LUCKIN COFFEE INC. – THE CHINESE KNOW HOW TO GROW !!! WANT TO HEAR A GOOD STORY ??
Conclusion: Short and Sweet: Pass
Luckin Coffee, Inc., domiciled in the Cayman Islands, operating in China, has filed a preliminary prospectus which indicates an IPO of $100M. However, that number is supposedly just a “place holder”. The talk is about raising $700-800M, with a total market value of about $5 billion. The last capital raise, including prestigious investors such as Blackrock, reportedly valued Luckin at about $3B.
The Chinese are drinking increasing amounts of coffee, as evidenced by the rapid development of Starbucks in China, now with 3500 stores on the way to 10,000. In terms of store growth, though, that’s nothing ! The Chinese know how to do it right. Sixteen months ago, at 12/31/17 there were 9 Luckin Coffee locations. As of 3/31/19 there were 2,370. In Q1’18: 281 locations opened (that’s on a base of nine), followed by 334 new locations in Q2 followed by 575 new locations in Q3 followed by 884 in Q4. The growth has scaled back in Q1’19 to only 297 new locations. Not to worry: 2500 new stores are planned for 2019. Talk about a fire drill 😊 Who needs Starbucks when you will soon be able to participate in the growth of Luckin Coffee?
There are three types of Luckin stores: pick-up stores (91.3%), relax stores (4.6%), and delivery kitchens (4.1%). The dominant category, pick-up stores, are only 20 to 60 sq meters in size, with limited seating, typically located in office buildings, commercial areas and university campuses. Relax stores are generally larger, more than 120 square meters in size. Delivery kitchens are often used to enter a particular market, only deliver, and are sometimes closed once other stores are opened. The 2370 stores are located in 28 cities across 16 provinces and municipalities Delivery was a big deal here at first, 61.7% of sales in Q1’18 and 62.2% in Q2, decreasing to 51.4% in Q3, 40.8% in Q4, and 27.7% in Q1’19.
There is a 200 page preliminary prospectus, plus exhibits, and we haven’t had time to read much of it yet, but the following summary financials provide a “flavor”. The good news is that, as you might expect, costs are being leveraged as Luckin grows out of its infancy. Financials are provided for calendar 2018 and the first quarter of 2019. Comparing the first quarter of 2019 to the full year of 2018, cost of goods is lower, store rental and “other” costs are lower, sales and marketing is a lot lower, G&A is lower, pre-opening expenses is lower, the (to be expected) loss as a percentage of sales is not much more than half of what it was for all of ’18.
Before reading the following paragraph: For those of our readers that are not familiar with line by line economics of restaurants, be aware that (generally) Cost of Goods runs about 30% of revenues, Labor (30%) and Other Operating Expenses including Rent (20%), which would total to 80% of Revenues. Marketing might be as much as 5%, G&A might be 12-15% when a chain is growing rapidly, Pre-Opening expense could be 3-5% depending on how fast the growth is. Pretax Income could be slightly positive, depending on G&A, Marketing and Pre-Opening, even at an early growth stage. Modest profitability for a young promising chain can become more meaningful as marketing & G&A are leveraged by the larger Revenue base. With this broad template, you can now see how far the operations of Luckin to date vary from the rough parameters of a successful restaurant chain.
Pay attention now: in Q1’19: Cost of goods was 57.6% of revenues, down from 63.3% for all of calendar ’18. (our template calls for 30%) Store Rental and Other costs (no cashiers but someone has to open and close and keep supplies in the right places) were 59.0%, down from 68.5% (template calls for Labor and Other to be 50%). Sales & Marketing was only 35.1%, down from 88.7% (template calls for under 5%). G&A was 36.1%, down from 45.2% (template calls for 12-15%). Pre-opening (with only 297 locations opened in Q1’19) was 4.7%, down from 11.6% (template calls for 3-5%, closest on this one). The loss of 110.2% of Revenues was emphatically lower than the 190.1% loss for all of ’18 (template calls for roughly breakeven). You read that right: The loss before taxes in ’18 was $238M against Revenues of $125M. In Q1’19 the loss before taxes was only $78M on revenues of $71M. (Maybe Luckin Coffee could merge with Uber.) Talk about a “leap of faith”.
What’s going on here? These are almost entirely cashless pickup locations. Dividing $71M of sales in Q1’19 by an average of 2225 stores gives quarterly revenues of $32k or $128k annualized. I couldn’t find (yet) the average investment per store but $180M has been spent in capex between inception and 3/31/19 to build 2370 stores which is about $75,000 per store. This is a long way from Starbucks. This is more like a vending operation than a retail facility. It’s already being speculated that the rapid growth of Luckin will impact Starbucks comps in China. I like to travel, but it’s a long haul to Beijing, so I’ll speculate for now that the Luckin cashless pickup or delivery “experience” is a lot different than at Starbucks.
There are lots of details provided in 200 pages of a prospectus, including details about the growth in coffee consumption in China and management makes the point that the apparent cost of customer acquisition is coming down over the last fifteen months. The 54% retention rate of customers who try the product is encouraging as well. On the other hand, I divided the $125M of sales for all of ’18 by the average number of stores for the year, which I calculated at 785 (almost 900 opened in Q4) and that calculates to average annualized sales of $159k, versus an average annualized rate of $128k in Q1. There is a chart in the prospectus that seems to confirm that the customer retention rate is somewhat lower now than at first. My estimates could be off, especially with unknown dates of opening and Q1 could be seasonally slow, but it doesn’t look like sales per existing store are accelerating. Granted: this is so early in the process that it is impossible to know what the long term model looks like. It is a sign of the times that this uncertainty hasn’t discouraged the private equity investors (at $3 billion) or the IPO underwriters with an apparent $5 billion valuation..
Getting back to unit level economics, aside from the investment per store, it doesn’t matter how small the capex/store, or even what your sales/store are, if your CGS is anything close to 57%, if your lease and other costs are anything close to 59%, if your sales and marketing are anything close to 35%, and obviously if your G&A is close to 36% (all of which will no doubt leverage to a degree with the inevitable growth).
Suffice to say: the jury is out on this one. I can’t know what the likelihood of success of this “concept” is. The Chinese like to construct residential towers, shopping malls, and cities that have almost 100% vacancy rates, planning to fill them out over time. Perhaps customers will fill out these vending facilities or retail stores (whatever you choose to call them) over time.
In terms of the valuation: Look at it this way. If the IPO valuation is about $5 billion, and we think about an aggressive valuation of 50x earnings, it would require $100M of after tax earnings to justify the IPO price. Considering that Luckin lost $78M pretax in Q1’19 and that rate of loss is no doubt going to accelerate as 2500 stores are going to be opened in calendar 2019, safe to say that it will be quite a few years before hundreds of millions of dollars of losses turn into $100M of after tax profits. Would you say: at least five years? So the IPO valuation will be at least five years ahead of the fundamentals and that is assuming that the whole process is successful, and of that there is at least a little doubt. Of course, markets sometimes go to extremes, and momentum driven growth stock investors could take Luckin higher after the IPO and there could be some quick money made by nimble traders. But: be careful out there. Case in point: Shake Shack, well managed with a far more predictable model than Luckin Coffee, came public in early 2015, at $21, a ridiculous valuation at the time, and ran to almost $100/share before it retraced to $30 where it sat for almost three years before the fundamentals caught up with the valuation, and those fundamentals have generally come through as planned.
One additional caveat and further sign of the times: There will be two classes of stock here. You wouldn’t expect that the Chinese would allow US shareholders to have equal voting rights, for their $700-800M capital contribution, as the Chinese founders, would you?
Conclusion: As you might suspect, we’ll follow with interest, but pass on the investment opportunity. Harvard Business School should do a case study on this one 🙂