Luckin Coffee: Management Prioritizing Expansion Over Profit Growth – Hold (OTCMKTS:LKNCY)

Luckin Coffee’s (OTCPK:LKNCY) stock has been trading down in recent months. On Thursday, it even dropped 10%. I covered Luckin Coffee at the end of 2022 and was careful about the stock. After my article was published, the stock gained. However, right now it is trading near 52-week lows. The last quarterly earnings report, which was rather disappointing, was published on 1 November, 2023. But the company’s stock started depreciating before that, mostly due to the challenging situation in the Chinese economy. My position in the company remains firm. In this article, I will cover the company’s recent news and will also explain why the position on the stock remains unchanged.

Summary of my previous article

Previously, I praised the company’s business model. I particularly liked the fact that the company had very low expenses and was able to expand rapidly thanks to the fact it never spent a lot of money on opening new fancy outlets the way companies like Starbucks (SBUX) did this. However, I was skeptical about its results’ sustainability. I also cited the company’s problems with the SEC, the fact that Luckin’s stock was delisted from the NYSE, and the fact that it is traded over the counter on the OTC. Moreover, in my opinion, the shares were far too overvalued at the time. The stock gained 11% versus the S&P 500’s 25% increase as I am writing this. But I still think the company is not too cheap. Let me explain why.

Luckin Coffee’s earnings

We can see that the company has been recording outstanding sales growth since its establishment in 2017.

Click to enlarge

Source: Seeking Alpha

You could argue that the TTM (trailing twelve months) figures are brilliant and suggest the company’s net profit margin is 12.1%. But the TTM figure does not cover the entire 2023, including 4Q 2023. For the whole of 2022, the net profit margin was 3.67%, whilst in 2021, it was 7.26%.

So, in order to get a better idea of the company’s earnings picture, we should have a better look at its quarterly earnings history.

Luckin Coffee has improved its earnings figures since my last article.

Below I have put the key figures from the company’s earnings reports, namely Luckin’s quarterly net income and revenues. The 2023 sales and earnings figures are not out just yet. However, the quarterly figures suggest some very sound improvements over the time period.

Click to enlarge

Source: Seeking Alpha

At the same time, if we have a close look at the September 2023 figures and compare these to the June 2023 period, we will see that the net income has decreased somewhat, whilst the total sales rise was not very dramatic. This was mostly due to the fact the total operating expenses increased thanks to the company’s business expansion. So, the operating expenses totaled 86.6% of net revenues in the third quarter of 2023. This happened because of the rise in the cost of materials, whilst the average selling price of the company’s products declined.

Dr. Jinyi Guo, Luckin’s CEO, said the company increased its footprint with more than 2,400 net new store openings. During the third quarter of 2023, Luckin’s average monthly transacting customers totaled 58.5 million, a 132.9% year-over-year rise. The profit margin, meanwhile, decreased substantially.

The growth rate has also been impressive over the 2022-2023 period if we have a look at the company’s number of stores and net new store openings.

In fact, it took the company just one year to almost double its number of stores.

The average monthly transacting customers has risen from 25 million to 58.5 million. This is a whopping increase for one year.

At the same time, we can clearly say that Luckin’s profitability margins are lower than those of its peers. This is especially true if we have a look at the company’s profit margin below. Note the figures are given for the 2022 period.

It seems the management considers growth to be more important than profits. Here is a quote from Luckin Coffee’s company statement. I have emphasized the most important parts.

As a result of our pricing strategy that is behind the increase of our market share, our operating profit margin in the third quarter fell from 15.0% of the same period last year to 13.4%. We have been continuously building a talented and hardworking team at Luckin Coffee and we remain committed to providing our customers with the exceptional products and services they expect from us at affordable price.” Dr. Guo continued, “As we move into the fourth quarter, we remain focused on delivering value to our customers, enhancing our product offerings, and continuing with our pricing and expansion strategy to serve more customers and expand our global footprint to ensure that we are well positioned for long-term growth.

Here is the management’s outlook given by Dr. Guo during the 3Q 2023 earnings conference.

“Facing the current intensified competition, as a market leader” Luckin “will continue with the current store expansion and pricing strategies and long-term returns to our customers to further enlarge” the company’s “market share. In the fourth quarter, considering seasonality and changes in product mix, raw material costs may further increase. As a result, there may be a decline in” Luckin’s “profit margin.”

Luckin is expanding at a very rapid pace, which is alone a source of concern for the company’s stockholders.

Expansion is also surprising, given the economic situation in China. According to the IMF, the Chinese economy’s growth rate is slowing down and could in fact get negative. It would indeed make much more sense to prioritize profits over growth at least for the time being. But the company is not doing this, unfortunately.

LKNCY fundamentals

On the surface, it does look like Luckin Coffee’s business has made incredible progress when it comes to its earnings results and other financial fundamentals.

Below are Luckin’s net debt and cash histories. Since Net debt = Total debt – Cash, very few companies have negative net debt. This means that in order to have negative net debt, a business has to have ample amounts of cash and very little or no debt. This is possible, of course. But this is not normally the case with companies that have been recording losses for several years in a row. The period between 2017 and 2020 was loss-making for Luckin Coffee. Luckin, meanwhile, has been recording negative net debt since 2018. Indeed, the company’s interest-bearing debt is equal to USD 0. That is why Luckin’s net debt is negative. That is because according to the management, the company’s Senior B Notes were fully redeemed in Q3 2022. Plenty of cash was also raised from the 2019 IPO because some investors believed in the idea of Luckin and financed this company. This is possible but very challenging to achieve, given the company’s scale and expansion statistics.

So, some conservative investors might feel skeptical about Luckin because of that.

Risks

As I have briefly mentioned before, the situation in the Chinese economy is quite challenging. Indeed, it could be used to invest in Chinese companies at low valuations. But it is not favorable for rapidly expanding businesses.

Many market participants also expect a global recession to be near, which could make matters worse for Luckin Coffee.

Another risk is the management’s rapid expansion, which could further push the profits downwards.

But the main risk that can scare many investors is the fact that Luckin’s stock is traded on the OTC and Luckin’s accounts are not checked as carefully as those of other companies, whose stocks are listed on the NYSE.

As concerns the upside risks, these are obvious too. Luckin Coffee is quite a popular company among investors, given its brilliant revenue growth and rapid expansion. Also, the years 2021 and 2022 were profitable for the company and some investors might assume Luckin Coffee is here to gain. Some might also find the company’s stock attractive thanks to lower valuations.

Valuations

For the sake of objectivity, we must say that the company’s valuations make more sense than they used to when I wrote my previous article on Luckin Coffee. For example, Luckin Coffee’s P/E ratio is not 40 but about 18. This is substantially lower but we cannot say that the stock is dirt cheap, especially if we have a look at Luckin’s P/B ratio of more than 5.

I also decided to compare Luckin’s valuations to those of its closest peers.

In short, its two closest rivals, Dutch Bros Inc. and The Wendy’s Company’s stocks have depreciated as well.

But we can clearly see that Luckin’s P/E is quite moderate compared to its peers.

The same is true of Luckin’s EV/EBITDA and P/B ratios.

Many stocks are trading down in the sector and Luckin seems to be relatively cheap. But I still would not buy the stock due to the management’s expansion priority even if it gets cheaper.

Conclusion

Luckin Coffee’s sales and international footprint have been growing at an impressive pace. However, concerning is the fact that management seems to prioritize growth over profits. The fact Luckin Coffee’s stock is traded over the counter should also make investors somewhat concerned. The external risks also matter. The company’s stock has got cheaper but does not seem to be on sale right now. My rating is unchanged. I still rate LKNCY as a HOLD.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.