Since Starbucks (SBUX -1.14%) opened its first store in China in 1999, it has dominated the Chinese market. The java giant has introduced coffee to a tea-drinking country and tapped into a culture of conspicuous consumption that's helped make the Starbucks brand a status symbol and its cafes popular spaces in many Chinese communities.

Starbucks sees near-boundless growth potential in China, as the company plans to open 500 stores a year in the fast-growing market through 2021. Former CEO Howard Schultz has said that he expects China to one day be the company's biggest market, ahead of the U.S.

But fast-growing upstart Luckin Coffee has recently emerged to challenge Starbucks' China supremacy. Luckin rapidly expanded from nothing to more than 2,300 stores in less than 18 months. It did this using a differentiated model that centers around specialized pickup stores preparing orders taken from its mobile app.

Two women drinking coffee in a cafe.

Image source: Getty Images.

Luckin filed to go public in the U.S. this week and provided limited details on its IPO and what it hopes to do. What is clear, though, is that this challenger is gearing up for a fight. Reuters, citing unnamed sources, reports Luckin aims to raise up to $800 million at a valuation of $4 billion to $5 billion to fuel its rapid expansion.

The China-based company, which currently operates only in China, also took the odd step of filing to go public in the U.S. rather than in China. Supposedly this is because the Hong Kong market normally requires companies to have at least three years of operating history before they will process an IPO. Reuters' sources also say Luckin filed in the U.S. because it wants investors to have a direct valuation comparison with Starbucks, its chief rival.

Here's what else Starbucks investors need to know about its upstart competitor.

What is Luckin Coffee?

Luckin was developed by the same team that built Chinese ride-hailing platform UCAR, and Luckin is driven by the same aggressive start-up mentality. Its CEO, Jenny Zhiya Qian, was previously the COO for UCAR. Her management team has forecast losses for the next three to five years as Luckin expands rapidly and offers generous discounts in order to build up a customer base.

Luckin plans to add 2,500 stores in China this year, bringing its total to more than 4,500. As of March 31, the company had 2,370 stores. Ninety-one percent of those are smaller, pickup-centric stores, which have limited seating in 200 to 600 square feet and focus on fulfilling app-based orders.

Luckin generated $125.3 million in revenue in 2018 and $71.3 million in the first quarter of 2019. However, the company is deeply unprofitable, with an operating loss of $238.1 million last year and $78.5 million so far in 2019. A closer look at its financials shows the company still needs to scale considerably (or cut back on discounts) in order to become profitable. It spends more on coffee, materials, and other store-level operating costs like rent than it brings in. The company is also spending heavily on sales and marketing and general and administrative expenses, though those line items should decline as a percentage of revenue over time.

Luckin believes that disrupting the traditional coffee shop model with its pickup stores provides it with cost advantages and an attractive value proposition for its customers.

Luckin vs. Starbucks

Starbucks finished its first quarter (ended on Dec. 30, 2018) with 3,684 stores in China. If Luckin follows through on its expansion plans, it will have more stores in that country than Starbucks by the end of the year.

Starbucks doesn't break out complete financial results for China, so a direct comparison between the two companies is difficult. In the China/Asia-Pacific region, where Chinese locations make up about 41% of its total stores and more than half of company-owned stores, Starbucks generated $4.5 billion in revenue and $867.4 million in operating income. Starbucks' company-operated stores in the region had average sales per store during the year of $794,000. That's significantly less than the $1.54 million Starbucks' company-operated stores in the Americas generated in average sales last year.

Luckin is such a young company that comparable numbers are hard to find and aren't very meaningful. But over the last four quarters, the company's revenue per store averaged $148,700, indicating they are still much lower in volume than Starbucks. Starbucks is likely to maintain a lead in average unit volume, as its stores are much larger than Luckin's and therefore able to handle more traffic. Consequently, Luckin likely won't top Starbucks in revenue in China for several more years, even if it finishes this year with more stores.

The numbers above also show that Starbucks has an enviable operating margin, while Luckin is currently operating at a considerable loss.

The market opportunity

Luckin's prospectus made one thing clear for both it and Starbucks: The growth opportunity in China is enormous. Luckin said that the average person in Mainland China drinks just 6.2 cups of coffee a year, compared with 209.4 in Taiwan, 249.5 in Hong Kong, and 279 in Japan.

In other words, the real opportunity for Luckin isn't in taking market share from Starbucks but in converting more Chinese into regular coffee drinkers. Luckin envisions the Chinese coffee market developing similarly to the way it did in Taiwan and Japan during their periods of rapid urbanization as they increased their disposable income. In Japan, for example, per-capita coffee consumption more than tripled from 1963 to 1970 and has continued to grow. Luckin cited a report from the consulting firm Frost & Sullivan that predicted the Chinese coffee market would triple in the next five years.

By that logic, Luckin's aggressive growth could actually help Starbucks by persuading more Chinese to drink coffee.

Should you take a chance on Luckin?

Luckin has not yet revealed the pricing for its IPO, but the company was valued at $2.2 billion in its latest funding round last December. That gives the company a steep price-to-sales ratio around 10. At its anticipated valuation of $4 billion to $5 billion, the stock would be even pricier at a P/S of around 20, though sales are growing quickly.

Luckin seems to be operating (and being valued) like a tech company. But the economics of a coffee chain are much different from a scalable tech business like cloud computing or an e-commerce marketplace. No matter how many stores the company adds, the basic input costs -- coffee, labor, rent -- will remain roughly the same, which makes Luckin's loss-generating strategy a risky one, since there's no easy way to scale to profits.

Though Luckin's is a story worth following for investors, if you want exposure to the Chinese coffee market, Starbucks' track record as a proven winner looks like a much safer bet.