Luckin Coffee: Upside Ahead, But Competition Risk Remains Elevated (OTCMKTS:LKNCY)

Luckin Coffee (OTCPK:LKNCY) is a Chinese coffee chain founded in 2017 with a digital-first business model that had been rapidly growing to overtake Starbucks (SBUX) before accounting fraud issues led to bankruptcy. Since 2022, they have been rebuilding trust under new management.

So far, things have been looking relatively good. Since 2022, the share price has nearly doubled, though performance has been rather volatile. Luckin saw a 1-year high of $34 in just October last year, before realizing a -44% decline to $20 level today.

I initiate my coverage with a buy rating. My model projects a 1-year price target of $34.72, implying a potential upside of over 65% from today’s level. I expect a few catalysts to help Luckin sustain its fundamentals and market share growth, while the risk level remains moderate.

Catalyst

Luckin’s balance sheet and fundamentals are strong. Cash remains consistently steady above $700 million, and excluding over $500 million worth of preferred shares and capital lease obligation, Luckin has virtually no debt.

I expect capital lease obligation to continue to increase along with revenue growth trends as Luckin continues to roll out more stores. On the other hand, having preferred shares should be a good thing for Luckin, since it helps increase its appeal to a broader investor base, especially given the past fraud issue. Preferred shares are not guaranteed safe, but they prioritize payments to the holders upon liquidation and often also provide steady income.

Meanwhile, the performance across revenue growth and profitability has been strong. YoY revenue growth has accelerated since 2022 to the mid-to-high 80s, while the operating margin has been mostly steady in the mid-teens. Considering the context of the slowing economy in China, Luckin’s numbers so far have been exceptional.

I expect Luckin to maintain strong growth and profitability into 2024 due to a few identifiable catalysts: 1) It seems that Luckin’s low pricing strategy puts it in good position to maintain demand level under weak macro environment, 2) new flavor innovation achieved through partnerships with local non-coffee brands to drive more efficient sales growth through cross-exposure between brands, 3) light-capex and maintenance store expansion strategy coupled with digital-first business model to enable faster store expansion and market share growth.

Given its competitive pricing strategy, I believe that Luckin is well-positioned to drive higher sales and continue capturing growth opportunities under the weak macro environment. Luckin’s average transaction price of 18 RMB ($2.5) is over 53% lower than Starbucks’ 38.8 RMB ($5.5) in China. In 2024, it remains unlikely for the macro situation in China to see a drastic change, in my opinion, suggesting that Luckin will potentially maintain its growth trend for the FY.

Given the relatively successful new flavor innovation in partnership with the well-known traditional liquor brand Moutai, I would expect Luckin to continue exploring similar partnerships with other brands. In my view, this type of brand partnership can deliver an efficient marketing strategy with potentially attractive ROI, driven by cross-marketing and brand awareness in each brand’s customer base.

In the end, I also expect Luckin to maintain its growth through market share growth into 2024 and beyond. One thing that is innovative and attractive about Luckin, in my opinion, has been its low-capex store expansion and digital-first strategy. The strategy enables Luckin to be very data-driven and agile in doubling down investments in high-performing stores while also closing lower-performing ones.

Total stores as of Q3 was 13,255, up from 8,241 at the end of FY 2022, meaning that Luckin just increased its number of stores by over 61% in under a year. In Q3 alone under slowing economy in China, Luckin’s net new store opened was 2,426, suggesting that Luckin opened about 26 stores every month on average, which is almost a net new store every day.

Risk

Competition will remain a key risk factor for Luckin. While we can argue that Starbucks is targeting a different customer segment, I continue to view it as a threat, especially given its relatively strong brand equity not only in China but globally. Meanwhile, new competitors like Cotti Coffee, a new coffee chain founded by an ex-Luckin executive, also present a more imminent threat, in my view.

Domestically, Cotti’s has been aggressively opening new stores to gain market share. Since launching in 2022, Cotti has had over 6000 stores. Most recently, due to Cotti and Luckin’s rapid growth, China has overtaken the US in terms of the country with the most branded coffee shops.

However, with Luckin and Cotti potentially saturating the domestic market further, I may expect the battleground for growth to shift from China to international markets in the next few years. In my view, Luckin’s slow international expansion could result in potential future opportunity loss.

I believe that Cotti’s rapid international expansion may give it a better position to become a more well-known global brand than Luckin today, effectively limiting Luckin’s overseas growth opportunity. Today, Cotti is already in 5 countries and 330 cities globally. Just over a month ago, Cotti continued with its international strategy by opening its first stores in Thailand and Malaysia. Luckin, in the meantime, had only 18 total stores outside China as of Q3.

Even worse, while Cotti Coffee has made its entry into Thailand market successfully, Luckin does not only encounter competition, but also a trademark infringement issue there, despite having not entered the market just yet.

It appears that a local Thai company, 50R Group, successfully registered Luckin’s modified logo and brand name and copied the store decoration and coffee cups. Despite lawsuit from Luckin, it was announced in December that Luckin ended up losing the case:

Despite all the efforts, followed by an appeal filed by 50R Group, in early December 2023, Thailand’s Central IP and International Trade Court announced that Luckin Coffee had ultimately lost the case. Furthermore, 50R Group reportedly claims nearly US$ 2.9 billion in compensation from Luckin Coffee due to its suffer and economic losses from the previous disputes. Luckin responded on Weibo, saying that the news is “to be verified”. Luckin’s loss in the lawsuit can be attributed to Article 63 of the Thai Trademark Law, which stipulates that a Thai company, upon initial trademark registration with the Thai Trademark Office, has the right to operate in the corresponding business in Thailand.

Source: Lexology

Learning from the latest challenge in Thailand, I would conclude that another factor that may amplify competition risk for Luckin is its overall low entry barrier, which may complicate its international strategies due to emerging local players attempting to copy the same model and steal not only market share but also trademark.

Valuation/Pricing

My 1-year target price for Luckin is driven by the following assumptions for the bull vs. bear scenarios:

1. Bull scenario (50% probability) assumptions – Luckin is to deliver FY 2023 revenue of $3.57 billion, in line with analysts’ estimate. I also project PKX to deliver FY 2024 revenue of $5.35 billion – assuming a 7.8% market share in 2021, I estimate Luckin’s 2024 market share to be in mid 30% due to its rapid growth. I assign Luckin a forward P/S of 3x, an expansion from the current level of 2x, to account for the increased market share in China despite revenue growth normalizing from 80% high in 2023 to 50% in 2024.

2. Bear scenario (50% probability) assumptions – Luckin to deliver FY 2023 revenue of $3.57 billion, as per analysts’ estimate. I also project Luckin to deliver FY 2024 revenue of $4.86 billion, a 36% YoY growth. Accordingly, I also expect P/S to slightly contract to 2x, below where Luckin is trading today.

Consolidating all the information above into my model, I arrived at an FY 2024 weighted target price of $34.72 per share, an implied over 65% potential upside from the current price level of $21. I give the stock a buy rating.

Conclusion

Luckin Coffee, though tarnished by past accounting fraud, has shown promise under new management. Its share price, despite volatility, has nearly doubled since 2022, reflecting investor confidence in its turnaround. This research initiates coverage with a buy rating and a price target of $34.72, implying a potential upside of over 65%. Strong fundamentals, a digital-first model in China’s tech-savvy market, and moderate risk due to addressed accounting issues and a focus on transparency position Luckin for continued growth. While moderate competition risks exist, the potential rewards here still suggest a compelling opportunity.

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.