Luckin Coffee (LKNC.Y -4.09%), China's second-largest coffee chain after Starbucks (SBUX 1.19%), plans to launch a new juice-making joint venture with Dutch commodity merchant Louis Dreyfus Company (LDC). The joint venture will initially produce co-branded fresh fruit juices and eventually build a bottling plant.
Luckin co-founder and senior VP Jinyi Guo stated that China is the "fastest-growing" market for not-from-concentrate (NFC) juices in the world. He said that the companies see a "significant opportunity to offer high quality, sustainably developed NFC juices" to Chinese consumers.
LDC generates most of its revenue from commodity crops, but it also owns a fruit juice unit, which has struggled with consumer concerns about sugar content in recent years. LDC previously mulled selling or spinning off its juice unit, but it announced earlier this year that it would expand the business via regional partnerships -- like its joint venture with Luckin -- instead.
Luckin and LDC didn't disclose the value of the deal, but they did say the co-branded juices will launch next year. Luckin's move into the juice market isn't surprising since it previously expanded its menu with light meals, desserts, and teas. But is it a smart move for the unprofitable company?
Do fruit juices have lower margins than coffee?
Luckin is diversifying its menu to better compete with Starbucks and other cafes, but that strategy could dent its margins.
Luckin doesn't disclose the exact margins for its food and desserts, but restaurants generally report higher margins for coffee (and other drinks) than meals and desserts. When it moved into the tea market earlier this year, it warned that the margin for its Xiaolu tea drinks would be roughly 25% lower than its margin for coffee.
Luckin didn't provide any margin expectations for its juices, but fruit juices usually have lower margins than coffee. For example, when Starbucks entered the juice market with its Evolution Fresh juice bars a few years ago, analysts immediately warned that the new stores would generate lower margins than its coffee shops.
Based on those facts, we can assume that Luckin's ongoing expansion of its menu boosts its revenue at the expense of its gross margins -- which is troubling for a company that still lacks a clear path toward profitability.
Will Luckin run out of luck?
Starbucks ended last quarter with 3,922 stores across China. Luckin grew its store count 375% annually to 2,963 locations last quarter and plans to surpass Starbucks with 4,500 stores by the end of the year.
That breakneck expansion significantly boosts Luckin's revenue, which soared 648% annually to RMB 909 million ($132 million) last quarter, but it hasn't lapped the openings of most of its stores yet -- so it's still unclear if they can generate sustainable same-store sales growth.
Luckin's drinks cost about 25% less than comparable drinks at Starbucks. It also constantly promotes its drinks with coupons and promotions. Those moves attracted a large number of consumers in a short time, but it's unsustainable because Luckin remains deeply unprofitable.
Luckin posted a net loss of RMB 611 million ($89 million) last quarter, compared to a loss of RMB 333 million a year ago. Meanwhile, it continues to increase its store count; expand its menu with lower-margin items like food, teas, and juices; and promote its new products with margin-crushing promotions.
There's no easy way for Luckin to narrow its losses. If it raises its prices and halts its promotions and marketing blitzes, it could lose customers to Starbucks. If it opens fewer stores to rein in its operating expenses, its triple-digit revenue growth could decelerate significantly.
Luckin is losing its focus
Much of Luckin's early success was driven by three factors: Its coffee was cheap, it offered a simple menu and delivery options via its app, and its ordering kiosks were cheaper and easier to set up than full-size cafes.
Luckin's coffee is still cheap, but its menu is getting bloated and its locations are getting bigger, with 20% of its locations offering full delivery kitchens and 4% of its locations offering larger "relax" stores which are as big as restaurants. It also lost its online delivery advantage when Starbucks teamed up with Alibaba's Ele.me for deliveries last year.
Therefore, Luckin's joint venture with LDC -- along with its expansion into teas and a plan to expand across the Middle East and India -- are all red flags which indicate that this red-hot coffee company is losing its focus. If Luckin continues down this path and continues to neglect basic issues like its widening losses, its negative cash flow, and its increasing dependence on promotions and lower-margin menu items, it could burn a lot of investors as its business implodes.