Luckin Coffee (OTC:LKNC.Y), the Chinese coffee store chain that went public in May, has repeatedly claimed that it will eclipse Starbucks' (NASDAQ:SBUX) store count in China. Luckin's growth rate indicates that could happen soon: Its number of stores surged 210% annually to 3,680 last quarter, while Starbucks' store count grew 17% to 4,125.
But there's a key difference between Luckin and Starbucks: Luckin is deeply unprofitable, while Starbucks generates stable profits and pays a 2% dividend. Should investors take a chance on the unprofitable newcomer with triple-digit revenue growth, or stick with the well-established leader?
How did Luckin grow so quickly?
Luckin was founded just two years ago, but it expanded rapidly with four main strategies: It sold its drinks at lower prices than Starbucks, it promoted new store openings with big discounts, its kiosks were cheaper to set up than full stores, and it adopted a digital-first approach that locked customers into its app and delivery ecosystem.
Luckin's venture capital backing, which boosted its valuation to $2.9 billion prior to its IPO, enabled it to expand aggressively without worrying about profits. It then raised over $560 million in its market debut, which ensured that its expansion could continue.
Luckin's revenue surged 558% annually to 1.49 billion yuan ($209 million) last quarter. It doesn't report comparable store sales numbers yet, since the vast majority of its stores haven't been open for more than a year. This makes it tough to tell if Luckin's expansion is sustainable.
Luckin also depends heavily on promotions, discounts, and marketing blitzes to gain new customers. But it excludes all those expenses from its proprietary "store level" operating margin, which only deducts its cost of materials, store rental fees, and other operating and depreciation costs from its total product revenue.
Luckin's "store level" operating margin of 12.5% last quarter marked a major improvement from an operating loss a year earlier, but its net loss still widened from 485 million yuan to 532 million yuan ($74 million).
The tailwinds that supported Luckin's initial growth are also dissipating. It's diversifying away from its high-margin coffee-based drinks toward lower-margin juices, teas, and light meals. It's opening a higher percentage of larger "relax" stores, which resemble traditional cafes instead of low-cost kiosks. Starbucks also countered Luckin's digital-first strategy with a delivery partnership with Alibaba's Ele.me.
All these issues indicate that Luckin's growth is unsustainable. If it raises its prices and dials back its promotions, it could lose customers to Starbucks, convenience stores, and other rivals. If it stops opening new stores, its revenue growth could hit a brick wall as it struggles to generate comps growth at its existing stores.
Is Starbucks a better choice?
Starbucks and Luckin Coffee can likely co-exist in China without competing with each other. Starbucks is considered a "luxury" brand in China, and it reinforces that reputation by opening high-end Roastery locations (including a 30,000 square foot flagship location in Shanghai) and consistently selling its coffee at higher prices than other chains.
Starbucks' comps rose 5% in China last quarter, indicating that Luckin's feverish expansion wasn't pulling away its core customers. Its comps in the U.S. (its largest market) also grew 6%, as its total worldwide comps improved by 5%.
Starbucks also increased its total store count 7% annually to 31,256 locations during the quarter, with expansions across both its Americas and International divisions. In fiscal 2020, Starbucks expects to open about 2,000 new stores worldwide -- consisting of 600 new locations in the Americas and 1,400 international stores -- all while generating 3%-4% comps growth. It didn't provide an exact store count for China, but it expects the country's store count to grow by the "mid-teens."
Starbucks expects its revenue and non-GAAP earnings to both grow 6%-8% this year. Those growth rates are a bit low for a stock that trades at 25 times forward earnings, but investors seem willing to pay a premium for Starbucks' brand, expanding moat, and consistent profitability -- three key strengths which Luckin sorely lacks.
The winner: Starbucks
Luckin generates jaw-dropping revenue growth, but most of that growth comes from new stores that are launched with loss-leading strategies. It still isn't generating consistent comps growth yet, it's drifting toward lower-margin products and more capital-intensive stores, and it has no clear path toward profitability.
In short, Luckin's future is still too speculative. Investors looking for a more sustainable bet on China's growing thirst for coffee should stick with Starbucks instead.