Luckin Coffee Updates: Luck In Hand (Part VII)
Competition and Cost Structure
Margin and Wealth Compounder
As discussed in the earlier sections, the People, Products and Places have all been lined up perfectly for LKNCY over the past three years. LKNCY is in a defensible virtuous cycle of profitable growth and is shaping up nicely as a wealth compounding machine. In this section, we will analyze the competition, cost and wealth compounding effect.
1) Competition
LKNCY has only one direct competitor in China, Cotti Coffee, which ironically was founded by Luckin’s oustered founders Charles Lu and Jenny Qian in October 2022. Cotti pursued a very aggressive growth strategy with only franchised stores and has opened more than 5,100 stores in China in a year and also entered five other international markets. So far Cotti Coffee has been taking a “free ride” strategy quite successfully by opening all its stores very close to the Luckin stores as the specific location has already been tested by Luckin. The pricing strategy of Cotti Coffee is also very aggressive at 8.8/9.9 yuan per cup aiming at poaching Luckin’s customers in each location. This is probably why LKNCY chose to implement the lower margin for market share strategy for at least two years. We think that the company’s strategy makes great and timely sense for two reasons:
LKNCY is now capable of flexing its muscles. Unlike three years ago, LKNCY is profitable and has a strong balance sheet with net cash. It now has both the capability and resources to execute a low pricing strategy whenever it wants without jeopardizing its own profitability. As mentioned in the Investment Thesis, we call it a Costco moment for LKNCY: the company chooses to lower the prices simply because it can!
The strategy of lowering the margin to maximize market share is preemptive and necessary to extend and fortify its already dominant leading position. Even though LKNCY is the largest coffee chain in China both by store count and by revenue, its market share in absolute terms is still small as Chinese market is very fragmented and super competitive. According to iResearch Consulting Group, the market for freshly brewed coffee segment (i.e. coffee chains) in China could reach 192 billion yuan or US$26 billion in 2024. LKNCY and Starbucks China each generated around $3 billion revenue (TTM) as of 3Q 2023, implying a 11.5% market share each. In other words, the top two coffee chains in China combined only accounts for 23% of the total market share. LKNCY can have tons of room to grow and should capture the market share as quickly as it practically can.
Cotti Coffee obviously has a very savvy management team but the jury is still out on whether its growth strategy is sustainable. Its two founders were ousted from Luckin due to the role they played in the accounting scandal in 2020. This tainted history will most likely limit their access to capital market any time soon, especially the IPO market in the US, Hong Kong or China Mainland. Besides the potential funding constraint, Cotti will have to do an impeccable job managing team training, logistics, product quality and customers experience as the company grow so big so quickly. Margin for errors will be very thin. LKNCY is definitely in a better position in this ongoing price war with its former founders and we are curious to see whether there could be unintended casualties from this price way, such as SBUX, Costa Coffee, Manner Coffee and other small independent coffee chains.
2) Cost Structure
LKNCY generated 14.5% EBIT margin on trailing twelve months basis as of 3Q 2023, only slightly lower than that of Starbucks during the same period (15.3%). This is a really remarkable achievement because it only took LKNCY three years from having operating loss to being on par with the formidable industry leader SBUX. The following chart illustrates the trajectory of LKNCY’s quarterly EBIT margin improvement. The key breakthrough of this turnaround actually happened as early as 2Q 2021 when the quarterly operating loss narrowed dramatically to -2% from -29% in 1Q 2021 and revenue jumped 51% quarter over quarter thanks to the successful launch of coconut milk latte.
LKNCY Quarterly EBIT Margin
Source: Company filings.
How did LKNCY pull this off? The simple answer is growing its revenue faster than the expenses. That is exactly what LKNCY did over the past three years (see chart below). In 3Q 2023, as part of the company’s margin for market share strategy, its quarter or quarter revenue growth rate lagged that of the expenses, which led to 6 percentage drop of its EBIT margin. In the earnings call, management indicated that the EBIT margin could remain low during 4Q 2023.
LKNCY QoQ Growth Rate: Revenue vs Expenses
Source: Company filings.
Now that the lower profit margin could be a new normal for LKNCY, we analyzed the five key drivers in its cost structure in order to have a better assessment of the profitability potential, i.e.
Cost of materials
Store rental & other operating expenses
Sales & Marketing
G&A Expenses
Delivery Expenses
We have calculated each cost component as a percentage of revenue and as a percentage of total cost (see charts below). A cost component as a percentage of revenue shows the relative weighting relative to the revenue which could reflect the benefits (or the lack of) of the economy of scale, especially for fixed cost. A cost component as a percentage of the total cost reflects the relative changes among the components within the cost structure, more of an indicator of financial discipline and efficiency.
Cost Structure
Source: Company filings.
One immediate observation from these charts is that for all five cost components, their respective weightings as a percentage of the revenue (blue line in the charts) started above the weightings as a percentage of the total cost (red line in the charts) three years ago in 3Q 2020 but had been trending down with the blue line being solidly below the red line in 3Q 2023. Obviously, this shift was largely due to the economy of scale effect.
The pivotal point of this blue line red line switch happened around 1Q 2022, which coincided with the timing LKNCY accelerated its pace of opening new stores to then the historic high of 6 new stores per day from 3-4 stores per day during 2021. That was also about three quarters after the historic launch of the first ever blockbuster product at LKNCY (most likely for the entire coffee industry in China), the coconut milk latte. Looking back at that period now, it seems to us that the Three Pillars had worked in the following sequence: a blockbuster product (the Products Pillar) generated unprecedented revenue and publicity (yes, the blockbuster product itself was successful marketing), more customers (the People Pillar) as a result were attracted to the brand and quickly retained as the transacting customers, and at this point the company accelerated the pace of new store openings (the Places Pillar) to amplify and fortify the “feat”. A flywheel was formed and the rest was just history.
The largest component in LKNCY’s cost structure is cost of materials which accounted for over 50% of the total cost in 3Q 2023, up from mid-thirties in 3Q 2020. This makes sense as the cost of materials is a variable component which goes up with revenue growth. In LKNCY’s case, the revenue outgrew its cost and as a result the cost of materials as the percentage of revenue actually leveled down from 46% in 3Q 2020 to 40% in 2Q 2023 and back up to 44% in 3Q 2023 due to margin for market share strategy. This was incredible result as it was achieved during the period when the price of Arabica coffee beans (key raw materials for Luckin) shot up and stayed high during the period (see chart below). Cost of materials could get additional benefits from logistics efficiency and vertical integration after the new roasting facility in Kunshan is put into operation in 2024 though we do not have enough data to quantify that.
Coffee Bean Price Chart
Source: tradingeconomics.com
Store rental & other operating expenses in theory are also in the variable cost category positively correlated with the store expansion. With the accelerated store opening pace, in the past three years, we would expect the weighting of this line item in the cost structure to go up year over year. However, that is not the case at all as the revenue growth outstripped that of the store rental by a large margin, which drove down the store rental and other operating expenses from 35.7% of the revenue in 3Q 2020 to 19.8% of the revenue in 3Q 2023. As a component within the cost structure, the store rental and other operating expenses were very well managed at the level of between 22% to 25% of total cost. LKNCY should still have additional levers to pull to contain and even lower the store rental and operating expenses. The obvious one is to leverage its technology advantages to open and manage more partnership stores.
G&A expenses is the only component that dropped over the past three years in both measures, which is understandable as they are mainly a fixed cost that benefits greatly from the economy of scale. As the company continues to grow at the current speed, its G&A expenses still have room to go lower. As a comparison, YUMC’s G&A expenses were 5.8% of revenue and 6.5% of total cost in 3Q 2023 while LKNCY’s were about one percentage points higher at 6.7% and 7.7% respectively. As discussed in the store network section, we believe that LKNCY will surpass YUMC in store count by the end of this year. It is reasonable to expect that LKNCY can close the gap on G&A expenses also.
LKNCY made significant changes in its sales and marketing strategy in 2020 to laser focus on more efficient marketing efforts driven by its technological advantages. As a result, its sales and marketing as a percentage of both the revenue and the total cost dropped from 14.7% of revenue and 10.5% of total expense in 3Q 2020 to only 4.8% and 3.5% respectively in 4Q 2020. Since then, those numbers climbed slowly as LKNCY’s business not only turned around but also reported explosive sales growth. As of 3Q 2023, Sales and marketing 5.2% of revenue and 6.2% of total cost which was at the highest level since 4Q 2020 but still in a very disciplined fashion. We think this cost component will remain at the current level and may even be a bit higher due to the execution of margin for market share strategy.
Delivery expenses had showed totally different trajectory from the other four cost components mostly due to COVID which had profoundly changed the consumer behavior in China up until 4Q 2022 when zero COVID policy was lifted. We would only look at the numbers in 2023 to gauge the normalized level of delivery expenses as the percentage of the revenue and the total cost. We are of the opinion that the delivery expenses could have room to drop further both in absolute terms and as a percentage of the revenue and total cost. The key driver is the store density as the coffee drinkers could most likely opt for pickup than delivery if a new store is opened nearby. This way the coffee drinkers could spare their share of the delivery fee charged by the third-party delivery platforms.
How have these cost components been impacted by the margin for market share strategy so far? We created the following margin impact analysis using the company’s quarterly financial data in 2023. The key metrics we included are quarter over quarter revenue and expense growth rate, average revenue per store (self-operated vs partnership stores), and cost components as the percentage of total revenue. Under the margin for market share strategy, the average selling price was on purpose kept lower while the selling volume and the variable expenses went higher hand in hand. The net result was lower EBIT margin.
Margin Impact
Source: Company filings.
In LKNCY’s case, the company reported 16% quarter over quarter revenue growth in 3Q 2023, visibly slowing down from the first two quarters this year. More importantly, the revenue growth rate was 12 percentage points lower than that of the expenses in 3Q 2023, mostly caused by the effects of implementing the company’s margin for market share strategy.
The trend was captured by average revenue per self-operated store which dropped 6.7% in 3Q 2023. This drop could be partially caused by faster new store openings. It was also because the company’s self-operated stores are all located in the first and second tier cities which are the main battlefield between LKNCY and its competitors, such as Cotti Coffee. These stores were negatively impacted more by the price war than the partnership stores. The average revenue per partnership store was actually trending higher each quarter during the first three quarters in 2023 which could be a reflection of lower competitive pressure in the lower tiered markets.
If the cost structure was broken into independent components, all the cost runup could be attributed to two cost components, i.e. cost of materials and store rental and other operating costs. Cost of materials as percentage of revenue went up by almost 4 percentage points from 2Q 2023 to 3Q 2023 while the store rental and other operating costs was up 1 percentage. Cost of materials was driven up by higher selling volume as a result of lower price. High selling volume in turn led to more in store staff and payroll expenses.
As a stress test, we assume that EBIT margin drops by half from 13% in 3Q 2023 to stay at 6.5% through 2024 which implies a net income margin of 4.9% assuming 25% tax rate. If we use Seeking Alpha’s revenue forecast of $5 billion in 2024 (43% year over year growth), the net income for 2024 would be $245 million, implying a P/E ratio of 32x based on $7.9 billion market capitalization on December 8, 2023. If we assume that low pricing strategy generates faster revenue growth at 60%, i.e. $5.6 billion revenue and $275 million net income in 2024, the implied P/E ratio would be 28x. The P/E ratios in both scenarios are actually within the 25x-35x range we discussed earlier in the valuation section. However, if the price was indeed leads to a much lower EBIT margin at this stress test level, we would have to quote what the famous economist Keynes once said to those LKNCY’s competitors, “the markets can remain irrational longer than you can remain solvent.”