Luckin Coffee Inc.

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 4/5

Luckin Coffee Inc. is a Chinese coffee company operating a network of self-operated and partnership stores selling coffee and other drinks, alongside food and merchandise products, mostly in mainland China.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Luckin Coffee, once mired in controversy, has been rebuilding its brand and operations, showing significant recovery over the past few years. However, its moat is somewhat limited and continues to be shaped by the competitive environment and regulatory uncertainties in China.

Business Overview:

  • Revenue Streams: Luckin generates revenue primarily through self-operated and partnership stores. The company’s revenue streams can be broadly categorized into:
    • Net revenues from product sales: Includes coffee drinks (the bulk of revenue), food, other drinks, and merchandise.
    • Revenues from franchise stores: Income from the company’s brand and operational support given to the franchisees.
    • Other Revenues: Revenues from delivery partners and advertising.

In 2022, Net revenues from product sales was RMB 10.7 billion, 75% of total revenue. * Revenues distribution: * Revenues from self-operated stores grew to 79.1% in 2022 compared to 74.4% in 2021. * Revenues from partnership stores decreased from 22.8% in 2021 to 18.6% in 2022. * Other revenues increased from 2.8% in 2021 to 2.3% in 2022.

  • Industry Trends: The coffee and beverage market in China is experiencing rapid growth, with increasing consumer demand for specialty coffee and related products. This market also sees intense competition with multinational and local players, with the industry becoming more competitive over time. The preference for convenient and quick solutions is also high among Chinese consumers.
  • Competitive Landscape: Luckin operates in a highly competitive market characterized by both domestic and international brands. Competitors range from large chains to smaller, local coffee shops. Major players include Starbucks, domestic players such as Manner, and boutique brands. This competitive landscape presents both opportunities and challenges for Luckin.
    • Key Points of Differentiation:
    • Strong brand recognition in China (however, it is important to note this reputation is now after the scandal)
    • Large and growing store network, primarily through self-operated and partnership stores.
    • Strong partnerships with delivery services for online purchasing.
    • Technology driven mobile apps for a seamless customer experience.
  • Business Model: Luckin relies on a combination of self-operated stores and partnership stores, and its mobile applications, online presence to reach its customers. The company focuses on delivering a convenient and technologically advanced customer experience, and its value proposition to be on high-quality coffee at affordable prices.
  • They offer a variety of coffee drinks, as well as food items and merchandise and are primarily focused on catering to the convenience of their Chinese consumers.
  • Business Resilience: Luckin has demonstrated the capacity to recover and restructure despite past scandals, but it still faces risks to its sustainability. The Chinese market continues to present regulatory, political, and financial challenges. The company has shifted strategy to focus on cost efficiencies and profitable unit growth.

Financial Deep Dive:

Luckin’s recovery is evident in the improved financials. The company has shown strong growth in revenue and profits, but the debt load is high and this may create headwinds to the company’s future success.

  • Profitability:
    • Net revenues were RMB 10,382 million in 2022, up from RMB 7,965 million in 2021.
    • Profitability has seen tremendous improvement with a jump from a net loss of RMB 5.0 billion in 2021 to a net income of RMB 432.2 million in 2022.
    • Gross margins have also improved.
  • Balance Sheet:
    • Total assets decreased from RMB 10.18 Billion to 7.04 Billion from 2021 to 2022, primarily due to the disposal of discontinued operations.
      • Current assets were recorded at RMB 3.85 billion in 2022, down from RMB 4.42 billion in 2021. This is mainly caused by a 20% reduction in cash, cash equivalent, and restricted cash. *Total liabilities decreased from RMB 13.85Billion to RMB 6.44Billion. Primarily due to a reduction in debts as some notes are converted to equity, the company also paid off lease liabilities.
      • Cash and cash equivalents + restricted cash: RMB 3.55Billion.
      • Total debt: 1.54Billion. *Shareholders’ equity increased to 4.61 billion from -3.70 billion a year prior.
  • Cashflow:
  • Net cash from operating activities increased from RMB 1.98 billion in 2021 to RMB 4.65 Billion in 2022. The company has greatly improved its core operations and cash generation.

  • They spent RMB 1.82 billion on capital expenditures in 2022.

  • Other observations:
    • The company has been successful in expanding its store network and reaching a wider consumer base
    • There are risks of fraud and investigations that may hurt investors perception of the company.

Moat Analysis:

Based on the above analysis, Luckin Coffee’s moat is rated a 2 out of 5. While the company shows a degree of competitive advantage, significant threats remain. A strong focus on a narrow and profitable base will be important to solidify it’s moat.

  • Intangible Assets (Brands, Patents, Regulatory Approvals): Luckin has brand recognition in its target cities in China, however, the company previously had to reconstruct its brand after the accounting scandal, so brand loyalty might not be that strong when compared to competitors like Starbucks. The company has no meaningful patents or regulatory approvals that protect its business.

  • Switching Costs: As a brand built around convenience, it has some switching costs when consumers have loyalty and rewards programs associated with their account, but overall, switching from a new app isn’t too much hassle to do, and this moat is somewhat limited.

  • Network Economics: There isn’t a strong network effect for Luckin. While more locations may provide more convenience, it does not directly translate to more customers in a non linear fashion.
  • Cost Advantages: The company has a somewhat sustainable edge due to its lower labor cost, but nothing that its competitors cant quickly copy. It’s also starting to leverage technology to improve the efficiency of its process.

Understandability:

The business of selling coffee and other related products is relatively straightforward, but the various components of their business model and the history the company has are a bit complicated to understand.

  • The various aspects of their business are easy to grasp, but how they interact with each other in different markets in China may be a bit tough to completely grasp.
  • The regulatory environment is something that an international investor needs to be fully aware of.
  • The past issues of accounting scandal are something that an investor should also be aware of.
  • For the above reasons, Luckin’s understandability is rated a 3 / 5.

Balance Sheet Health:

Luckin’s balance sheet shows signs of improvement, but their capital structure makes some of their financials risky.

  • They have improved cash flow, reduced debt, and added to equity.
  • They have a very high degree of goodwill on their books (RMB 1.40 billion in 2022).
  • The company still has large outstanding leases liabilities and debt.
  • Overall though, their improved profitability and management decisions to reduce debt, gives a decent level of strength for the company’s financials which is why it is rated a 4 out of 5.

Recent Concerns/Controversies and Management Response:

  • Historical Accounting Issues: The main issue that plagued the company, was their accounting scandal in 2020. Since then, the company has re-evaluated its financials, and is also delisted from the NASDAQ and moved to the OTC market. These events have definitely caused damage to the company’s reputation. The company has been audited by new independent auditors to provide additional transparency.

  • Competition: As stated above, the competitive landscape is very crowded and they face competition from both national and international brands, so it’s very important that they are able to retain and also attract customers.
  • Regulatory Risk: China’s regulatory environment continues to change and investors need to consider the risks that come with these changes.
  • Management Response:
  • Luckin’s management has focused on rebuilding trust, profitability, and efficiency. This strategy has focused on improving operating margins by reducing costs and increasing same-store sales. The CEO of the company had mentioned that the main focus is now on profitable growth and increased profitability. The company has mentioned that they are working closely with their accounting partners and regulators to remain as transparent as possible.

Conclusion

Luckin Coffee has shown strong signs of a turnaround but remains a risky investment, as competitive and regulatory risks are an important challenge for the company to consistently produce superior results for shareholders. By improving fundamentals, maintaining profitability and working towards a leaner balance sheet will allow the company to dig deeper and build its moat to create a worthwhile long term investment.