Luckin Coffee Updates: Luck In Hand (Part VIII)

Wealth Compounder

3) Wealth Compounder

In the process of our analysis of LKNCY’s technology, people, products and places, it becomes more and more obvious to us that the company is forming up as a wealth compounding machine.

Based on 3Q 2023 revenue ($987 million) and store count (13,273), the company generated $74,350 quarterly revenue per store or $297,400 annual revenue per store. Though the company reported 14% net income margin in 3Q 2023, we used a more conservative 8% net income margin to reflect the impact of the “lower margin for market share” strategy. At 8% net income margin, the company can generate $23,792 annual net income per store. As mentioned before, the upfront cost of setting up a pickup store is about $56,200 which means that the annualized return on this investment could be 42% when the net income per store hit the average level in 3Q 2023 of $23,792. We would do this trade all day long.

The store level calculation above uses a lot of assumptions which could be simplistic. We repeat the exercise at the corporate level using several different return metrics, such as return on assets (ROA), return on equity (ROE) and return on total capital (ROTC). LKNCY would lead its peers on all these metrics (see table below) as of 3Q 2023. The only exception is ROTC where SBUX is higher than LKNCY, only because SBUX has a negative shareholders equity which distorted the calculation. It is interesting that LKNCY’s ROE is at 41%, very close to the store level investment return of 42% we discussed earlier.

Return Comparison: LKNCY vs Industry Peers

Source: Seeking Alpha.

Key Risks

1) Customer royalty.  Over the past few years, the consumer behavior in China was heavily influenced by COVID shutdown and economic down cycle. LKNCY had established very sizeable client base for its high quality high affordability product offerings. The jury is still out on whether its customers are “sticky” when the economic cycle turns for the better and consumers start to seek “consumption upgrade”.

2) Growing pains. The companies, such as Starbucks, Chipotle and Haidilao, all came across similar challenges in their high growth phase as the store growth might not be fully in sync with adequate logistics and team size. LKNCY should have already learned this in a very hard way as the account scandal created by its ousted founders was driven by the mistake of “growth at any cost”. LKNCY under current management has put the company back on track of profitable growth. More importantly, LKNCY’s technology platform could readily address these potential challenges in the high growth stage.

3) Competition. Given LKNCY’s current leading position in the industry, it will be very hard for any new entrant, or small or medium chains to catch up and compete. However, companies such as Starbucks China, Lavazza (premium coffee chain under YUMC) and THCH, can still create competitive challenges as they all have well recognized brand name, deep pocket investors or parent companies, and highly experienced local management.

4) China economic downturn. China economic recovery is still weak which will certainly negatively impact consumer related sectors should the weakening trend is not timely reversed by the government. LKNCY could somewhat cushion the impact as it has positioned its products as high quality and high affordability, which is exactly what Chinese consumers would like to have during an economic downtown.

Conclusion

Despite the spectacular business turnaround and solid stock performance, LKNCY is still undervalued versus its industry peers with over 60% upsides in our base case scenario over the next 12 months. Given its leading and sustainable industry position, our investment thesis about LKNCY is not about closing the valuation gap with its peers, but about commanding a premium over them.  We would not be surprised if LKNCY, with luck in hand, can achieve that goal in which case the price upside could be over 200%.

The risk/reward is certainly very different from when it traded at $8 per share, however, it is evolving into a Warren Buffett style long term buy and hold stock. TH International Limited (THCH), on the other hand, provides the asymmetrical risk reward profile we used to see in LKNCY back early 2022, and is well worth looking into (our THCH writeups are here and here).