Shares of Luckin Coffee (LK: NASDAQ) surged 13.07% on November 13 after the company released its financial results for the third quarter ended September 30, 2019. With store-level profitability of 12.5%, the chain hit the milestone of breaking even at the store-level during the quarter. The result is in line with the aim that Charles Lu (陆正耀) – Luckin’s co-founder and chairman – shared with investors during its second-quarter 2019 earnings call.

The firm reported a three-month revenue of CNY 1.49 billion (USD 208.9 million), representing a year-on-year increase of 557.6%, which exceeds the CNY 1.47 billion average of analysts’ estimates. The net loss was CNY 531.9 million (USD 74.4 million), which was an increase compared to CNY 491.1 million in the third quarter of 2018. However, this figure improved considerably compared to CNY 681.3 million (USD 99.2 million) in the second quarter of 2019, also beyond analysts’ unanimous expectation.

The Xiamen-based company, founded in October 2017, took only 15 months to be listed on NASDAQ in May 2019. The firm accounted for only 2.1% of the coffee brewing market in China in 2018. However, it has already grown to the second-largest participant, and is expected to take over Starbucks as the top player in China by the end of this year in numbers of stores, according to Reinout Schakel, CFO and CSO of Luckin Coffee.

The stores began to make money

Luckin Coffee realized CNY 186.3 million (USD 26.1 million) in store-level operating profit in the third quarter of 2019, representing 12.5% of net revenues from products. The number in the third quarter of 2018 was a loss of CNY 126.0 million.

Unwrapping this 12.5% store-level operating profit margin, Luckin Coffee calculates the number from its quarterly business revenue of CNY 1493.2 million (USD 208.9 million), deducting the costs of materials at CNY 721.1 million (USD 100.9 million), the store rental and other operating costs of CNY 477.3 million (USD 66.8 million), and depreciation expenses of CNY 108.5 million (USD 15.2 million). This means that, according to Luckin’s approach, all expenses incurred on marketing, administration, and store preopening were attributed to the corporate level.

Nevertheless, reaching this break-even point strongly suggests that the coffee chain has taken a big step in improving its fundamentals and structure of operations, which could be due to the following revenue and the cost aspects:

Breakneck expansion, remarkable increase in active consumers and selling price contribute to significant sales growth

According to Luckin, 717 new stores were opened between July to September; the chain had 3,680 stores in operations as of September 30, 2019. Its continuous expansion in terms of new stores has brought the company with a sustainable source of new customers and sales growth.

The company aims to have 4,500 stores as of the end of 2019, which means that it may prepare 820 new stores in the fourth quarter. Based on its incredible growth rate, this is an achievable goal, given Luckin’s vast resources and rich relevant experience.

Apart from its massive expansion in the number of stores, the average monthly total items sold ratio also rose considerably – the number surged 470% year-on-year and 60% quarter-on-quarter, to reach 44.2 million. The main reason for this lies in Luckin's continuous improvement in its product structure.

Xiaolucha (小鹿茶), a separate tea-drinking brand that was launched during the quarter, targets a complementary market, along with various SKUs in coffee and light food – together these advanced the total sales volume of the firm to a large extent.

Non-coffee products accounted for 22% of total sales volume in this quarter, contributing 45% of total revenue; both figures saw a remarkable increase from the same period last year and the previous quarter. This suggests the expansion of its product category effectively improved the output capacity and operational efficiency of the stores.

The average net selling price of all its products has risen to CNY 11.3 per item in the third quarter of 2019. Fresh-brewed coffee recorded a unit price of CNY 11, while the average net price charged on other products – tea and light food – was CNY 12.1, which was the highest level since the start-up of the coffee chain.

According to Mr. Schakel, its key drivers lie in the improvement of Luckin’s user structure. This could be broken down to two aspects: 1. the proportion of new users and users whose consumption behavior is strictly triggered by free gifts is decreasing continuously, and the number of effective users, on the other hand, has been gradually increasing at the same time; 2. an increase in the number of users who pay at the normal price level.

“This trend already occurred in the second quarter of 2019, we saw that it has been continuing in the third quarter, and will be maintained in the forthcoming one,” said Mr. Schakel during the earnings call. “The average selling price is expected to be around CNY 16 to CNY 17 in the long-run, and we will proceed to take action to boost the effective unit price.”

Better cost controls brought by economies of scale and higher operating efficiency

The third quarter of 2019 is the first time the average per cup cost of Luckin’s fresh-brewed drinks was fully covered by its per item net selling price. The number was CNY 9.7, representing a 40% year-on-year narrowing down. This is considered to be a very important trigger of Luckin's store-level profitability.

The lower cost of raw materials and higher operating efficiency, owing to economies of scale, along with enhanced bargaining power and management, contributed to this remarkable improvement in cost control to a large extent.

Xiaolucha injects new energy into the business

Xiaolucha– the tea branch of the company that was split into a separate brand this July, only three months after its unveiling in April – complemented the coffee chain's business by entering the tea-based beverages market in this traditionally tea-drinking country. Targeting lower-tier cities, the hand-brewed tea brand is designed to help the company to cover more areas, and to educate people from the lower-tier markets in forming the habits of consuming java.

Although it is less than three months since Xiaolucha was launched, the brand accounts for 20% of Luckin's total product sales. With a growth rate that far exceeds its coffee drinks, this means that the momentum of the coffee chain will be largely shaped by the development of its tea business over the next few quarters. During its third quarter’s earnings call, Mr. Lu claimed that he believes hand-brewed tea will contribute more than 50% of the company’s revenue in the future.

Unlike its coffee business, via open direct stores, in order to shift part of the expenses, Luckin adopts a partnership model operating its tea branch. Partners are responsible for renting, renovating and operating the store, while Luckin shares its brand image and provides supply chains.

Although the franchise model may contain certain operational and management risks, Mr. Lu said that the company still prefers to operate its tea business with an asset-light strategy – to export its technical systems and methodologies rather than go down the road of cash-burning.

Cash-burning marketing campaign – headwinds still at play

Despite Luckin breaking even at store-level in the third quarter of 2019, its corporate net loss continued to expand year-on-year. The primary reason lies in its cash-burning marketing strategy.

In that quarter, sales and marketing expenses for the coffee chain increased by 147.6% year-on-year to CNY 557.7 million (USD 78.0 million), mainly due to increases in advertising expenses as the company entered into new cities and launched Luckin Tea as an independent brand. According to its financial report, this does not include all promotions and coupons provided to customers other than free product promotion expenses.

At present, marketing is still an important driving force for Luckin's business growth.“Brand building is very important for our long-term development. Our marketing expenses will be at a relatively high level from the second quarter of 2019 going into the second quarter of 2020,” said Qian Zhiya (钱治亚), CEO of Luckin Coffee, during its second-quarter earnings call, “Starting from the third quarter of 2020, this part of expenditures will return to a normal level.”

Moreover, as the company is still expanding at a high speed, the preopening fee for the 820 stores that it expects to open in the fourth quarter is another cost that cannot be underestimated. This suggests that the relevant expenditures will further increase in the fourth quarter.

Therefore, although Luckin realized store-level profitability through sales growth and cost control, its core problem of 'sacrificing profit for scale' still remains unresolved. A large proportion of expenditures still lie in marketing and store preopening activities. These two factors, however, are the key driver of the company's sales growth at the same time. In this case, how to reach a balance between growth and costs could be a sticking point as it goes on pursuing the break-even point at the corporate level.

What's next?

The IPO lockup period for Luckin Coffee expired on November 13, which has been seen as a negative signal suggesting that the stock price will stumble afterwards. However, with the release of its third-quarter results on the same date, the company is showing the market a very different path. With its strong third-quarter results released on the same date, its stock price popped incredibly – and this momentum has been carried to the following trading days of the week. This suggests investors’ optimism regarding the future of the Chinese coffee chain, which is on the track in taking over Starbucks to be the number one player in China’s coffee beverage market.