China was once Starbucks' (NASDAQ:SBUX) hottest growth market, but its Chinese sales hit a brick wall last year as it fell behind the tech curve in deliveries and faced new domestic competitors.

One of those rivals was Luckin Coffee, a rapidly growing chain backed by big investors like private equity firm Centurium Capital and GIC, Singapore's sovereign wealth fund. Last May, Luckin revealed that it had opened over 500 locations across the country in less than nine months since being founded. That figure likely reached 2,000 at the end of 2018.

A Luckin Coffee ad campaign.

Image source: Luckin Coffee.

Starbucks still has a bigger presence in China with over 3,500 mainland locations, and wants that figure to hit 6,000 by the end of 2022. But Luckin's growth is tough to ignore since its business model directly targets Starbucks' weaknesses.

Why is Luckin Coffee a major threat?

Luckin operates small cafes and kiosks instead of full-sized stores like Starbucks, which significantly reduces its operating expenses. Most of its locations offer pick up services and deliveries for online orders. For comparison, Starbucks didn't offer any viable delivery options in China until it partnered with Alibaba's (NYSE:BABA) Ele.me last August.

A customer paying for coffee with a QR code.

Image source: Getty Images.

Luckin's customers can't pay with cash. They can only place orders through its mobile app, which gives customers loyalty points; the payments are processed via Tencent's (NASDAQOTH:TCEHY) WeChat Pay. Luckin also offers special promotions on WeChat, the top mobile messaging app in China with 1.08 billion monthly active users, which locks in customers.

Luckin's drinks are generally 20% to 30% cheaper than Starbucks' comparable drinks. It also uses marketing blitzes featuring Chinese celebrities, while Starbucks often shuns traditional or localized ads.

Last year Luckin sued Starbucks for anti-competitive practices, and penned an open letter to the company claiming that it leveraged its long-term leases with landlords to block competing coffee chains from opening nearby stores.

Starbucks called the lawsuit a publicity stunt, but it may have dented its reputation with Chinese consumers. This wouldn't be the first time Starbucks faced PR issues in China -- the state media slammed the company a few years back for charging higher prices in China than in other countries. Starbucks is also an easy target for a nationalist backlash if trade relations between the US and China continue to deteriorate.

Could Luckin really topple Starbucks?

It's unclear how much revenue Luckin generates, but it was valued at $2.2 billion after its last funding round in December. The company is also reportedly in early talks for an IPO in Hong Kong or New York.

A public offering would give Luckin a lot more capital to fund its expansion against Starbucks, which could cause headaches for the coffee giant. Here's how Starbucks fared in China over the past year:

 

Q4 2017

Q1 2018

Q2 2018

Q3 2018

Q4 2018

Comps

8%

6%

4%

(2%)

1%

YOY growth in China. Source: Starbucks' quarterly reports.

The rebound in China's comps growth in the fourth quarter allayed some fears about the region's comps turning negative, especially since it faced a tough year-over-year comparison to its 8% growth a year earlier.

Starbucks attributed that recovery to a rapid expansion of its delivery services, which covered about 2,000 of its locations at the end of 2018, the unification of its Chinese regions for better operational efficiency, and new menu items like ice cream coffee drinks.

"Coffee plus ice cream" drinks at Starbucks in China.

Image source: Starbucks.

The fact that Starbucks' comps recovered as Luckin aggressively expanded suggests that there might be enough room in China for both coffee chains to thrive. Luckin and Starbucks could stay in their lanes, with the former serving lower-end customers and the latter serving higher-end ones who prefer lingering at its cafes.

But Luckin isn't the only major coffee chain which Starbucks should watch out for -- Gourmet Master's 85°C Bakery Cafe, Coca-Cola's Costa Coffee, McDonald's McCafé, and countless convenience stores are also offering cheaper coffee to Chinese consumers.

It's unlikely that Luckin will topple Starbucks on its own. However, Starbucks' growth in China could still decelerate as the coffee chain market becomes saturated. If that happens, Starbucks' aggressive brick-and-mortar expansion could backfire as its new stores fail to generate positive year-over-year sales growth.

Check out the latest Starbucks earnings call transcript.