SmileDirectClub (NASDAQ: SDC) Stock Analysis

Democratizing orthodontics through first principles and offering better customer experiences.

5yr Target Price

  • 2022/07/14: $15 (closing price $1.01)
  • 2022/08/10: $15 (closing price $1.14)

Investment Case

SmileDirectClub (SDC) has serious bankruptcy risks in my opinion, if the macro environment continues to deteriorate. Major risks include: 1) running out of cash reserves (400 million cash while burning 100-200 million a year, with almost 1 billion in debt), 2) CEO moving on to other businesses (a serial entrepreneur currently running multiple companies), 3) significant defaults on its financing option SmilePay (no credit checks while making up 60% of their revenue, delinquency rate at 10% currently), and 4) ongoing and future lawsuits leading to bankruptcy.

Outside the major risks addressed, SDC is the best positioned players to turn the orthodontics industry on its head, much like what Uber did to the taxi industry or what Hims & Hers did to the sensitive care industry. In my opinion, they have superior price, customer experience, technology, and TAM compared to every other clear aligner company, including Invisalign. They are doing everything they can to maneuver within the macroeconomic backdrop, including introducing SDC Plus (early 2023), expanding the dental network, shutting down unprofitable international operations, and streamlining marketing channels. They still have a corner to turn, but if they do turn the corner, SDC has a chance to become a 20%+ FCF margin business growing topline 30%+ a year for decades to come and is currently trading at <1x LTM sales.

Thinking in first principles, face-to-face orthodontist care is simply no longer needed for cases of slight malocclusion, a potentially larger market than the 15 million annual case starts today. Through complementary tech (3D printing and software) advancements, virtual dentists/orthodontists can now handle larger volume of cases at a cheaper price with a shorter treatment time. This frees clinics to treat more serious oral problems, ultimately leading to positive spillover effects for consumers and dental practices alike.

*”Thinking in first principles” inspired by Ashlee Vance’s book on Elon Musk, “complementary tech” inspired by Peter Thiel’s book Zero to One, and “positive spillover effect” inspired by John List’s book Voltage.

Table of Content

Business Overview

SDC is the first DTC (direct-to-consumer) clear aligners company and plans to expand its product lines into general oral care. It was able to adopt a new business model as Invisalign’s patent expired in 2017. SDC operates through 3 channels: 1) dental office (scan is done by dentists with SDC paying a fee, while the rest of the aligner), 2) SmileShops (a location either standalone or placed within other businesses like a CVS, hair saloon, or dental office, with SDC staffing), and 3) impression kits (sent directly to your home). They charge around 2000 USD, and you must pay for retainers afterward the 4-6 months treatment, costing 100 each (every 6 months). This is compared to Invisalign’s and traditional braces’ 5000-8000 USD cost, which must be done through a licensed orthodontist, and generally take twice as long or longer.

The most significant SDC’s advantages include: 1) owning the entire consumer experience from scan to treatment to retainers, 2) vertically integrated for the best unit economics and fastest improvement on product offerings compared to competitors (introduced nighttime aligners and soon to release high-end SDC Plus offerings in 2023), and 3) market share (owning 80%+ of the DTC aligner space which represents only 3% of the entire aligners market).

I would argue DTC aligners are in general better experience. SDC has successfully disassociated with the traditional pain, money, and tears that orthodontics usually come with. It’s a smile brand. Although they have garnered negative reviews just like any other DTC brand, the product has successfully helped 1.5 million+ members achieve the smile they previously couldn’t afford. Numbers don’t lie. Incremental improvements in customer care and new strategies targeting different channels will likely continue to improve the brand perception. Will need to continue to monitor website visits, conversion rates, and public reviews (Facebook, Reddit, and YouTube).

Ultimately, the turning of the corner could be the mutual beneficial friendship that SDC has started with general practitioners, driving more business to these dental clinics while having professionals educate SDC customers, there are now around 600 locations, with 1200 in the pipeline, and more to come. It could also be the higher-end product releasing in early 2023 that targets the higher-income household. It could be their continued focus on the teen market (representing 70% of the market, but only 10% of SDC’s business). Or it could just be time, with conversion sometimes taking up to 2 years, clear aligner decisions are not impulse buys, and product as well as brand marketing efforts may need more time to show.

Mind Map Summary

Unit Economics (Past, Present, and Future)

Invisalign is a good proxy of what margins will be like. The P&L is rather similar, given Invisalign essentially sells to orthodontists at the same 2000 USD price. However, it is likely that Invisalign has an overall leaner structure with less customer acquisition cost (a well-established brand marketing to orthodontist channels) and less maintenance (does not own the entire customer experience). With 25-30% EBITDA margins consistently for Invisalign (aligner business ex-scanners), it is likely that SDC will achieve somewhere around the 20% margins once it reaches a stabilized growth phase. The company is currently losing money, at a rate of 40-50 million operating loss and 10-15 million capex per quarter. This amounts to 200-250 million loss in 2022 alone, and with 400 million on the balance sheet it will be quite dangerous if the losses are not contained and turned around through scaling in 2023.

Management

Management still holds over 60% of total shares outstanding (class B shares), they have a lot of skin in the game. The tone as of 1Q22 earnings call still suggests a strong commitment to the mission despite past headwinds, CEO David Katzman still knows every single detail of the business, no signs of passing on the throne.

Numbers

Key metrics

  • Market size: Aligner case start per year is 15 million, about 500 million people with some form of malocclusion that SDC can address
  • SDC market share: 3% of total market today
  • Google trend: trending down, inconsistent with “clear aligners” search, Invisalign dominant here
  • Website tracker: Organic search still down significantly from previous highs according to Semrush
  • FDC official complaint: comparable to Invisalign on a complaint-to-total cases percentage basis

Valuation

  • Bull case
    • Cashflow positive by 2024
    • 1.1 billion USD revenue by 2026
    • 20% FCF margins by 2026
    • 30% clear aligners market share by 2026 (10% of global aligner case starts)
    • 25x FCF multiple
    • Moderate dilution
    • TP = 24
  • Base case
    • 13% clear aligners market share in 2026 (same as 2022)
    • 20x FCF multiple
    • Moderate dilution
    • TP = 10

Others

Legal matters could be problematic in the future. It has already cost SDC to limit their future SmileShop openings in Georgia and Alabama when these states passed laws to require orthodontist to be present in SmileShops. However, in the grand scheme of DTC clear aligners, SDC has prevailed in almost every circumstance. It is now a legal powerhouse that has successfully befriended the American Academy of Clear Aligners (AACA), increased its 3rd party dental professional rating for several quarters consecutively, and double-downed on symbiosis with dental partners. The results continue to speak for itself, and it’s hard to see a reversal in regulation on a proven and widely accepted product.

2Q22 update (2022/08/10)

  • David Katzman sounded motivated as ever, emphasizing “innovation led” vs. “marketing led”.
  • Moving up the buyer funnel by 1-3 weeks with in-app purchase after showing customers the 3D scans and adjustments through SmileMaker platform. Could improve conversion rate (still have to do impressions or scans). The ultimate goal of allowing direct 3D printing with only smartphone software seems impossible in the near-term. However, allowing iPhone equipped with 3D scanning to provide such capabilities may not be 1-2 years away (Matterport-like approach).
  • SDC Plus will launch in 4Q22, the price point of USD 3900 could boost profitability. CFO claims 30% of that goes to SDC while the rest goes to GP, which should boost GP’s willingness to adopt such programs, as it comes together with the normal 2K USD version. Should accelerate GP adoption of SDC, currently at 690 partner locations.
  • Cash flow control was well executed, expect to end the year with midpoint 140 million USD in cash, with more available from the HPS credit line.
  • Revenue guidance decreases mostly due to inflationary pressure on the core demographic, which could improve as the core demographic expands to higher income customers.
  • No significant changes to model & TP.
  • New Bull TP = 20
  • New Bear TP = 9

Book: “The Deficit Myth” – Stephanie Kelton (Read)

Improve the world economy, all the while ditching arbitrary constraints.

Rating: 4 out of 5.

Stephanie Kelton aims to demystify the government budget deficit propaganda that is reigning fear all over the world and redirect the readers’ attention to more important metrics such as inflation and unemployment rate. Through Modern Monetary Theory (MMT), the author also proposes an interesting solution to navigate the inevitable ups-and-downs of business cycles – guaranteed employment programs by the government.

Takeaways

Don’t Think of a Household

  • Currency “issuers” are fundamentally differently from a currency “user”. The issuer, with infinite printing capabilities (it does not have to tax or borrow before it spends), is limited only by fundamental metrics of a country such as employment rate and inflation.
  • The purpose of the tax is not to raise money, but to control inflation, discourage undesirable behaviors, and incentivize people to work hard and earn the currency with which they pay taxes in. A virtuous cycle of productivity. The US government does not “make” any money when it taxes its citizens, it only subtracted money out of the system.
  • The is more income and wealth inequality today in the US than any other time in US history. This income discrepancy will create troubles because capitalism runs on sales (GDP), and the wealthy save more than they spend.
  • The government still operates through the PAYGO model, where one must formulate tax revenue to subsidize the cost of a program before the program can be passed. An unnecessary delay and hassle that potentially hinders public well-being by delaying and cancelling well-structured programs.

Think of Inflation

  • “The government deficit isn’t supposed to balance. Our economy is.” Too small of a deficit can lead to unemployment, too high can lead to inflation. The way government defines natural unemployment and healthy inflation rate are all arbitrary, and more of an after-the-fact observation.
  • Modern Monetary Theory suggests that a government backed job guarantee program geared towards a care economy is a solution to the unemployment problem during business cycles. It also acts as an automatic stabilizer, with government spending more in recessions and spending less in booming times. As for inflation, the government hasn’t been evaluating impacts when they pass trillion-dollar bills, and the US economy is generally fine because there is enough slack in the economy to absorb the money.

The National Debt (That Isn’t)

  • Debt-to-GDP is irrelevant. It’s all about inflation (governed by slack and productivity). The so-called debt is an instrument that the US utilizes to its advantage. A trade deficit with China means Chinese ship goods to the US, and US pays more USD to China (can be converted to treasuries), which is just a number that the US can pay down whenever they want with 1 keystroke.
  • The Greek default is a result of converting to Euro. It is no longer a currency issuer, but a currency user.
  • Currency issuers have the power to control interest rates, so financial markets have no way of pushing these currency issuers into crisis. By printing money to replace debt instruments, investors now hold the same value of their bond in cash, which means the net wealth is unaffected. It could push prices lower (deflation) because while net wealth is unaffected, income is, with future income becoming 0 because you now hold cash.
  • Fighting deficit led to depression in many cases in the past. The US has experienced six significant economic depression, each preceded by a sustained period of budget balancing.

Their Red Ink Is Our Black Ink

  • People believe that government deficit results in lower savings because the loanable fund theory suggests that there is a fixed pool of money available for borrowing, and if the government borrows money for its deficit, other borrowers will face higher borrowing cost with less cash availability. MMT rejects this because fiscal spending ultimately leads to more money in the non-government bucket, it could potentially lead to lower savings of the poor though if the money flows to the rich. Without intervention, the additional reserve by the government drives the interest rate lower.

“Winning” at Trade

  • Foreign debt can be dangerous, as observed in Venezuela and Russia when natural gas fracking in the US drove oil prices down significantly, and when Argentina soybean prices collapsed. These countries have a lot of US denominated debt, so their ability to pay back is critical, but countries like US, UK or Australia don’t face the same risks.
  • A rising interest rate means a higher borrowing cost for developing countries that need US denominated debt. It also makes US assets more desirable, leading to currency devaluing for developing countries (and ultimately hyperinflation), a double gut punch. The interest rate hike by Paul Volcker in 1979 ultimately led to crashes in developing countries. A lessened dependency on US dollar could be important (could be alluding to crypto).

You’re Entitled

  • Entitlement programs are necessary and doesn’t need to be self-sustaining because US is a currency issuer. The rich want it gone because they would like to see the money go to better use, which just leads to greater imbalance.

The Deficit That Matter

  • The real deficits today are good job deficit, savings deficit, health care deficit (infant mortality rate in the US is more than twice the average for all developed countries), education deficit, infrastructure deficit (graded D+), climate deficit, and equality deficit (in 1950, S&P 500 CEO made 20x as much as the average worker, it is 361x in 2017).

Building an Economy for the People

  • Argentina’s Jefes de Hogar plan is like the proposed MMT government guaranteed job program. The program employed 13% of the total labor force, and 75% were women. 50% of participants leave the program to join the private sector within 3 years. Extreme poverty fell by 25% within 6 months.
Summary

The deficit propaganda focuses on the wrong metrics to gauge the economy’s health, instead look at inflation rate and unemployment rate. The balance sheet is arbitrary to a sovereign country (currency issuing), and there are much more serious deficits like the infrastructure, healthcare, and climate deficits. It is time to stop worrying about losing the trade game to other countries (because you’re not really losing) but balancing the economy fundamentally bottoms up (starting with employment).

Personal

Through the lens of MMT (am particularly interested in the Japan markets, Rakuten and Z Holdings) applied to investing, the continued low interest rate and deflation phenomenon in Japan could be interesting to think through.

Taiwan is equally problematic compared to the US in terms of CEO-to-employee pay ratio, and much worse on housing prices-to-salary ratio. The proposal of a guaranteed job could be an intriguing solution, but perhaps best done through private sector & public sector partnerships, maybe C.Hut (my own startup attempt) could be an interesting solution.

Book: “This Changes Everything” – Naomi Klein (Skim)

A book about undeniable apocalyptic environmental health, and the remedies

Rating: 4 out of 5.

Naomi Klein uses anecdotes to help the reader better understand her messages. The book dives deep into political issues at hand, and socioeconomic factors at play, that are exacerbating the apocalyptic situation. Naomi ultimately talks about the remedies, and her bravery and passion for human preservation engages the audience on a higher level.

10 takeaways

Summary

Unlike a lot of apocalyptic movies like the “Silent Sea”, Naomi believes environmental apocalypse may not be widespread corpses, but just an absence in life due to lower birth rates.

Book: “When” – Daniel Pink (Read)

A book about timing effects, explained through science and correlation

Rating: 4.5 out of 5.

The author uses anecdotes to help the reader better understand his messages. The book also helps readers understand themselves and people around them, while allowing the readers to be aware of what they can change.

15 takeaways

  1. Afternoon, specifically between 2-6pm, people enter the emotional trough of the day. People might want to avoid important decisions during this time. This applies to most of us (around 65%), while around 35% other people wake up either super early or super late, therefore the emotional trough may be pushed back or brought forward.
  2. Tips to help with decision-making during 2-6pm (unavoidable). 1) deep breaths, 2) run checklist, 3) temporary disengagement. In fact, test scores are lowest in the afternoon (equivalent to spending less time in school and having low-income parents) but is boosted significantly after a short break. Judges also are more lenient after a short break. Breaks are very important. Social breaks are even better.
  3. Exercise the early, you’ll enjoy the full effects for the whole day.
  4. Naps of 20 minutes or less usually don’t produce sleep inertia. However, longer naps also give longer cognitive functioning.
  5. Kids tend to sleep later and wake up later as they hit puberty. Colleges should be designed to have its first class at around 11am (according to Frontiers in Human Neuroscience).
  6. People don’t take “when” as seriously as “what”, even though it’s just as important.
  7. Using “fresh start effect” to your advantage. Use it often to jump start projects or ideas, it is like “thinking slow” in Daniel Kahneman’s book (Thinking, fast and slow). Frame things and dates to give them meaning, allowing a new beginning in an organization, like naming a certain date the birthday of a company.
  8. Avoiding bad starts with “pre-mortem”, identify all possible threats before starting.
  9. Going first or last? Go first to set an impression, especially if you’re not the default choice (runner-up). When the pool is large, go last.
  10. Recognizing midpoints of everything. Mid-life crisis, middle of day, middle of test, middle of projects, and many more middles. The slump usually occurs during the middle. So set frequent targets, get over the slump quicker.
  11. Buffet technique: Write down the top 25 goals, circle the top 5 and discard the rest. Aim to achieve the top 5 before even considering anything else.
  12. Encoding is powerful, it’s how you remember the essence of matters. It is often communicated and implied by endings (therefore just as important), the last sentence of a book or the last thing to occur for an event. Use it to your advantage by journaling daily achievements, remind yourself of what you have/haven’t accomplished for the day.
  13. Entrainment, a term that means synching of internal clocks with external cues (sleep when dark outside). It is key to group efforts, where a leader is needed for ultimate synching. A culture and sense of belonging (unique to the group) will help with the synch.
  14. Strong-future (English & French) vs. weak-future languages (Mandarin & German). Future feels more closely connected to the current self in a weak-future language, allowing people to think about consequences down the line. It really isn’t about “living in the present” but rather “integrate the present in the bigger picture”.
  15. “I used to believe that timing was everything. Now I believe that everything is timing” – Daniel H. Pink

Summary

Be cognizant of the “when” of an event, whether it’s tests, games, or competitions. Realize that everyone has the same 24 hours, so the more effective it is being used, the better results will become. Use every and any time as a positive sign (practice “glass half full” mentality), know your best times and prioritize, organize, plan, and execute accordingly. Know what you truly need, whether that’s things, friends, tasks, or goals, you get better at weeding out the unnecessary over time but be conscious of your decisions.

Personally, I’m trying to juggle between too many things, while having a hard time focusing on what to prioritize. I now know that I will prioritize my day by working on 1) startup idea, 2) blog, and 3) work during my free time.

Post-COVID Retail Industry

Physical retail turns around post-COVID, time to fish for winners

Background

COVID has brought significant change within the retail industry, many stores have been ordered to shut down, especially those within US. This has led to many bankruptcies, both private and public. Those with high fixed costs and subpar balance sheet went under relatively quickly (Tailored Brands, J.C. Penny, Guitar Center, Ascena Retail etc.), a quick comparison between specialty retailers and general retailers will show that general retailers are much more resilient under tough conditions.

Online Shopping

The Online segment of almost most companies increased significantly, interestingly though, traditional retailers like Kohl’s, Target, and Nike grew their online segment faster than e-commerce companies like Amazon, effectively gaining share in the online market.

Structural Change in Physical Retail

  • Location intelligence: Software that tracks consumer preference and demographics become increasingly important as inventory and product curation controls can minimize cost in a short-handed physical retail environment.
  • Depth vs. Breadth: Depth may become more important than breadth to tailor to individual needs and create emotional attachments. Multi-channel approach will allow brands to maximize revenue while limiting SKUs and shelf space.
  • Contactless environment: Sensors that can take cues from hand gestures, voice, and reflections will be utilized for a contact-minimized environment.
  • Distribution centers: Key to deliver goods at maximum efficiency, limiting idle inventory and the need to discount.
  • Advertising: Small brands may be aggressive with online advertising as well as pop up stores. Store-in-store may be a preferred format for brands.
  • Delivery: Drones may be utilized for last-mile, and LTL may be the preferred method for most retailers as more distribution centers come online and inventory controls continue to tighten.
  • Off-mall: Most enticing retail format if the location is planned carefully with complementary offerings (food, massage, haircut, theaters).

Industries to Benefit

RFID: E-ink (8069)
Drone: Parrot (PARRO), Zhongyang (6668)
E-commerce: Rakuten (4755)
Sensing (mmWave/VCSEL/IR LED/Mic): JMicron (4925), Win Semi (3105), Knowles (KN), Zilltek (6679)
LTL: XPO Logistics (XPO), Saia (SAIA)
Off-mall: Kohl’s (KSS)

Conclusion

Retail has suffered its largest shock, and many changes have been accelerated. I think it is one of the most interesting industries to be a part of right now. Unforeseen demand will likely surge for multiple industry verticals, aided by a permanent change in consumer behaviors.

Kohl’s Corporation (NYSE: KSS) Stock Analysis

Improving traffic & unit economics through off-mall presence post COVID-19

Target Price

  • 2021/02/08: $100
  • 2020/03/07: $60

Investment Evaluation

2020/03/07: Kohl’s (NYSE: KSS) is a department store focusing on apparel through national brands and private labels. Kohl’s will become an icon for off-mall leisure through Michelle Gass’s leadership, foot traffic will increase substantially in the coming years. Substantial stock repurchases throughout the past 2 decades accompanied by sluggish price performance now allows the management to payout safe and stable dividends with yields upwards of 30%.

Table of Content

Intro

Kohl’s (NYSE: KSS) is a department store. “Most stores are located in strip malls (67%) with about 26% that are freestanding and 7% of stores are in malls. The company sells both national brands and private-label brands focusing on clothing, shoes, accessories, cosmetics, and home furnishings. Roughly 28% of sales is from women’s apparel. The website generates about 20% of total revenue.” Athleisure has been its focus as of late.

Opportunity

Partnerships

Kohl’s announced partnerships with Amazon in 2017, Aldi in 2018, and Planet Fitness in 2019. The purpose of these collaborations is to drive foot-traffic to the store. The physical retail segment has been decimated by the emergence Amazon, and e-commerce in general, which contributed to the fall of Forever 21, Toys R’ Us, and Sears. What Kohl’s is trying to achieve with its initiative is rather unique in my opinion. With around 1200 locations and an average size of 90,000 ft² per store, Kohl’s is primed to be working with national level businesses that require “actual physical engagement” (referred to as APE from now on). With the emergence of e-commerce, APE is absolutely vital in the current environment. Barbershops and gyms have been largely immune to the IoT movement (not immune to the laziness enabled by the IoT movement though), since haircuts and weight-lifting can’t really be ordered online as of right now.

Competitors

Nordstrom, Macy’s, and other big brand retailers can adopt a similar strategy, but their spaces are simply too big for the strategy to be impactful, and nobody would workout at a mall. On the other hand, many of the smaller department stores or discount retailers are too small to execute the strategy and team up with national brands, both in store size and store count across the US. The only possible competitor that may follow suit it the strategy succeeds are Target and Walmart, both with wider reach and similar store sizes. The problem with Target, is that they are mostly located in downtown metropolitan areas, it is not suited for parking, or traveling in and out of in general. Moreover, the stock has done great due to its off-mall locations (stand-alone rather than strip mall), the management will not likely want to pivot their strategy with shareholders appreciating their current strategy so much. If it ain’t broke, don’t fix it. While Walmart’s “Town Center” idea is interesting, it generally attracts lower income household. According to Kanter Research, the average Walmart shopper is a white, 51-year-old female with an annual household income of $56,482. On the other hand, the average household income of Kohl’s shoppers is $69,442 annually, and nearly 30% of the chain’s shoppers make more than $100,000.

Management

Kohl’s malleability in strategy execution (teaming up with Aldi, Planet Fitness, as well as other options according to the company) is a great strength demonstrated by the management. CEO Michelle Gass is comfortable in changing the company’s image, and with her expertise from Starbucks, I believe the management is fitted to execute this strategy successfully. Willingness to pioneer is a well demonstrated strength of KSS’s management. They tested out small store format and decided against rolling it out due to various reasons. They are not scared of trying things out, and are not scared of moving on when ideas don’t work out. Gass witnessed first-hand, the powerful effects of “the 3rd place” ideology for Starbucks. It’s work, home, Starbucks, and a bunch of other places for you to run errands. Now, you may have a reason to go to Kohl’s for EVERYTHING (almost) that you cannot do online. I expect Kohl’s to leverage their space and continue to lease out to gyms, barbers, shipping centers (Amazon returns), pet hospitals, and other players. It will become the next rendition of places you go to “get things done”.

Execution

I think the number one initiative right now for Kohl’s is to save up on cash to weather potential general economic pressure, retail environmental toughness, and deploy cash to scale its growth strategy nationwide once proven profitable. According to Kohl’s balance sheet, its leased stores on average have a 16-year-long contract, while average for a department store, it can absolutely wreak havoc. I think Kohl’s has the right person, the right strategy, the right balance sheet, and the right property portfolio, it just needs to right its capital allocation policy. If such a strategy is executed successfully, I believe KSS will be considered a high moat company with its extended relationship with local firms, as well as hard to replicate scale and store size, and thus warrant a re-rate to at least 10x FCF.

Number Crunching & Assumptions

Key Assumptions

  1. Average member count of Planet Fitness is 8,000, members visit on average once a week, and 30% of gym goers will shop at Kohl’s on the same day they visit the gym.
  2. The average spending of Planet Fitness gym members at Kohl’s are 90% of regular Kohl’s customers.
  3. Kohl’s store downsizing of approximately 25% will only lower average transaction ticket by 10%.
  4. 90% of strip malls are reworkable, and 50% of stand-alone stores are reworkable.
  5. Rent contribution from leased out spaces for Planet Fitness (more remodeling) is 80 cents per square foot per month, while rent contribution from Aldi/Amazon/Others (less remodeling) is 40 cents per square foot per month. https://blog.gyminsight.com/307-health-club-sales/
  6. Kohl’s revenue 20% comes from online, meaning 16 billion generated through physical visits. With an average of 1000 visits per day per store, an average visit roughly generates $35-40 in revenue for Kohl’s. According to Town Sports International (NASDAQ: CLUB) filings, an average member visits the gym once per week.

Valuation

Upside: Successful partnership with third parties, driving retail foot-traffic and revenue growth while successfully maintaining store-level sales with downsized area and lowered SKUs.

Risks: Change of management, slower-than-anticipated-execution, and significant drop in sales due to store downsizing, and significant drop in sales resulting in insolvency remain as risks.

Conclusion

Kohl’s stock price has been an absolute disaster in terms of total return throughout the past 2 decades. However, it wasn’t completely due to a weak business, but rather, constant de-rating had led to this phenomenon. The company will turn this around in the coming years.

I believe Kohl’s is primed to capitalize on this mall-apocalypse by showing its customers that strip-malls are a better option to spend your day than shopping at malls. I also believe Michelle Gass is the right person to execute this strategy, and I wish her all the best in the endeavor.

Target

  • 2020/03/07: $60
  • 2021/02/08: $100

Investment Evaluation

2020/03/07: Kohl’s (NYSE: KSS) is a department store focusing on apparel through national brands and private labels. It is worth $60 per share based on Michelle Gass’s strategy to return the company to growth through partnerships. Kohl’s will become an icon for off-mall leisure, foot traffic will increase substantially in the coming years. Substantial stock repurchases throughout the past 2 decades accompanied by sluggish price performance now allows the management to payout safe and stable dividends with yields upwards of 30%.

Table of Content

Intro

Kohl’s (NYSE: KSS) is department store. “Most stores are located in strip malls (67%) with about 26% that are freestanding and 7% of stores are in malls. The company sells both national brands and private-label brands focusing on clothing, shoes, accessories, cosmetics, and home furnishings. Roughly 28% of sales is from women’s apparel. The website generates about 20% of total revenue.” Athleisure has been its focus as of late.

Opportunity

Partnerships

Kohl’s announced partnerships with Amazon in 2017, Aldi in 2018, and Planet Fitness in 2019. The purpose of these collaborations is to drive foot-traffic to the store. The physical retail segment has been decimated by the emergence Amazon, and e-commerce in general, which contributed to the fall of Forever 21, Toys R’ Us, and Sears. What Kohl’s is trying to achieve with its initiative is rather unique in my opinion. With around 1200 locations and an average size of 90,000 ft² per store, Kohl’s is primed to be working with national level businesses that require “actual physical engagement” (referred to as APE from now on). With the emergence of e-commerce, APE is absolutely vital in the current environment. Barbershops and gyms have been largely immune to the IoT movement (not immune to the laziness enabled by the IoT movement though), since haircuts and weight-lifting can’t really be ordered online as of right now.

Competitors

Nordstrom, Macy’s, and other big brand retailers can adopt a similar strategy, but their spaces are simply too big for the strategy to be impactful, and nobody would workout at a mall. On the other hand, many of the smaller department stores or discount retailers are too small to execute the strategy and team up with national brands, both in store size and store count across the US. The only possible competitor that may follow suit it the strategy succeeds are Target and Walmart, both with wider reach and similar store sizes. The problem with Target, is that they are mostly located in downtown metropolitan areas, it is not suited for parking, or traveling in and out of in general. Moreover, the stock has done great due to its off-mall locations (stand-alone rather than strip mall), the management will not likely want to pivot their strategy with shareholders appreciating their current strategy so much. If it ain’t broke, don’t fix it. While Walmart’s “Town Center” idea is interesting, it generally attracts lower income household. According to Kanter Research, the average Walmart shopper is a white, 51-year-old female with an annual household income of $56,482. On the other hand, the average household income of Kohl’s shoppers is $69,442 annually, and nearly 30% of the chain’s shoppers make more than $100,000.

Management

Kohl’s malleability in strategy execution (teaming up with Aldi, Planet Fitness, as well as other options according to the company) is a great strength demonstrated by the management. CEO Michelle Gass is comfortable in changing the company’s image, and with her expertise from Starbucks, I believe the management is fitted to execute this strategy successfully. Willingness to pioneer is a well demonstrated strength of KSS’s management. They tested out small store format and decided against rolling it out due to various reasons. They are not scared of trying things out, and are not scared of moving on when ideas don’t work out. Gass witnessed first-hand, the powerful effects of “the 3rd place” ideology for Starbucks. It’s work, home, Starbucks, and a bunch of other places for you to run errands. Now, you may have a reason to go to Kohl’s for EVERYTHING (almost) that you cannot do online. I expect Kohl’s to leverage their space and continue to lease out to gyms, barbers, shipping centers (Amazon returns), pet hospitals, and other players. It will become the next rendition of places you go to “get things done”.

Execution

I think the number one initiative right now for Kohl’s is to save up on cash to weather potential general economic pressure, retail environmental toughness, and deploy cash to scale its growth strategy nationwide once proven profitable. According to Kohl’s balance sheet, its leased stores on average have a 16-year-long contract, while average for a department store, it can absolutely wreak havoc. I think Kohl’s has the right person, the right strategy, the right balance sheet, and the right property portfolio, it just needs to right its capital allocation policy. If such a strategy is executed successfully, I believe KSS will be considered a high moat company with its extended relationship with local firms, as well as hard to replicate scale and store size, and thus warrant a re-rate to at least 10x FCF.

Number Crunching & Assumptions

Key Assumptions

  1. Average member count of Planet Fitness is 8,000, members visit on average once a week, and 30% of gym goers will shop at Kohl’s on the same day they visit the gym.
  2. The average spending of Planet Fitness gym members at Kohl’s are 90% of regular Kohl’s customers.
  3. Kohl’s store downsizing of approximately 25% will only lower average transaction ticket by 10%.
  4. 90% of strip malls are reworkable, and 50% of stand-alone stores are reworkable.
  5. Rent contribution from leased out spaces for Planet Fitness (more remodeling) is 80 cents per square foot per month, while rent contribution from Aldi/Amazon/Others (less remodeling) is 40 cents per square foot per month. https://blog.gyminsight.com/307-health-club-sales/
  6. Kohl’s revenue 20% comes from online, meaning 16 billion generated through physical visits. With an average of 1000 visits per day per store, an average visit roughly generates $35-40 in revenue for Kohl’s. According to Town Sports International (NASDAQ: CLUB) filings, an average member visits the gym once per week.

Valuation

Upside: Successful partnership with third parties, driving retail foot-traffic and revenue growth while successfully maintaining store-level sales with downsized area and lowered SKUs.

Risks: Change of management, slower-than-anticipated-execution, and significant drop in sales due to store downsizing, and significant drop in sales resulting in insolvency remain as risks.

Conclusion

Kohl’s stock price has been an absolute disaster in terms of total return throughout the past 2 decades. However, it wasn’t completely due to a weak business, but rather, constant de-rating had led to this phenomenon. The company will turn this around in the coming years.

I believe Kohl’s is primed to capitalize on this mall-apocalypse by showing its customers that strip-malls are a better option to spend your day than shopping at malls. I also believe Michelle Gass is the right person to execute this strategy, and I wish her all the best in the endeavor.

Target

  • 2020/03/07: $60
  • 2021/02/08: $100

Investment Evaluation

2020/03/07: Kohl’s (NYSE: KSS) is a department store focusing on apparel through national brands and private labels. It is worth $60 per share based on Michelle Gass’s strategy to return the company to growth through partnerships. Kohl’s will become an icon for off-mall leisure, foot traffic will increase substantially in the coming years. Substantial stock repurchases throughout the past 2 decades accompanied by sluggish price performance now allows the management to payout safe and stable dividends with yields upwards of 30%.

Table of Content

Intro

Kohl’s (NYSE: KSS) is department store. “Most stores are located in strip malls (67%) with about 26% that are freestanding and 7% of stores are in malls. The company sells both national brands and private-label brands focusing on clothing, shoes, accessories, cosmetics, and home furnishings. Roughly 28% of sales is from women’s apparel. The website generates about 20% of total revenue.” Athleisure has been its focus as of late.

Opportunity

Partnerships

Kohl’s announced partnerships with Amazon in 2017, Aldi in 2018, and Planet Fitness in 2019. The purpose of these collaborations is to drive foot-traffic to the store. The physical retail segment has been decimated by the emergence Amazon, and e-commerce in general, which contributed to the fall of Forever 21, Toys R’ Us, and Sears. What Kohl’s is trying to achieve with its initiative is rather unique in my opinion. With around 1200 locations and an average size of 90,000 ft² per store, Kohl’s is primed to be working with national level businesses that require “actual physical engagement” (referred to as APE from now on). With the emergence of e-commerce, APE is absolutely vital in the current environment. Barbershops and gyms have been largely immune to the IoT movement (not immune to the laziness enabled by the IoT movement though), since haircuts and weight-lifting can’t really be ordered online as of right now.

Competitors

Nordstrom, Macy’s, and other big brand retailers can adopt a similar strategy, but their spaces are simply too big for the strategy to be impactful, and nobody would workout at a mall. On the other hand, many of the smaller department stores or discount retailers are too small to execute the strategy and team up with national brands, both in store size and store count across the US. The only possible competitor that may follow suit it the strategy succeeds are Target and Walmart, both with wider reach and similar store sizes. The problem with Target, is that they are mostly located in downtown metropolitan areas, it is not suited for parking, or traveling in and out of in general. Moreover, the stock has done great due to its off-mall locations (stand-alone rather than strip mall), the management will not likely want to pivot their strategy with shareholders appreciating their current strategy so much. If it ain’t broke, don’t fix it. While Walmart’s “Town Center” idea is interesting, it generally attracts lower income household. According to Kanter Research, the average Walmart shopper is a white, 51-year-old female with an annual household income of $56,482. On the other hand, the average household income of Kohl’s shoppers is $69,442 annually, and nearly 30% of the chain’s shoppers make more than $100,000.

Management

Kohl’s malleability in strategy execution (teaming up with Aldi, Planet Fitness, as well as other options according to the company) is a great strength demonstrated by the management. CEO Michelle Gass is comfortable in changing the company’s image, and with her expertise from Starbucks, I believe the management is fitted to execute this strategy successfully. Willingness to pioneer is a well demonstrated strength of KSS’s management. They tested out small store format and decided against rolling it out due to various reasons. They are not scared of trying things out, and are not scared of moving on when ideas don’t work out. Gass witnessed first-hand, the powerful effects of “the 3rd place” ideology for Starbucks. It’s work, home, Starbucks, and a bunch of other places for you to run errands. Now, you may have a reason to go to Kohl’s for EVERYTHING (almost) that you cannot do online. I expect Kohl’s to leverage their space and continue to lease out to gyms, barbers, shipping centers (Amazon returns), pet hospitals, and other players. It will become the next rendition of places you go to “get things done”.

Execution

I think the number one initiative right now for Kohl’s is to save up on cash to weather potential general economic pressure, retail environmental toughness, and deploy cash to scale its growth strategy nationwide once proven profitable. According to Kohl’s balance sheet, its leased stores on average have a 16-year-long contract, while average for a department store, it can absolutely wreak havoc. I think Kohl’s has the right person, the right strategy, the right balance sheet, and the right property portfolio, it just needs to right its capital allocation policy. If such a strategy is executed successfully, I believe KSS will be considered a high moat company with its extended relationship with local firms, as well as hard to replicate scale and store size, and thus warrant a re-rate to at least 10x FCF.

Number Crunching & Assumptions

Key Assumptions

  1. Average member count of Planet Fitness is 8,000, members visit on average once a week, and 30% of gym goers will shop at Kohl’s on the same day they visit the gym.
  2. The average spending of Planet Fitness gym members at Kohl’s are 90% of regular Kohl’s customers.
  3. Kohl’s store downsizing of approximately 25% will only lower average transaction ticket by 10%.
  4. 90% of strip malls are reworkable, and 50% of stand-alone stores are reworkable.
  5. Rent contribution from leased out spaces for Planet Fitness (more remodeling) is 80 cents per square foot per month, while rent contribution from Aldi/Amazon/Others (less remodeling) is 40 cents per square foot per month. https://blog.gyminsight.com/307-health-club-sales/
  6. Kohl’s revenue 20% comes from online, meaning 16 billion generated through physical visits. With an average of 1,000 visits per day per store, an average visit roughly generates $35-40 in revenue for Kohl’s. According to Town Sports International (NASDAQ: CLUB) filings, an average member visits the gym once per week.

Valuation

Upside: Successful partnership with third parties, driving retail foot-traffic and revenue growth while successfully maintaining store-level sales with downsized area and lowered SKUs.

Risks: Change of management, slower-than-anticipated-execution, and significant drop in sales due to store downsizing, and significant drop in sales resulting in insolvency remain as risks.

Conclusion

Kohl’s stock price has been an absolute disaster in terms of total return throughout the past 2 decades. However, it wasn’t completely due to a weak business, but rather, constant de-rating had led to this phenomenon. The company will turn this around in the coming years.

I believe Kohl’s is primed to capitalize on this mall-apocalypse by showing its customers that strip-malls are a better option to spend your day than shopping at malls. I also believe Michelle Gass is the right person to execute this strategy, and I wish her all the best in the endeavor.

UPDATE: 2Q20 & 3Q20 & 4Q20 Prelim takeaways, Sephora partnership, and new assumptions
  • 2Q20 & 3Q20 & 4Q20 Prelim Takeaways
    • 2Q20:
      • Store productivity was 75% for reopened stores
      • Physical stores fulfilled 50% of digital sales (customer trend adopting BOPIS, acronym for buy online pickup in store)
      • Significantly reducing our choice counts, operate across women’s and men’s to increase depth and meet our customers’ expectations, in the fourth quarter, women’s choice counts will be down over 40% with depth up 50% (emphasizing depth not breadth)
      • Exit of 8 underperforming private label brands (Kohl’s is aggressive with testing, but quick to cut lose underperforming projects, looks to be building on existing brand equity)
      • Expanding “Curated by Kohl’s” to 300 plus stores (social media initiative to give smaller brands exposure)
      • Amazon returns moved to the back of the store “for safety reasons”
      • Brought digital research in-house in 4Q19, paying dividends
      • Fitting rooms closed (remain a pain point for customers)
    • 3Q20:
      • OP Margin goal of 7-8%
      • Expand Active from 20% to 30% of business
      • Introducing FLX, new athleisure private label focusing on sustainable materials with modern fit and aesthetics (current offerings include plus sizes, could fill a niche market)
      • Inventory turn at 5-year high (better with inventory management, lower shipping related costs for better margins)
      • PLNT at 20 stores so far, slight pause
      • More than USD 1.9 B in cash
    • 4Q20 prelim:
      • Revenue in the range of 6 billion ish
      • EPS between 1-1.05 (means extreme cost control, perhaps OP margin in high single digits already)
      • Digital sales over 40% of total sales
  • Model update
    • New assumptions:
      • COVID reduces stores visits by 10% indefinitely
      • Gym to penetrate 30% of stores by 2025, with a 20% willingness to visit kohl’s for every trip to gym, flat ticket size of USD 35, nearly 1.5 MM visits per year
      • Cash/share of USD 9 by 2025, discount rate of 10%, multiple of 10x/15x would yield 93/140 TP
  • Sephora partnership
    • Sephora and Kohl’s win-win situation with 25M users from Sephora and 65M users from Kohl’s (30M are members)
    • Brings younger demographic into Kohl’s (good for Kohl’s private label brand and lacking social engagement)
    • KSS expects to open 200 Sephora shop-in-shop locations in Fall 2021, and at least 850 locations by 2023. They will be designed within a 2,500 square ft. space and prominently located at the front of the Kohl’s store
    • Kohl’s will fund capex for store build, with estimates of less than USD 700-800 MM historical run rate for the next few years, while Sephora will be in charge of brand curation
    • 50/50 split for operating profits
    • Sephora and JCP partnership led to USD 1,300 per square ft. revenue, with Sephora’s eventual expansion, it could contribute USD 2.75 billion annually, amounting to around 13% of KSS’s current revenue
  • Conclusion & TP update
    • Aldi and PLNT seems to have taken a backseat amid pandemic, but Sephora is a great move nonetheless and presents a quick turnup in unit economics, where traffic and ticket size are likely to increase
    • 4Q20 expenses seems to be in control, cash position should remain strong after distribution center lease-back
    • New modeling suggests minimum TP of $100 after rounding up, with potential upside in ticket price and better expense controls, unit economics are still in favor
    • Structural change in retail space continues, a mix of store closure in underperformers and share taking in leaders will continue to happen, Kohl’s continues to be one of the most well-positioned players

Luckin Coffee Inc (NASDAQ: LK) Stock Analysis

Economically viable new-retail model that everyone is afraid to like

Target Price

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

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.

 

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