China's Coffee Market: Luckin, Starbucks, and Massive Untapped Potential

Yes, Starbucks (SBUX 1.03%) is opening a new store in China approximately every nanosecond, but it's not the only name in town (or country). Luckin Coffee (LKNC.Y -4.58%) has been snapping up market share with an "expand first, profit later" model that works by exposing as many new people to coffee as possible. Turns out, people tend to like coffee. Don't worry, Starbucks shareholders -- there's plenty of room for both in this massive market with minuscule coffee exposure.

In this week's episode of Industry Focus: Consumer Goods, host Shannon Jones and Motley Fool analyst Dan Kline dive into the Chinese coffee market, explaining the demand picture, the business models, just how big this could get, and more. Also, the hosts talk about Target's (TGT 1.22%) recent brand partnership debacle with Vineyard Vines, and how Target could have bungled this one less.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on May 21, 2019.

Shannon Jones: Welcome to Industry Focus, the show that dives into a different sector of the stock market every single day. Today is Tuesday, May the 21st, and we're talking Consumer Goods. I'm your host, Shannon Jones, and I have a very special guest here in studio, none other than Dan "the man" Kline. 

Dan Kline: Thank you for having me!

Jones: Dan, always so good to have you here at Fool HQ!

Kline: It's always more fun to be here than the stress of remote internet connections. I think we had one where I kept blinking out. [laughs] 

Jones: Yeah, among other things. 

Kline: That doesn't happen in person. 

Jones: Yes. But so glad to have you here in studio, especially for today's show!

Kline: We're talking coffee!

Jones: We're talking coffee and shopping, two really awesome topics. We're diving into the Luckin Coffee IPO. Also, we're talking about Target and their Vineyard Vines collaboration/debacle, I guess you could call it. I don't know. Either way, we're going to be diving into all of that. 

But let's kick things off. Let's talk about Luckin. First off, Luckin Coffee, ticker LK. It did make its debut on the NASDAQ on Friday, I believe it was. And this is a company, Dan, that's really taken China by storm. I can't even really put into words their growth story since 2017. 

Kline: So, there's a couple of different models when you look at businesses. There's the, we're going to open a store, we're going to get to profitability, then we're going to open a second store. This is not the model Luckin has followed. They have decided that there is a huge untapped coffee drinking market in China. Very, very few people compared to the U.S., and even some of the rest of the globe, drink coffee. It's a tea-based culture. But Starbucks has shown that if you expose people to coffee, they will drink it, they will pay for premium tea experiences, coffee experiences. Starbucks has gone in and opened 3,000 stores in China, opening about one every 15 hours, I believe is the number. Maybe it's slipped to 18. It's basically one every day. They have shown that if people see coffee, get to try it -- so, what Luckin has done is, they have opened at a breakneck pace without any regard for profitability. Their goal is to just get in the market. They will give you your first order for free. They will deliver it to you. Have you ever used Starbucks' delivery in the U.S. through DoorDash?

Jones: I have not, only because there's two right around the corner.

Kline: It's like a $4.99 fee. Unless you're at a meeting with 10 people -- I did it one day because I was just desperate. I was stuck in the house, I didn't have coffee. My coffee was like $14.

Jones: Was it hot coffee?

Kline: No, it was iced coffee. I live in Florida, I don't think they have hot coffee. [laughs] They do, but I've had like three hot coffees in two years. But, Luckin is doing everything they can to sign you up, to gain membership. They have 15 or 16 million people using their app, which is actually comparable to the number of people using the Starbucks app in the United States, where they've been for 20-plus years, or whatever the actual number is. So, their goal is to get you to drink coffee. And they've done that exceptionally well. 

They IPO-ed so they could have money to grow in an unprofitable way. And at some point, they will flick the switch and stop heavily couponing and giving you your first order for free. Maybe they'll still keep some of those levers for first-time customers. But at some point, the price will go up, and they will still be cheaper than Starbucks. 

Jones: Yeah. And I want to go back to the Luckin model because compared to Starbucks, Starbucks is of course more of the retail setting, I can come sit down --

Kline: It's a people-driven model.

Jones: Right, it's a very people-driven model, whereas Luckin is pretty much a grab and go/delivery model, which in theory should drive down a lot of the overhead costs. You were talking about profitability.

Kline: And it's much more heavily automated. When you look at a Starbucks vs. a Dunkin Donuts in the U.S., Dunkin Donuts has spent money on its espresso platform, they've totally redone it. But it is not a barista who knows a recipe making it for you. It's a button. It's a machine, it's very much like what they do at McDonald's. Frankly, it's similar to the machines at a high-end rest stop where you can get a latte, a hot chocolate, a cup of soup, all from the same machine. Luckin does not have the five people behind the counter that Starbucks has. Now, there is going to be a coffee snob like me who isn't going to do this. But if your only exposure to coffee was at a restaurant or the occasional, I don't know what the coffee situation is with convenience stores in China. But if it's generally bad coffee, this is going to be a big step up. So, it's very much the Dunkin Donuts model of, yeah, we're selling you an iced coffee. Hey, how about on a splurge day, you spend twice as much money and get a macchiato? That's what Luckin is doing. And I think it's going to be very, very good for Starbucks. 

Jones: Yeah, I definitely think in China, it's not going to be a winner-takes-all model at all. 

Kline: I don't think it is because it's an entry-level brand. If I've never had a cappuccino, which sounds preposterous now, but when I was in high school, a cappuccino was something you got at a French restaurant. I had a fancy aunt who took me, and I had my first like cafe au lait in a big bowl. Coffee houses were rare, and they were artsy. These things weren't on the menu at 7-Eleven or McDonald's. So the first time you have this at Luckin, at some point, you are naturally going to go, "Hey, I like this macchiato thing. What about the fancy place over there, Starbucks, that charges twice as much?" You may not become an everyday Starbucks customer. You are going to become a luxury Starbucks customer. And with the population base and the tiny, tiny percentage that drinks coffee, if Luckin can create a coffee market, some of those people will graduate to Starbucks. And that's going to be very good. I think these two companies can absolutely play well together. 

Jones: Absolutely! And let's dive into some of those numbers. So, Chinese consumers drink only about six cups of coffee a year. 

Kline: I had that today.

Jones: It's not even 11:00 o'clock.

Kline: We got new cold brew in the office. 

Jones: So, compare that to 279 in Japan, 388 in the U.S. And then we've got Germany, the outlier here, 867 in a full year. You can see, the opportunity is huge in China. If you look at some of the adjacent markets in Hong Kong and Taiwan, consumers are drinking about 200 cups of coffee. The opportunity is there. To your point, I think this is -- I hate to use this term, but it's really like a gateway drug to coffee in general.

Kline: I think globally, it's been proven that if people are exposed to coffee, they will drink it. So, yes, China has a tea culture. But Luckin and Starbucks also sell tea. Tea is probably more profitable than coffee. Maybe not some of the very high-end teas. But in general, a cup of tea is cheaper to produce than a cup of coffee. So it isn't purely a coffee model. They will increase the amount of cups of coffee, they will also increase the out-of-house ability to purchase these beverages. 

Jones: Exactly. And you talked a little bit about how many stores. I think 2,400 stores they have currently. They're hoping to open another 2,000 stores by the end of the year. I was talking with some of the analysts here at the Fool about this. And some of them were raising concerns, like, can you grow too fast? Does it become an issue when you're growing at that pace? Because they're hoping to have more stores than Starbucks by the end of this year.

Kline: See, I think at some point, they have to dial back. But they have proven scale. And when you're doing delivery as a prime point of your business, if you are delivering three miles and figure out you have this much business, you can use that data to say, "Well, I'm going to open here and it's going to lower my delivery costs." They have enough of a base that they can sort of open strategically. And hopefully they'll follow what Starbucks has done in the U.S., and every few years, they'll clean up their store base. Hey, there's been a bit of a population shift. We have a full-size sit-down store, it really only needs to be a kiosk. Or, let's open three more in this area, but let's quietly close one here. As long as they're as disciplined as Starbucks -- and Starbucks, it's only 40 or 50 stores a year they close. But they have been very strict with, if/when a store doesn't perform, getting rid of it.

Jones: Yeah. And so I think this entire market is just so ripe for Starbucks, for Luckin, for McDonald's, for all of these. 

Kline: Right now, Starbucks is the No. 1 coffee provider. No. 2 is McDonald's, which has about 5% of the market. Luckin is just behind that. Now, have you ever had a cup of coffee from McDonalds? 

Jones: I have. 

Kline: It's awful!

Jones: I disagree with you here.

Kline: Do you really?

Jones: For $1, I can actually get a pretty decent -- granted, it's not on the Starbucks level, but it's a decent cup of coffee. 

Kline: Take me to Wawa. Wawa, Cumberland Farms. I've never had a Luckin cup of coffee. If a Fool wants to send me on a trip to China, I'm happy to do that. I'm going to guess they're executing at a Dunkin Donuts level, where it's a comparable beverage to Starbucks. That suggests to me that at a cheap price, they can take the McDonald's share, or at least some of it. There's a convenience factor. McDonald's will also sell you an Egg McMuffin or whatever, and Luckin's not doing much food. They're not doing food at the level that Starbucks or McDonald's does food. But yes, there's a huge addressable market here. And the coffee ceiling, I don't think we've hit 5% in China. These chains could both go to 10,000 stores, and we'd probably be fine. 

Jones: Yeah, I agree there. And with Luckin, they're really kind of pulling all the tricks out of the bag right now. So I was reading how basically, not only are they offering discounts, sometimes 50% or more, but they're also paying customers. I think the latest promotion was, if you buy seven or more items in a week, we'll actually pay you, we'll put you in a pool with other customers who have bought this amount within a week, and we'll pay you. I think last week's payment was like $4 per customer, cash. They're hoping to actually pay customers in total about $7 million U.S.D. That's huge! I have to wonder, Dan, at the end of the day, when these discounts, when these flashy cash grabs go away, will it be enough to keep people coming to this cheaper, some say even doesn't-taste-as-good-as-Starbucks brand coffee?

Kline: Hopefully they'll be strategic. One of the things we've talked about before about Starbucks is, they've changed their promotions to drive behavior rather than drive sales. It's not 50% off a latte all day. It's, hey, we saw you came in this morning, you want 50% off a Frappuccino from 3:00 p.m. to 6:00 p.m., [when] our business isn't as busy? And it's hyper-localized. So I would assume Luckin will have the ability to say, in this market, those cash incentives need to stay. This market is mature, but you're buying once a day? How about lunchtime? How about dinnertime? All those tools are there. And when you have a company that's digitally driven, Luckin is built ground-up with Starbucks having already existed. So they get to look at what Starbucks has done with their app, and use those lessons. And now, I think they're teaching Starbucks some ways to, when they go into a new market, how you drive customer business. So they're a technology company that happens to sell coffee, and they'll be able to shift those promotions. I doubt anyone is going, "I don't like coffee, but if I buy eight of them, they'll give me $4." So you already want it. And at some point, they'll figure out the delta of, well, he'll still buy six cups. He won't buy eight because he's not getting his $4. But I don't worry about that at all. 

Jones: Yeah. Looking at the IPO last week, debuted on the market $17 a share. Higher end of their range. Ended up raising about, I think it was $570 million, with plans to use that cash to open up these stores. Dan, it sounds like you're quite bullish on their prospects. 

Kline: Yeah, I am. And I would also point out that I'm bullish on Starbucks as well. I am a big fan of the growth potential in China. When I say I'm bullish on Starbucks, I have been a little bit negative on how they're not pursuing a premium strategy in the U.S. anymore. I do think that constrains some of their growth. But in the China market, I almost don't think you can move fast enough. Starbucks has proven there is a demand. Luckin has proven that Starbucks isn't filling that demand. If Starbucks doubled how many stores they opened, it still wouldn't force Luckin out of the market. 

Jones: Yeah, so, a lot to watch here. All in all, I do worry about their path to profitability. It sounds like it's years out, but a lot to watch. 

Kline: It's years out. 

Jones: Alright, let's shift gears here. Let's talk about Target. Over the weekend, preppies all over the world came together to go to Target with their collaboration deal with Vineyard Vines. I'm sure a lot of our listeners will probably recognize Vineyard Vines for the famous pink whale that's all over its branding. 

Kline: Before we get into the business of this, I'm not fashionable. Anyone who's seen me on the show knows I have a uniform. I'm either wearing this shirt or a long sleeve black shirt. I am not a fashion guy. Vineyard Vines is an Izod shirt. But instead of a lizard, it has a whale. What am I missing? 

Jones: It's a pink whale, Dan.

Kline: I didn't even know that. What am I missing? Why is this popular? 

Jones: Vineyard Vines really got its start, I believe the founder started that based off being in Martha's Vineyard. So you've kind of got this Massachusetts vibe, on the coast. 

Kline: I am from Massachusetts.

Jones: It's been able to build up its brand around this exclusivity. They are premium retailers. Generally, their clothing is not going to start any lower than $50.

Kline: It's very expensive. I bought some for my cousin.

Jones: Pretty expensive, even on their lower end. So, this collaboration deal with Target -- Target has been doing a lot of these collaboration deals with a lot of these exclusive retailers, really trying to open up the market, and also drive demand and foot traffic back. 

Kline: Let me take you through the business story for Target. Target a few years ago decided it needed to differentiate its merchandise. They've been launching, call it 12 to 20 owned and operated brands. If you went to Target three years ago, they had a lot of merchandise that they didn't control. Now you go in, and you're like, well, what's Goodfellow & Co? There are three different ladies underwear brands that they have. And you're looking, like, "I've never heard of this brand." So, to drive interest and traffic to that, they've done some big-ticket collaborations. They have a home and hearth line with Chip and Joanna Gaines. They have a cookware brand with Chrissy Teigen. When I think cookware, I think supermodel Chrissy Teigen. [laughs] 

Vineyard Vines is an exclusive, high-end brand. And they partnered with Target not so much on clothing, more on stuff. Do you want a beach towel with the big pink whale on it? Do you want a bandana with it? 

Jones: Do you want a wagon with the whale?

Kline: Yeah, it was a lot of really weird merchandise. But this is sort of a cultish brand at a price point that was more of a Target price point. And I'm going to argue it was a misstep. It got Target a ton of attention. And that's great. You come to the store, you see all these other brands, you realize that they have a lot of great merchandise. I really feel they've stepped up their merchandise in areas -- I would never have bought furniture from Target three years ago. I'd buy a desk from Target now, their quality is dramatically better. You see all this, that's great!

But what people did is, they rushed the Target stores, they bought whatever they could, and they put it on eBay. That creates, in my opinion, a negative customer experience. They should have figured out how to manage this a little bit better, because you don't want people who are just walking in blindly scooping whatever they got. They should have figured out how to make it a little less exclusive, if that's a fair way to say it. 

Jones: I totally agree! I think by Sunday, maybe 9,500 items were actually being sold on eBay's website, sometimes [for] two, three times the amount [...] they bought it for.

Kline: It's a tough position for Target to be in because they also run the issue of -- so let's say they're selling that beach towel for $25. A regular beach towel without the whale is $12. It could sell on eBay for $150. Is Target going to charge you $125 for that beach towel without also creating ill will? But maybe the releases should have been staggered, or somehow done a little bit more secretively. It's a very smart play, and I'd love to see Target do more of this. But they have to make it so it's not Beanie Babies. They don't want people rushing the store, buying the Princess Diana Beanie Baby, storing in their attic, and then realizing in three years it's not worth any money. 

Jones: In 2015, for investors who've been watching and for shoppers, the Lilly Pulitzer collaboration was also a debacle. Literally had inventory sell out in store and online within minutes. Granted, I think they did a little bit better in terms of demand and inventory this go around. But you still had people who were pretty upset that stayed up until 3:00 a.m. on Saturday waiting for this collection to be released and weren't able to get it.

Kline: Right. And they could look to Black Friday tactics. Maybe you get a card, and you're only allowed to buy one. Maybe there's a managed line. What you want to do if you're Target -- and again, these are good problems to have. Their problem is, they did a deal, and everyone bought it. This isn't a bad issue. But you might want to move to a system to make sure the most people possible get a chance to buy something. We've seen it [on] Black Friday, you get rain checks, there's a line, you get a color-coded bracelet, whatever it is. I don't think you want to see this stuff end up on eBay. Great for eBay, which is another company I like sometimes, but this could leave a bad taste in the regular Target customer's mouth. Like, "Wait a minute, I've never seen this guy shop here before. I shop here three times a week." But, again, these are just little nit-picky operational things. 

Jones: Yeah. Target has collaborated, as I mentioned, with Lilly Pulitzer, Alexander McQueen, and even Justin Timberlake's William Rast line at Target. So I do think strategically, it makes a lot of sense to offer these limited-time collections to really drive that exclusivity, drive some scarcity, and really have people excited about what's coming out in the stores. Overall, though, when you look at Target, fourth-quarter comparable sales did grow 5.3% on traffic growth of 4.5%. I'll be looking, I know they're going to be reporting earnings, I believe tomorrow, just to see how holistically -- because I mean, ultimately, these collections are not going to be pushing the needle that much. But what it is about is driving traffic into the store, getting people to put more items into their cart. 

Kline: Three years ago, you could argue about the fate of Target. They lost some of the Target exclusivity. Amazon was nipping at their heels. Walmart was doing it. The transformation of Target under Brian Cornell is not something we can underplay. They have made themselves, again, a high-end brand. You no longer compare Target with Walmart. Target and Kohl's are closer comparables. I will buy clothing at Target, which would have been something four years ago, maybe I'd buy a bathing suit or a T-shirt, but you weren't going to buy a work shirt. So, seeing their comparable-store sales rise at a time where their digital sales are rising, and they're reasonably, I would argue, behind Walmart when it comes to omnichannel. They don't do a great job of buy online pick up in store, all of which they're going to figure out. Their ownership of Shipt and their ability to get you same-day orders, which has been overshadowed by Amazon saying they're going to deliver you orders in one day. Target has the ability to bring your groceries same-day in, like, 85% of the country. So there's a growth story here that's going to continue.

But from a same-store sales point of view, balance that number with their digital growth. If they only have 2% same-store growth, but their digital sales are up 23%, that's fine. I made that number up. 

Jones: I think it's 31%, but we'll take it. 

Kline: Yeah. You really have to look at the whole picture, because how people shop has been shifting. 

Jones: Yeah, and so, this has been truly a growth story. Slower than we might have liked. But to your point, I really think this is a longer-term story, longer-term transition, and really about the omnichannel presence they're trying to build out.

Kline: And this type of special deal also gets you thinking about some of the reasons Costco or TJ Maxx or Marshalls are exciting. What's going to be there now? I'm sure there's people following the Target blog that didn't follow the Target blog, because you want to know when the new Hearth & Hand release is. Even though there's not the crazy demand for that, I'm going to guess some of the best items sell out quickly or become things you have to back order. So, this is strengthening a connection to Target and giving some of that fun shopping -- the reason you go to Costco and come home you're like, "I bought a kayak? Why did I buy an eight-foot teddy bear?" Some of that. I'm sure there's people at home with a pillow that has the Vineyard Vines logo, who are like, "What did I do?"

Jones: Lots of buyer's remorse this weekend.

Kline: Hey, you can sell it on eBay!

Jones: That's right, sell it on eBay! Well, that'll do it for this week's Industry Focus: Consumer Goods show. Thank you so much for tuning in! As always, people on the program may have interest in the stocks we talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based on what you hear. This show was produced by Austin Morgan. For Dan Kline, I'm Shannon Jones. Thanks for listening, and Fool on!