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Is Luckin Coffee's Coronavirus Sell-Off Justified?

By Leo Sun - Jan 27, 2020 at 2:17PM

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The viral outbreak will make it tough for the coffee chain to generate sustainable growth.

Luckin Coffee's (LKNC.Y -4.25%) stock tumbled this past week amid concerns that the ongoing coronavirus outbreak in China would curb the coffee chain's sales growth. The outbreak, which has killed over 80 people and infected 2,700 others across China as of this writing, has already resulted in the lockdown of nearly 20 Chinese cities.

The Chinese New Year holiday, which spans Jan. 23 to Jan. 29, is also exacerbating the virus's spread across China and into other countries. Do those fears justify Luckin's steep sell-off? Or is gravity simply catching up to the high-flying stock, which until Jan. 21 was up 194% from its $17-a-share IPO (initial public offering) price last May, but is now down 25% since that 52-week high on Jan. 17?

Reviewing Luckin's strengths and weaknesses

Luckin is a divisive stock for bulls and bears. The bulls highlight its meteoric growth rates: Its revenue soared 558% annually to 1.49 billion yuan ($209 million) last quarter; its store count grew 210% to 3,680; its number of active monthly customers jumped 398% to 9.3 million; and its store-level operating margin -- which excludes promotions, discounts, and marketing expenses for new stores -- is improving.

Two mugs of barista-decorated coffee on a wooden table

Image source: Getty Images.

However, the bears will note that Luckin is still deeply unprofitable, and its net loss widened annually from 485 million yuan to 532 million yuan ($74 million) last quarter. Its non-GAAP (adjusted) net loss, which excludes stock-based compensation expenses, also widened from 484 million yuan to 491 million yuan ($69 million).

Luckin sells its drinks at lower prices than Starbucks (SBUX 0.12%), and it constantly offers steep discounts to attract new customers. It also generates most of its revenue growth from new store openings, and most of its stores have been open for less than a year -- so we can't tell if they'll generate sustainable comps growth yet.

Luckin is opening larger stores and adding menu items like juices, teas, and light meals to drive its sales growth, but those strategies all generate lower-margin revenue than its original coffee kiosks. It will likely lose customers if it dials back promotions, and it's unclear whether it can lock in enough customers to generate sustainable growth.

Analysts expect Luckin's revenue to rise 186% to $2.13 billion next year; its market cap of $10.5 billion gives it a reasonable forward price-to-sales ratio of 4.9. However, its losses are expected to continue widening for the foreseeable future.

Gauging the coronavirus impact

Luckin's aggressive expansion enabled it to surpass Starbucks in total number of Chinese stores at the end of 2019. Research company Thinknum Alternative Data claims that Luckin ended the year with about 4,500 stores, compared to roughly 4,300 Starbucks stores.

However, Luckin's massive expansion increased its exposure to coronavirus-stricken areas. Luckin doesn't offer an updated map or store count for its Chinese locations, but it reached over 40 major cities in early 2019.

The skyline of Wuhan, China

Image source: Getty Images.

Last quarter, Luckin noted that its coffee stores mainly serve first- and second-tier cities, while its tea stores "cover the whole country, including fourth- and fifth-tier cities." It stated that its coffee stores would mainly be company-operated, while its tea stores would mainly be operated by partners or franchisees. Wuhan, the epicenter of the coronavirus outbreak, is a "new tier one" city that rests between the first and second tiers.

Transportation restrictions and fears of infection should cause more customers to stay at home after the Chinese New Year, which could throttle the growth of Luckin's larger and more capital-intensive "relax" stores. Tighter travel restrictions could also choke Luckin's delivery platform, which gave it an early edge against Starbucks. Couriers for top food-delivery platforms like Alibaba's Ele.me and Meituan-Dianping are already being closely monitored for exposure to the coronavirus, and tighter rules could result in fewer and slower deliveries.

If the coronavirus outbreak matches the scale of the SARS outbreak in the early 2000s, it could last for nearly two years before being contained. If that happens, it could be difficult for Luckin's new stores to generate year-over-year comps growth -- which would spook investors and prevent its franchisees and partners from opening new stores.

Don't catch a falling knife

Luckin Coffee was expected to prove itself over the next few years. Unfortunately, the coronavirus crisis is ramping up the difficulty level and giving investors a compelling reason to take profits. Therefore, Luckin should remain a falling knife until the market sees clear signs that the coronavirus outbreak is contained.

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