Luckin Coffee's Breakneck Expansion Comes at a Price

Luckin Coffee (LKNC.Y 3.52%) issued its first earnings report since its May 2019 debut on the public markets Wednesday morning. The technology-driven retail chain, which aims to usurp Starbucks (SBUX 0.65%) as China's largest coffee network (by number of units) by the end of 2019, posted a wide loss in its second quarter of 2019. Let's review the quarter's details below, as well as management's outlook. Note that all comparative numbers are presented against those of the prior-year quarter.

Luckin Coffee: The raw numbers

Data source: Luckin Coffee. RMB=renminbi. 

What happened at Luckin Coffee this quarter?

• Average monthly customers increased by 411% to 6.2 million, while the total number of Luckin stores soared 375% versus the prior year to 2,963 stores. The company added 593 new stores to its base during the quarter.
• Net revenue from brewed drinks of RMB 659.2 million ($96 million) declined to 75.2% of total revenue, versus 82.7% in the prior-year quarter, as other product revenue and delivery fees (stemming from the company's delivery-heavy business model) both expanded rapidly.
• Store-level operating loss decreased to RMB 55.8 million ($8.1 million), against RMB 81.7 million in the second quarter of 2018.
• Despite the improvement in its store operations, Luckin's overall loss widened due to a near 220% increase in sales and marketing expense to RMB 390.1 million ($56.8 million), and a 488% increase in general and administrative expense, to RMB 265.8 million ($38.7 million).
• Luckin burned through cash this quarter, revealing a net use of operating cash of RMB 375.2 million ($54.7 million), against RMB 196 million in the comparable quarter. The company ended the quarter with ample balance sheet resources, however, sporting cash and short-term investments totaling over 6 billion RMB ($881.5 million). Luckin raised roughly $816 million this spring between a preferred share issuance, private placement of securities, and its IPO.
• After quarter-end, on July 22, Luckin signed a memorandum of understanding (MOU) with Kuwait Food Company Americana, a restaurant development group in the Middle East, to form a joint venture to bring Luckin stores to the Middle East and India.
• Management affirmed that the company is on track to become the largest network of coffee stores in China by year-end. Currently, Starbucks has 3,922 units in China. Thus, at Luckin's current expansion rate, it appears likely that it will add another 1,000 stores in the remaining months of 2019 to surpass its rival. It should be noted that the majority of Luckin's units are pick-up locations with limited seating, and thus have lower costs to build -- and lower per-unit sales -- than Starbucks' higher-end locations. 

What management had to say

In Luckin's earnings press release, CEO Jenny Zhiya Qian extolled the company's rapid growth while focusing on the improvement in store-level economics:

We are pleased with the performance of our business as we continue to execute against our long-term growth plan. Total net revenues from products sold increased 698.4% year-over-year, driven by a significant increase in transacting customers, an increase in the average number of items purchased by our transacting customers and higher effective selling prices. We believe this is the result of our distinguished value proposition of delivering our customers high quality, high convenience and high affordability.

At the same time we have substantially reduced our store operating loss as a percentage of net revenues as a result of benefits of scale and increased bargaining power, operating efficiency from technology, and higher store throughput, and we are on track to reach our store level break-even point during the third quarter of 2019.

While Luckin is shoring up store profitability, it still has a significant overhead burden that stems from its plan to aggressively expand in the Chinese market. The current quarter's loss is a near-term result of this strategy. Investors were unprepared for the magnitude of red ink spilled to service rapid growth -- shares traded down roughly 15% at midday on Wednesday.

Looking forward

In terms of forward guidance, Luckin provided a single number for investors in its earnings release. The company anticipates net revenue from product sales in the third quarter to land between RMB 1.35 billion and RMB 1.45 billion, or roughly $196 million at the midpoint of this range. While investors certainly welcome the enormous projected top-line expansion, today's reception to the company's first quarterly report suggests that the bottom line will also be scrutinized for progress next quarter.