the stock price has fallen due to a multiple contraction rather than fundamental business deterioration. In fact, it’s a testament to the management’s ability to gather necessary capital or a reflection of the investment banks’ inability to correctly price the prospects of the firms.

I also think the time is ripe for Luckin to capture larger market share than it would have under the current political tension. With China up against the U.S. with all kinds of trade war tactics, Chinese may feel more patriotic towards “home” brands, rather than foreign options. With the largest footprint in China, Luckin benefits from this timely incident.

Misconception: Investors seems to think either Starbucks or Luckin needs to “win the game of coffee” to survive, when it’s simply not a binary situation and China’s coffee market will likely grow to a size that allow many players to survive. There also seems to be confusion over whether Luckin can be profitable in the future. This is a company selling coffee and food to consumers, not a space exploration company (literally rocket science). With much of the one-time expenses in G&A expenses going away along with the decrease in delivery and free promotions expenses, I believe it is rather easy for the management to achieve profitability if it so desires (at the expense of market penetration).

Retail investor advantage: Time arbitrage is a real advantage for retail investors especially in the current environment. Many fund managers may be discouraged from. Counterparty arbitrage should be available post IPO lock-up period (2019/11/13) as well, as certain investment banks would likely be forced to sell in order to lock in their gains. I would happily assume the other side of those transactions if the Q3 report (2019/11/13) doesn’t have any material negative news that would impact my valuation calculations.

There is a high level of fear of recession right now, and the IPO environment has been sub optimal to say the least. Many investors draw comparison between WeWork, Uber, Lyft, and Luckin, claiming that the “cash burn” is simply too much. Luckin is a completely different story than Uber, where Uber pioneered the car-sharing business model and opened itself up to many regulatory concerns. The car-sharing business model’s profitability is indeed questionable as driver and rider acquisition costs continue to rise. With strong competitions (other taxi-like services) and regulatory concerns, Uber and Lyft may need an eventual bailout from autonomous vehicles. Luckin, on the other hand, sells coffee, and we all know selling coffee can be a profitable business. I believe management is carefully examining the sweet spot for market penetration and profitability.

A considerable amount of thesis is based on the competency of the management team. So far, Jenny Qian Zhi Ya has accomplished what she promised, which is to open 4000+ stores in 2019. She also didn’t forecast expectations of profitability and says that Luckin Coffee will continue to execute this promotional strategy for 3-5 years.  I believe capital allocation is ultimately the deciding factor of a stock’s return to its shareholders, and the management team of Luckin, boasting a remarkable track record, will allocate capital well in terms of its expansion into coffee plant operations, juice joint venture, and tea franchising.

Conclusion

I believe Luckin Coffee’s (NASDAQ: LK) core business (freshly brewed coffee and light snacks) is worth between 16 and 31 USD per share using conservative measures. The lock-up period and 3Q19 earnings report are both coming up on 2019/11/13, which will significantly spike the short-term volatility of the stock. There may be forced selling from underwriters and other insiders (to book gains), which may represent opportunities for potential investors.

Update: Shenanigans post muddy waters
  • Topic 1: Fraud
    • According to the company’s analysis, revenues were overstated by USD 35 MM in 2Q19, USD 99 MM in 3Q19 and almost USD 166 MM in 4Q19, in present day U.S. dollars (after adjusting for 3Q19 revenue overstatement, with average ticket size of 9-10 RMB, per store item still amounted to 250-300)
    • Company expenses were overstated by more than USD 300 MM
  • Topic 2: Delisting
    • Forced to delist from NASDAQ 2020/06/29 (when I first started acquiring shares)
  • Topic 3: SEC Settlement
    • Reached agreement with SEC to pay USD 180 MM for settlement
  • Topic 4: Chapter 15 Bankruptcy
    • Declared chapter 15 bankruptcy on Feb 2021, remain in operation with most stores and continue to pay suppliers
    • The move will protect the company from lawsuits by U.S. creditors while it reorganizes in China (post delisting from NASDAQ, LK could’ve very well declared bankruptcy then, wipe out shareholders and enter restructuring, yet choosing to file chapter 15 so late while guaranteeing operations to continue feels like a power move)
  • Topic 5: Valuation Update
    • Unit economics remain the same, with smaller store format, faster turnover, fewer employees, LK still operates at higher dollar per square ft. and lower operating cost than most coffee chains
    • Going through many stories shared by customers/baristas/managers, LK is extremely anal on cost control and efficiency, which drives people mad (supply of sufficient baristas could be a challenge), however, they are also in the forefront of implementing AI to supplement everyday decisions for managers and baristas alike, making sure that a cup of coffee can be made on average within the 1-minute mark. Cleanliness and inventory protocols are stringent, and product launch rate is beyond fathomable. LK are ending unprofitable endeavor fast, just to test out new ones.
    • On a per-store basis, LK is being valued at 1/10 of SBUX stores, and half of Dunkin’s stores
    • Assuming 2024 results of 15% margin (slightly better than SBUX), 350 cups of coffee per store (400 would be the max output of 2 employees), 70 food items (similar to SBUX’s food sell-through ratio), 5,000 stores, 20x/25x multiple, and 10% discount rate would yield a TP of $15/$19, with many upside potential I would only consider selling after LK exceeds the $20 mark
    • Think about a scenario where the stock has a 50% chance of going to $0 and a 50% change of returning to the intrinsic value of $20 a share. The expected outcome taken into both probability is $10, yet it makes no sense to sell at $10 because that number is never achievable in a binary outcome. So, if you have bought the stock then you have already committed to the $20 story, and with the other side being $0, one should size accordingly

 

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