Game of foams

Starbucks’ business in China was lossmaking for the first nine years after it opened its first cafe in Beijing in January 1999. Investors weren’t happy with all that red ink but company founder Howard Schultz argued that some pain was inevitable in the bid “to introduce the coffee culture to a country that’s so used to tea”.

By 2013, Starbucks had turned much more profitable in China and outgrown its competitors with a network of more than 500 outlets. But the Seattle-based firm had a new problem with CCTV, the state-run broadcaster, which was irked that the brand’s coffee was more expensive in China than in any other market.

A regular cup of latte, CCTV noted, cost less than Rmb5 to make but was selling for Rmb27 (about $4) in China. The same drink was priced at Rmb24.25 in London, Rmb19 in Chicago and Rmb14.6 in Mumbai. Hence Starbucks was making “unreasonable windfall profits” in the Chinese market, it warned viewers, feeding on consumers’ “blind faith in foreign brands”.

Starbucks’ fans went online to defend the chain. They argued that if the American firm had priced its coffee unreasonably there would be ample room for a local player to offer cheaper alternatives and challenge Starbucks’ dominance.

Maybe CCTV feels vindicated, as just such a challenger emerged last year in the form of Luckin Coffee. And despite being in business for less than two years, the Chinese upstart is on the verge of going public in New York. The listing has fuelled debate among analysts and investors about the growth models of both Starbucks and Luckin.

What is Luckin Coffee?

Most of the founders at Luckin arrived from the ride-hailing platform UCAR, which is controlled by Hong Kong-listed CAR Inc. Luckin’s chairman Charles Lu is a major UCAR shareholder and its CEO Jenny Qian served as chief operating officer for UCAR, a ride-hailing service, from 2016 to 2017. It was also a company that grew at light-speed, progressing from incubation to a $5.5 billion valuation at IPO in about 18 months.

Luckin’s start-up capital mainly came from local private equity investors close to Lu, WallStreet.cn has reported, and it only opened its first coffee store in January last year.

After a similar period of rapid growth, it has since enticed the likes of BlackRock and Singapore’s GIC to become investors. According to its IPO prospectus, which was filed with US regulators last month, its retail network had grown to 2,370 stores nationwide as of the end of March. All these stores are self-owned – Luckin has shunned the franchise model as it grows.

In comparison, Starbucks now operates 3,600 stores in more than 150 Chinese cities. Its network is expected to top 5,000 by 2021 as it expands at a rate of one and a half outlets a day. Yet incredibly Luckin could still unseat Starbucks as the country’s biggest coffee chain by the end of 2019 as it is pledging to open 2,500 more of its own outlets this year alone.

The start-up is looking to raise up to $586 million with its Nasdaq listing. If investor demand is strong and it prices its shares at the top end of the range, the IPO would give the coffee firm a market capitalisation of close to $4 billion.

That kind of valuation is a long way back on the same metric for Starbucks (the multinational had a market capitalisation of about $95 billion as of this week). Nonetheless, Luckin’s rise has been a rapid one. WallStreet.cn notes that many in the industry are still coming to terms with how the newcomer could be claiming unicorn status (i.e. a company worth at least $1 billion) in barely a year after brewing its first latte.

How did Luckin get started?

Luckin first appeared in WiC in April last year after it told local media that it had already opened 300 or so stores in just three months of operations (see WiC406). For comparison, it took 12 years for the UK’s Costa Coffee, China’s number two coffee chain prior to Luckin’s emergence, to attain similar scale.

At that time, Luckin was operating about 200 “delivery kitchens” and 83 “pick-up stores”. The rest of its outlets, mainly for image-building purposes, were termed “relax stores”, meaning they had more costly lounges that allowed consumers to drink their coffee onsite (like a typical Starbucks).

This sales model – emphasising deliveries and pick-ups – underlined Luckin’s strategy for disrupting the status quo in the coffee chain model. While Starbucks takes pride in the “third place” concept – offering another venue outside the home or the office where people can hang out – Luckin focused on “delivery kitchens” that pump out coffee to be couriered to customers’ desks or homes. Orders are made on its app and delivery is promised within 30 minutes.

The “pick-up stores”, as their names suggest, aren’t places to hang around either. No cash is accepted. Customers have already paid for their app-based order. They pick up their drink and depart.

Luckin says its online-to-offline (O2O) model has helped it price its freshly brewed coffee at a discount to Starbucks’ (at least 25% cheaper for most drinks).

Combined with some clever marketing via social media platforms such as WeChat, Luckin was an instant internet sensation. The sudden emergence of such an aggressive competitor even forced Starbucks to rethink its approach and it introduced its own delivery service in partnership with the Alibaba-backed food delivery platform Ele.me in August last year.

Luckin has since earned the nickname of “Little Blue Cup”. This refers to its corporate colour but for some analysts it flags a few potentially alarming similarities with the “Little Yellow Bike”. That was the nickname for the bike-sharing unicorn Ofo (its dockless hire bikes are painted yellow), another O2O sensation that grew at breakneck pace before later riding into a cash crunch (see WiC436).

A New York IPO might help Luckin raise another $500 million or so but its listing prospectus mentions similar risks in its growth model. A case in point: rapid network expansion has been fuelled by the addition of cash-burning “pick-up stores”, which had grown to 2,163 by March this year (from 83 a year ago). The number of “delivery kitchens” has actually declined to 98 from 192 during the same period, however. That suggests that Luckin’s initial focus on deliveries hasn’t kept pace with its overall growth. Perhaps its model isn’t proving as disruptive as it first proclaimed.

Is Luckin still keen on coffee delivery?

Were Luckin’s delivery concept working well, many of its stores would become redundant. A growing number of coffee-producing kitchens, supposedly less costly to operate, would give it a financial edge. But the change in the composition of Luckin’s distribution network suggests that it now expects most of its customers to collect their orders from its “pick-up stores”. Perhaps the company has been put off by the unexpected costs of sustaining a coffee delivery service – it spent twice as much on delivery expenses in the first three months of this year as on advertising. Many commercial buildings also forbid food delivery staff from going beyond their office lobbies. That means that Luckin customers have to go downstairs to collect their orders, reducing some of the appeal.

In fact, more than 91% of Luckin’s network are now pick-up stores, some of which are simply coffee machines (made in Switzerland) that churn out orders from customer QR codes. This approach has allowed Luckin’s self-owned network to expand at pace, incurring relatively lower rental and decoration costs (than a typical Starbucks) and offering cheaper brews than rivals. Also significantly the cheaper pick-up stores make Luckin look like a much bigger proposition – on paper, large enough to overtake Starbucks in reach, for instance. Company executives started talking about overtaking Starbucks in outlet terms at the start of this year – probably with an eye to Luckin’s New York listing. Indeed, even if like-for-like comparisons are difficult – given that Starbucks outlets are typically fully-fledged cafes – the metric has been promoted heavily to investors.

Luckin is burning cash?

Luckin’s plan for an IPO has fuelled a lively debate among China’s financial sector bloggers. The coverage has been contentious (online commentators are often hired to generate positive mentions or smear business rivals; see WiC416 for accusations levelled by Bytedance and Tencent at one another for similar behaviour). In one negative piece published on WeChat in early April, Luckin was revealed to have borrowed Rmb45 million from a financing firm by collateralising its coffee machines in several major cities. That stirred concerns over its financial health. Although the company explained it as “standard financing”, critics used the story as ammunition for speculation on whether Luckin was heading in the same direction as Ofo (see WiC439).

Luckin lost Rmb1.6 billion in 2018 and Rmb550 million in the first quarter of this year. It managed to generate about Rmb4 billion in funds last year (from private equity investors and borrowing) but by the end of 2018 there was only Rmb243 million of cash or equivalents sitting on its balance sheet.

One of the main reasons for burning through the funding was Luckin’s reliance on customer subsidies to drive sales growth, especially its bid to make its coffee cheaper than Starbucks’.

It sold 85 million cups of coffee last year and more sceptical analysts have been quick to point out that all this means is it lost Rmb18 for each coffee that it sold.

Compare this, says the Financial Times, to the sales performance at Starbucks stores which are bringing in much more revenue from higher-paying customers who stay for longer.

While the average Luckin store makes daily sales of $334, Starbucks outlets in the Asia-Pacific region (where China accounts for 40% of stores) sell nearly five times as much.

Getting customers to spend more will be challenging for Luckin, the FT predicts.

Other analysts have described Luckin’s pricing strategy as akin to pengci or “hitting porcelain” – a phrase for scammers who throw themselves in front of cars and feign injury to solicit compensation from drivers (see WiC372).

The “porcelain” in this case is said to be Starbucks, with Luckin determined to disrupt its business in China to the point that it gets a buyout offer from its bigger rival (some of the more cynical bloggers think this is the company’s true goal).

If so, Starbucks isn’t showing much sign of feeling the pressure yet. “We’re generating the return on invested capital that we believe is sustainable to continue to build new stores at this rate for many years to come,” its CEO Kevin Johnson told CNBC in an interview last week, also suggesting that Luckin’s “heavy, heavy discounts” were not going to deliver the same kind of sustainable business model.

So is Luckin a genuine challenger to Starbucks?

Just a few months after opening its first store last year, Luckin said it had filed an antitrust lawsuit against its American rival. The filing accused Starbucks of using its scale to pressure landlords in its negotiations over leases – alleging in particular that clauses were inserted t0 prevented landlords from renting space to its competitors, including “any store that includes the word ‘coffee’ in its name”.

(This bargaining power, the Economic Observer newspaper suggests, comes from the footfall Starbucks brings to other tenants in the same area.)

The hearing for the case is still pending but the rivalry with Starbucks has cropped up repeatedly in coverage of Luckin’s IPO roadshow in the last few weeks. But as they have come to understand the company better some analysts have started to talk about other comparisons, noting that Luckin is “more 7-Eleven than Starbucks”.

“If convenience is your main selling point, what’s to stop an established convenience store chain – 7-Eleven, say – from launching a similar app and selling discount coffee from its 2,892 existing stores in China?” Jeffrey Towson, a professor at Peking University and private equity investor, told TIME magazine this week. “Luckin’s business model is innovative but vulnerable to imitation.”

Huxiu has come to a similar conclusion on who to benchmark as Luckin’s real competition. A cup of latte at Starbucks is now selling for about Rmb30, the news portal noted, which is already higher than Luckin’s advertised price of Rmb24. However, Huxiu says that the prices for Luckin’s lattes drop to Rmb12 or less when various customer subsidies are factored in. “Luckin’s real target is never Starbucks,” it suggested. “Its real rivals are the coffee machines in the pantry.”

That said, Luckin argues that there is plenty of room to grow a profitable business because the average Chinese drinks so little coffee. Consumption was just six cups per head last year, the IPO prospectus claims, compared to 867 by the Germans, the biggest consumers. Even across the Strait in nearby Taiwan they are drinking 209 cups each.

Another option is that once consumers get accustomed to ordering from Luckin, they might pick up other food and beverages from its outlets. In this sense, a national chain of outlets would become mini distribution centres for a range of orders online, bringing in higher revenue per square foot

Indeed, there might be a more immediate boost to sales if the Sino-US trade war further escalates today (see page 9), triggering consumer boycotts of some of the best-known American brands in China. If Starbucks is targeted Luckin looks like one of the most obvious beneficiaries as patriotic coffee drinkers switch their spending to the local champion.

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