Luckin Coffee: In Luck in China?

06/21/2019 5:00 am EST

Focus: GLOBAL

Carl Delfeld

editor, Cabot Emerging Markets Investor

I suggested caution a few weeks prior to the initial public offering of Luckin Coffee ADR (LK); the IPO was priced at $25, quickly lost steam, moving as low as $14, before climbing back, observes Carl Delfeld, global expert and editor of Cabot Emerging Markets Investor.

No question this is a big growth story, with Luckin since June 2017 opening 2,400 coffee outlets in 28 cities and gunning for 4,500 by the end of 2019.

This would put the company ahead of Starbucks (SBUX) in China by the end of the year. Starbucks has a goal of having 6,000 stores in China by 2022 and has a deal with Alibaba (BABA) to deliver coffee.

Keep in mind that Luckin’s model is very different than that of Starbucks. Luckin outlets are usually quite small delivery points with customers using apps to order and then pick up at a pre-determined time.

Luckin in 2018 had only $125 million in revenue and lost $238 million before taxes. One reason why: their coffee is priced at a 20% — 50% discount to Starbucks’ and they have so far given away a lot of free cups of coffee to get things moving.

The big attraction here is that history shows that with economic development and higher incomes comes higher consumption of coffee — even in tea drinking Asia.

The average Chinese only drinks between 5-6 cups of coffee per year. That’s per year—not per day! For Taiwan, the number is 209 cups of coffee per year, for Hong Kong, 249 cups, and for Japan it is 279 cups of coffee.

You can see the upside, which is why Starbucks is making a major bet on China since opening its first store in 2000. LK’s competitive advantages include:

1) exposure to a rapidly evolving coffee culture in China where the average annual consumption is only six cups per year;
2) limited direct competition;
3) low development costs;
4) better tech and data analytics than peers;
5) low per-unit cost structure, and
6) the ability to take its model to other markets in Asia.

Another plus is that three well-regarded investment firms have recently picked up research coverage of LK. Morgan Stanley has it rated a buy, Key Banc has a $22 price target, and Needham has it rated a buy. Several large hedge funds have reportedly also taking some significant positions.

Given that LK is a young company with a long way to go before becoming profitable, this is an aggressive recommendation and I suggest you put in place a 20% trailing stop loss. For now, we would recommend buying one half our out intended position in the stock.

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