Luckin Coffee: A Fascinating Turnaround Story
Luckin Coffee Inc (LKNCY) was founded in June 2017. It has since become the largest coffee chain in China with more than 12,000 stores. The companys previous management team defrauded investors in 2020 which resulted in Luckins delisting from Nasdaq. After the delisting, Luckin Coffee Inc (LKNCY) went through two years of debt restructuring, change of management team, and the settlement with the SEC. Today Luckin Coffee Inc (LKNCY) has emerged as a much better and stronger business.
Under-penetration of Chinas Coffee Market
According to Deloitte, in 2021, the per capita annual coffee consumption in mainland China was only 9 cups, much less than Japan, U.S and South Korea, which has per capita annual coffee consumption of 280 cups, 329 cups and 367 cups each. The per capita annual coffee consumption in mainland China is only 3.21% of Japan's, 2.74% of the United States', and 2.45% of South Korea's.
Even in Shanghai, which has the highest per capita consumption of coffee in mainland China, the current per capita coffee consumption is merely over 20 cups per year. Whats more interesting is that Deloitte found that of habitual coffee drinkers, more than 50% are constantly increasing their coffee consumption, thereby developing a coffee drinking habit. Consumers in 1st-tier cities, in particular, are becoming more dependent on coffee, and are now more likely to consume more cups of freshly brewed coffee.
Clearly, China still has great potential in per capita coffee consumption, the industry is far from mature.
Business Models in Chinas Coffee Market
Within Chinas freshly brewed coffee market, there are mainly five types of business models: large store, small store pick-up, boutique chain, fast food stores, and convenience stores.
Starbucks dominates the large store segment with almost 6,600 stores. Tim Hortons have grown rapidly in China with more than 700 stores. COSTA, Peets Coffee and Lavazza are other major players in the large store segment. The large store model requires heavy up-front capital expenditure and high operating cost. Therefore, they charge more for their products. One cup of coffee costs between 30 and 40 yuan for the large coffee chains.
Boutique chains focus on quality and charge less than the large chains. Major players include Manner, M-Stand, Seesaw, and Arabica. These chains often feature Nordic style design and a simplified menu. These boutique shops mostly operate in tier-1 and top tier-2 cities. Shanghai is the most important market. Currently the biggest two players are Manner, which has more than 500 stores, and M-stand which has almost 400 stores. Boutique chains customers are very sensitive to the taste and flavor of coffee. After discount, one cup of coffee costs between 18 and 30 yuan.
The Small Store Segment
The small store segment is very different. The shops are small and often only offer pick-up services. Both up-front capital investment and operating cost are low. Although they are branded as coffee shops, their products are often called beverage coffee because they are a combination of milk-tea and coffee. One cup of coffee costs between 9 and 18 yuan. Although Luckin Coffee Inc (LKNCY) dominates this market, competition has picked up.
Fast food stores mostly sell cheap to-go coffees that customers order with food. They dont really compete with the other three types of coffee shops.
Convenient stores such as 7-Eleven and Family Mart also sell cheap to-go coffees. One cup of Americano costs between 6-10 yuan. Undoubtedly, they offers a very compelling value proposition for many consumers but customers cant pre-order on their smartphones.
To sum up, Chinese coffee market has five major segments. Each segment has its own consumption characteristics and competitive landscape. Although Starbucks and Luckin Coffee Inc (LKNCY) both sell coffee, they are completely different businesses. Since this article is about Luckin Coffee Inc (LKNCY), Ill write more about the small-store segment and Luckins competitive advantages in this space.
Luckin Coffee Inc (LKNCY)s Dominance in the Small-Store Space
As mentioned above, Luckin Coffee Inc (LKNCY) dominates the small-store space of Chinas coffee market. Before the accounting scandal, Luckin was even more dominating. But Luckin had to halt its business expansion for a few months after the scandal. Luckins competitors such NOWWA Coffee and Xingyunka grabbed the opportunity and expanded rapidly. However, neither NOWWA nor Xingyunka posed serious threats to Luckin. After resuming expansion plan, Luckin quickly regained market share and remains the dominant position.
Luckins Competitive Advantages
The reason why Luckin can still dominate the small-store segment is that Luckin has a few competitive advantages against its competitors.
First of all, Luckin Coffee Inc (LKNCY) has successfully established a brand image of young, modern and energetic. Luckin partnered with celebrities such as beloved Chinas singer Han Lu and winter Olympic gold-medalist Aileen Gu in its advertising campaigns. Both Han Lu and Aileen Gu are young, energetic and successful.
Secondly, Luckin Coffee Inc (LKNCY) has a research lab of more than 60 employees. Their job is to develop and optimize different flavors as quickly as possible. This research lab enables Luckin to come up with blockbuster products such as Newer Latte, Coconuts Latte and the recently launched Sauce-flavored Maotai Latte. For flavored latte, there is clearly a first-mover advantage. Luckins competitors have tried to copy Luckins Coconuts Latte but none is successful. Consumers clearly have associated Coconuts Latte with Luckins brand.
Thirdly, because of the first-mover advantage, Luckin Coffee Inc (LKNCY) has occupied the best locations for its directly-owned stores. And Luckins brand has attracted the best franchisees because Luckins shops are much more profitable than competitors shops.
Last but not least, Luckin Coffee Inc (LKNCY) has built its own large and complex supply chain. This gives Luckin an enormous scale advantage in terms of raw material and equipment procurement.
Luckins Response to New Competitors
Luckins moat was tested recently with the emergence of a very formidable new competitor. In November 2022, the man who was responsible for Luckins fraud, namely Zhengyao Lu, founded another coffee brand called Cotti Coffee to compete against Luckin. Within less a year, Cotti has opened almost 6000 stores across China. Cotti basically copied Luckins playbook and started a pricing war with Luckin. Cottis price was 3-4 yuan less than Luckin in its early expansion stage.
Luckin Coffee Inc (LKNCY) was caught off-guard by Cottis rise. But on June 5th, Luckin Coffee Inc (LKNCY) announced its own weekly 9.9 yuan coupon event, placing significant pressure on Cotti. In consumers mind, Luckin deserves a pricing premium over Cotti. Therefore, Luckin can constantly charge a small premium. This makes it impractical for Cotti to keep lowering the price. After Luckins response, Cotti is rapidly losing momentum.
Furthermore, Luckins recent partnership with Maotai solidified Luckins lead in the game. Luckins Maotai Latte sold more than 5 million cups on its first day of launch and brought in more than 100 million yuan of revenue. Luckins partnership with Maotai is exclusive. Therefore, Cotti wont be able to copy Luckins blockbuster product this time.
Conclusion
Luckin Coffee Inc (LKNCY)s turnaround is one of the most fascinating business case studies in recent years. The business restructuring and SEC settlement has made Luckin Coffee Inc (LKNCY) better and stronger. With Chinas growing coffee market and Luckin Coffee Inc (LKNCY)s competitive advantages, Luckin Coffee Inc (LKNCY) is well-positioned to continue to grow in the next few years.
This article first appeared on GuruFocus.