LUCKIN COFFEE (LK) – CHANGING THE WORLD – STOCK UP 25% SINCE Q3 REPORT – WHAT TO DO?
Luckin Coffee (LK), a Chinese company, came public on May 16, 2019, at $17.00 per share. It sold off immediately to $14.00, then rallied to $26 by the end of July, fell back and traded between $18 and $22 until last week when the stock rallied from $20 to almost $30 in the wake of their Q3 report.
Luckin is truly changing the world in terms of providing coffee, related products, and now tea to the Chinese public at bargain prices. The stores are more like kiosks or vending operations, with few operating personnel. These units require a capital investment a small fraction that of a Starbucks, a Dunkin Donuts or Tim Horton’s, and generate a fraction of the revenues. For example, a Luckin location, in Q3’19 generated about $65,000 for the quarter, increasing materially from about $50,000 in Q2 and $30,000 in Q1, as the brand has become more well established. As we described in our report back in May (which you can access through our Search function), Luckin is growing far faster than any retailer in the history of the planet. The first unit opened in late ’17, there were 2,083 units opened by the end of ’18, 3,680 locations at 9/30/19 and will be about 4,500 by 12/31/19.
Unit level profitability and the bottom line corporate return on investment, after corporate G&A support, of course represent the sustainability of this model. The chart below provides the reported corporate income statement, down to the Operating Loss which closely resembles the bottom line Net Loss, after other income, financing and foreign exchange adjustments, and other relatively minor items. The Company does not tell us the average capex per location, so we have divided the quarterly capex by the number of stores opened in the quarter, and find that the cost per store was about $70,000 in Q3, for some reason up from $51,000 in Q2, both numbers down substantially from $139,000 in Q3’18. The highest number ($139k) was much earlier in the growth cycle when LK went from 290 to 624 locations. We are not drawing a current conclusion in terms of the cash cost going up from $50k to $70k recently, because the money spent relates not only to the stores just opened but also the upcoming locations. We conclude only that the average capex, in order of magnitude, is well under $100k, a great deal less than a typical competitive location. This relatively modest investment corresponds to the much lower sales/location, compared to a Starbucks, Dunkin, or Horton’s.
It is clear that Luckin intends to continue along its incredibly rapid growth path, even augmenting it with Luckin Tea locations that will involve operating partners/franchisees. They have stated that they will be profitable from a bottom line corporate standpoint by Q3’20. With over $700M in cash on the balance sheet as of 9/30/19, if a new location costs about $70k, without allowing for the continuing quarterly losses, that would allow for 10,000 additional stores. No doubt the $82M Operating Loss in Q3, with $15M of depreciation reducing the cash outflow to $67M. We conclude therefore that the resources are in place to continue opening at least 750 locations per quarter, which would bring the total at 12/31/20 to close to 7,000 locations and perhaps 10,000 by 12/31/21.
It is instructive at this point to look at the numbers over the last three quarters.
You can see that expense line items are “leveraging” nicely, as one would expect with such rapid growth. Cost of materials have come down from 57.6% to 46.8%. Store Rental and Other “ have come down from 59.0% to 31.0%. Depreciation is down from 17.5% to 7.0%. Sales and Marketing are about the same at 35-36%. G&A is down from 36.1% to 16.0%. The reductions in Cost of Materials, Store Rental & Other, Depreciation, and G&A, have allowed the Operating Loss to be reduced substantially, from 110% of Revenues to “only” 38.3%.
The question is: where do we go from here, in the short run and longer term. We expect most of the expense line items to continue “leverage”, with the exception of Sales & Marketing, which the Company has said will remain “relatively high, returning to normal starting in Q3’20”. Overall however, with the Operating Loss have been reduced by almost $20M in Q3’19, it seems possible that further leveraging of most expense lines could bring the Company close to breakeven by Q3’20.
STORE LEVEL PROFITS
The Company has said that store level profitability was 12.5% in Q3’19. We point out that: subtracting store expenses of 46.8% CGS, 31% from Store Rental, etc., and 7% Depreciation, leaves 15.2%, but there was an additional 1.5% of CGS, 1.0% Store Rental, and 0.3% of Depreciation that was apparently included in Sales or G&A that could have, or should have, been charged to four wall store operations, bringing the “store profits” down to 12.5%.
Whether the store level profit was 12.5% or 15.2%, revenues were supported by a huge 36.2% of revenues spent on Sales & Marketing. It’s possible also that some portion of G&A was directly supporting store level operations, so the “four walls” were heavily subsidized. We can’t help but conclude that it remains to be seen what the sustainable four wall economics of a Luckin Coffee look like. We are not saying it won’t work. We just don’t know.
THE INVESTMENT PROPOSITION
The total market value of LK equity is currently about $6.3B, with the stock trading at $26-$27/share. There are about 240M shares outstanding, fully diluted. If we a assume that a very rapidly growing profitable retailer would have a P/E multiple of about 50x expected fully taxed earnings, the $6.3B valuation is discounting expected earnings of $120M after taxes, perhaps $160M pretax. Assuming the $83M Operating Loss can be reduced steadily by $20M per quarter, it would take 12 quarters to get to the $160M pretax earnings run rate. In that case, the current market value is something like 3 years ahead of the fundamentals.
We have no idea to what degree CGS, Store Rental, Depreciation, Marketing, or G&A can be reduced further. Most important, we have no idea what level of Sales & Marketing is necessary to create and hold brand awareness, market by market. We have no idea how successful the competition will be in resisting this insurgency. It is impossible to know how much further sales per location will build. We have no idea how well tea will sell within Luckin Coffee stores or how well the planned Tea partnered (“franchised”?) stores will work.
What we do know is that analysts and money managers will take each quarterly report apart, analyzing “the second derivative”, that is whether the “rate of unit growth or comp growth” is decelerating, whether the Marketing or G&A is leveraging or not, and whether the bottom line profitability (loss) is improving at the predicted rate. Investors are tolerant until they are not. Witness the investor disillusionment recently relative to Uber, Wayfair and the most famous unicorn of all, WeWork. An example we have personally studied is Chewy’s (CHWY), a pet product supplier which we view as a very fine company with a compelling selling proposition, growing very rapidly but a couple of years away from profitability. CHWY has run up against a newfound concern about the exact timing, and extent, of profitability. After running from its IPO price of $23 in June’19 to a high above $35, CHWY has retreated steadily to $23. Though there has been no material disappointment in terms of progress. Investors have just decided that there is plenty of time to get involved with CHWY.
We are open minded. There is a possibility, for sure, that Luckin has invented, and will successfully exploit, a revolutionary approach to retailing caffeinated beverages and related products. At the same time, we read today that Bandit, a Luckin lookalike founded by an Uber veteran, is about to open its first store in Manhattan. It’s a big world, no doubt more than large enough to support many competitors in this space. Bandit is far from a threat, but we wouldn’t write off Starbucks, Dunkin or Horton’s, each of which is capable of opening “express” locations. It will be interesting.
P.S. For what it’s worth, below is an article regarding Bandit, referred to above:
An Ex-Uber Employee Wants to Swarm NYC With ‘Mobile-Only’ Coffee Shops
Bandit’s first coffee shop in Midtown Bandit [Official]
A longtime Uber employee has his eyes set on New York City for another start-up: a “mobile-only” coffee shop.
The term “mobile-only” when it comes to food and drink is a bit of a misnomer. By nature, the new company called Bandit needs physical locations where people can pick up their coffee; there’s currently one at 466 Lexington Avenue between 45th and 46th streets. It serves a standard menu of cafe fare, like coffee, espresso drinks, and matcha lattes, plus seasonal specials like a peppermint chocolate latte. Pastries and other snacks come from Colson Patisserie and Three Owls. There’s life-sized Jenga and Connect Four.
But co-founder Max Crowley, who left Uber last year, is calling Bandit mobile-only because people can only buy coffee through a corresponding app — or as he tells Eater, “We are coffee at a push of a button.”
That means anybody showing up to the new coffee shop with only cash, a credit card, or a phone without an app store won’t be able to buy a latte until they download the Bandit Coffee app on an iPhone or Android phone, create an account, upload a profile photo (required so that the barista can recognize them), and put in a payment method. It’s similar to the first pickup-only Starbucks shop and the fast-growing Chinese company Luckin Coffee, which is the biggest competitor to Starbucks in China and the inspiration for Bandit.
Though there’s just one outpost now, Crowley plans to open at least five or six in the city or New Jersey within the next year. The goal: “We never want to be more than five minutes walking from someone who wants coffee,” he says. He’s targeting density in Midtown first, with hopes that there will be one “on every corner” soon.
Bandit’s cafe in a vacant space Bandit [Official]
Crowley’s banking on landlords with vacant spaces who might want a temporary coffee shop on their properties.
Instead of building out existing spaces, Bandit constructs its coffee shops in factories in Michigan and California, as 11 by 11 “modular, self-contained units.” (In a blog post, Crowley calls it one of the company’s “core innovations.”) They work with New York landlords who have vacant commercial spaces that have yet to be filled, and instead of a traditional lease, Bandit signs licensing agreements where the landlord gets a percentage of the sales for rent, a common practice for commercial tenants. (Crowley calls this “activating vacant spaces with modular, movable coffee shops.”)
The shop can be up and running within four hours, Crowley says, ideal for a landlord who needs a vendor fast. The same timeline could be applied to co-working spaces, hotel lobbies, or any store that wants a coffee component. When the landlord leases out the space to a longterm tenant, Bandit can hop out of it just as quickly.
The existing Lexington location, for example, is in a vacant space, and Bandit may eventually move out of it.
“We really see ourselves as flexible from a landlord perspective,” Crowley says.
A bonus for the customer, he argues, is that the coffee is “really good” and “cheaper than Starbucks,” possible because of lower build-out costs and roasting at Pulley Collective in Red Hook. Drip coffee is $2, cold brew is $3, and everything else goes up to $4.50. (A FiDi Starbucks charges $2.35 for a tall drip coffee and $4.95 for a tall eggnog latte, also before tax.) For frequent buyers, there’s also membership plan, where for $20 a month, members can get unlimited drinks for $1 a piece.
“It’s about speed and convenience, and at an affordable price point,” Crowley says.
So far, Bandit has raised money from more than 30 investors, mostly Crowley’s fellow ex-Uber employees, though he declined to name the amount. He’s also partnered on the project with James Gallagher, who used to be COO at tech start-up Good Uncle, an app that delivers restaurant food to college campuses.
It’s a risky proposition — plenty of tech people have recently come into the food and drink world and quickly failed despite millions in investment and claims of innovation. Automated quinoa restaurant Eatsa, the supposed “robot” lunch spot, shut down, as have most of the tech-fueled delivery-only restaurants, like Maple, Ando, Munchery, and more.
And New Yorkers — particularly those working in Midtown, where Bandit is targeting — can already get coffee in under five minutes from third-wave coffee shops, bodegas, restaurants, and Starbucks, which has its own mobile app and tons of existing real estate. None of these places require downloading a new app to get coffee, and Bandit’s prices aren’t significantly lower than competitors.
Plus, there’s talk in New York about banning businesses that don’t accept cash. Many people also go to their coffee shops out of habit and proximity, and for now, by nature of the business model, Bandits will be in their locations temporarily.
But Crowley believes that Bandit is “the future of retail design and build.” He says people are already going to Bandit’s current location, with more than 60 percent of customers returning. (“Thousands” have downloaded the app, a spokesperson says, and “hundreds” of customers come in daily.) Some of the locations could eventually become permanent, too, with potential for the Lexington one to go in the lobby or elsewhere with the landlord, the real estate company RXR Realty.
And if the company expands quickly enough, Crowley thinks that Bandit will be ubiquitous enough that people will feel compelled to install the app on their phones.
“Our goal and model is to have these everywhere,” he says. “If Bandits are everywhere, it will make sense to [download the app].”