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Replaying Luckin’s Financials and Strategies: What Went Wrong? Part 2/2
COVID-19 and China
Image credit: Luckin Coffee.

In the previous article, we analyzed the status quo of Luckin Coffee in 2019 after adjustment for its CNY 2.2 billion misconduct. This chapter will discuss the harmonization of coffee with a ‘cash burn’ aggressive expansion strategy in the Chinese market for now.

Luckin vs. other players on the table

With the existing data that can be considered reliable, the average effective selling price of Luckin’s products was generally slightly lower than CNY 10 up to the third quarter of 2019. After its chain formed an initial scale (after the first quarter of 2018), its store-level average items sold per day tended to wax and wane with its net selling price. The figure was slightly lower than 300 in the six months starting from April 2018, and reached a peak of 361 units in the fourth quarter of 2018 due to a price drop, then decreased to around 250 units for the nine months starting from January 2019.

Here are the explanations on the data and relevant assumptions:

# About the price: data up to the first quarter of 2019 is taken from its audited prospectus. Data reported in its second quarter and the third report of 2019 cannot be used anymore as the result of the misconduct, but fortunately, we may get a taste of it from the short-side report published on Muddy Waters Researches – wherein it is claimed that Luckin inflated its effective selling price by 12.3% in the third quarter of 2019. In this case, we can estimate its average selling price during the quarter by deducting 12.3% on its reported figure of CNY 11.2, which gives us a number of CNY 9.8.

As the misconduct on turnovers of Luckin started from the second quarter of 2019, we assume its effective selling price as reported in its second-quarter 2019 report was also manipulated. We assume the degree of this inflation to be similar to that of the third quarter of 2019, so we also applied the 12.3% taken from the report published on Muddy Waters Researches, where the number was obtained from the serious due diligence conducted by its authors.

It has to be mentioned that this is only a rough projection as we didn’t separate out its snacks and tea drinks (which launched in the second quarter of 2019) from coffee. So for coffee alone, the actual price charged would be slightly higher; but anyway, as coffee is the main product of Luckin, and its selling price for other categories does not deviate much from coffee, the difference should not be significant.

# About the quantity: Data up to the first quarter of 2019 is taken from its audited prospectus. As for data for the second and the third quarters of 2019, we first take the adjusted total revenue from products, and divide it by the adjusted average selling price per item, as we just explained above.

For the adjusted revenue from products, we assume the inflated percentages in revenue are the same for all the three quarters subjected to the misconduct. Luckin’s inflated total revenue during the nine months is calculated as the number reported in its existing quarterly report for the second quarter (CNY 909.1 million) and the third quarter (CNY 1.54 billion) plus the number for the fourth quarter (CNY 2.1 – 2.2 billion) projected by its board in its third-quarter earnings call, which adds up to CNY 4.6 billion. The misconduct accounts for the CNY 2.2 billion according to its announcement on April 2. Therefore, the percentage is 47.81%.

We have obtained ‘quasi-accurate’ data regarding Luckin’s historical store-level operating figures. So how were Luckin’s results, as a coffee chain store? To answer this question, we have to compare its figures with its peers.

►Luckin vs. Starbucks China: 1/3 average selling price, about 60% items sold per store per day.

Before we move on, it has to be the first mentioned that it is, in fact, not so easy to compare Luckin against Starbucks. The only aspect that is truly similar is that they are both coffee chains in which fresh-brewed drinks are the main product category.

Luckin targets affordability and convenience, while Starbucks emphasizes branding and experience. They are in two different niches in the market, and furthermore, they are probably going to be more and more differentiated from each other.

However, Luckin’s board has always been (almost madly) over-focused on Starbucks China – especially after the company went public. This can be easily observed from their remarks during the conferences at the company.

Therefore, hereby we compare the store-level operating performance of the two to investigate if Luckin truly has the potential to beat the American giant in the Chinese market.

The average net selling price of Luckin was about CNY 10, which is approximately one-third of that of Starbucks China, and meanwhile, with a slogan of “we don’t have to pay for space,” Luckin offers convenient in-store pickup and delivery services rather than a cozy environment.

Considering the position of the two, and the fact that Luckin’s store-level numbers of items sold surpassed those of Starbucks China to a certain extent, we can say that its operations can be considered as satisfactory. However, as Luckin was in its massive expanding stage, the ramp-up period of the new stores would negatively affect its overall performance, so we leave it with some room to compensate for this effect. But anyway, to indicate that Luckin did a decent job on daily operations under a comparable approach, its store-level numbers of items sold should not have a huge gap from that of Starbucks China.

The results for Luckin were sad. Its store-level number of items sold was only about 60% of Starbucks China, under an average net selling price is only one-third of that of the latter.

The only thing that Luckin caught up quickly in compared to Starbucks China was the number of stores; however, the bigger network did not empower it with the capabilities to compete against Starbucks in terms of demand.

►Luckin vs. convenience stores and fast food restaurant chains: Is Luckin really cheap?

In fact, from our perspective, to continue to emphasize the comparison with Starbucks China was a trick used by the board of Luckin to lure the market into looking away from other players in the field that also emphasizes affordability and convenience.

The relevant field includes convenience store chains like FamilyMart (Par Coffee), fast food store chains like McDonalds (McCafe), and coffee store chains that are similar to Luckin Coffee like Manner Coffee. These players – which already have a certain scale and customer base – also offer fresh-brewed coffee with net selling prices that range from CNY 8 to CNY 15.

Therefore, it is actually hard to say that a highly affordable price can contribute to a major competitive advantage for Luckin Coffee.

Is coffee truly a decent category in which to employ a ‘cash burn’ strategy in the Chinese market now?

Based on the following points, the answer to the question is probably a no:

►The user base acquired with heavy subsidies in China is yet to be proven to have rigid demand for coffee.

China has a strong culture of tea, while coffee, as an exotic product, has yet to become a daily essential among the majority of people. According to the prospects of Luckin coffee, the annual per capita coffee consumption in China was only 6.2 cups in 2018. Even if we only consider the urban population aged between 15-60, this number was only about 20.3, which is far lower than the 400 cups level in Japan and South Korea, where people tend to have similar cultures around diet.

As long as there is still not a rigid demand for coffee among the general population, it is hard for a coffee brand that does not have a strong brand and decent taste to simply employ aggressive marketing strategies to attract users with solid retention. Customers that are not coffee lovers themselves but simply attracted by the highly affordable price tend to switch to other substitutes when the price increases.

This is reflected in Luckin’s store-level average number of products sold, which has waxed and waned with its net selling price, as well as the fact that its intrinsic growth (revenue per store) in 2019 was significantly lower than its extrinsic growth (number of stores).

Therefore, for a market whose demand has not yet been proven to be rigid enough among the general population, the aggressive marketing strategy that takes scale as the first place can hardly be efficient. A better path might be to open new stores gradually to test the demand.

►Using the growth strategy of an Internet company cannot help a coffee chain store to avoid the high marginal costs in serving additional users.

Employing the model of an Internet company brought Luckin the capability to get a large user base rapidly. However, this model could not help an Online-to-Offline (O2O) business – where the products are made and delivered to the customer in offline scenarios – to cut expenditure on infrastructures and operations.

However, is Luckin’s idea of offering highly affordable and convenient coffee with a technology-driven model a fundamentally flawed proposition?

Not really, for this reason. The dilemma of Luckin is the combination of coffee – an asset-heavy industry without rigid demand among the majorities in China at present – with a ‘cash burning’ marketing strategy which considers aggressive expansion as the first priority. However, talking about either side – its highly standardized and digitalized approach in operations and productions or China’s coffee market – there is nothing to blame the founders for in wanting to grow in these fertile areas.

*Contributor: Ivan Platonov | Editor: Luke Sheehan

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