Can China Become a Coffee Market?

Luckin Coffee (LKNC.Y -5.46%) is betting that Chinese consumers will drink more coffee. The country's citizens currently drink only six cups per year. That's hundreds below what citizens in countries around the world drink, and the chain is betting it can change that. Luckin plans to open thousands of stores over the next few years as it introduces coffee to a consumer base that seems more than willing to try it.

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This video was recorded on May 21, 2019.

Shannon Jones: Chinese consumers drink only about six cups of coffee a year.

Dan 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 p.m. to 6 p.m. where 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.