Luckin Coffee Inc.’s (LK, Financial) biggest problem isn’t murky accounting, which crushed its shares earlier this month. Rather, it's the company’s business model, which relies on store openings, free cups of coffee and technology to beat the competition.
Ever since launching its first stores in Beijing and Shanghai two years ago, Luckin Coffee appears to have a dual mission, beat Starbucks (SBUX, Financial) in store count and in cups of coffee sold to customers. And it has done whatever it takes to accomplish that mission as quickly as possible.
One way of accomplishing this goal has been opening small “pick-up” shops in buildings and college campuses at a feverish pace. That’s how the company reached 4,509 sores by the end of 2019, beating Starbucks, which has 4,123 stores, according to Statista.com.
Then there’s technology. Luckin has been using an app to streamline its operations and analyze consumer preferences.
And then there’s free coffee. Luckin has been giving a lot of cups of coffee away to win customers, which has helped it gain a huge base of users.
These are costly strategies, but money isn’t the problem these days. Venture capitalists and Wall Street have provided plenty of it in the hope that they have discovered another Starbucks.
But Luckin Coffee is not and cannot be another Starbucks because it doesn’t have a business model that rivals its largest competitor. It also doesn’t operate at the same “social context” as Starbucks did back in its early days.
At the core of the coffee chain giant’s business model is the “third place,” an “affordable luxury” away from work and home where people can share and enjoy a cup of coffee with friends and colleagues.
That’s something that was missing from the American urban landscape back in the 1980s and the 1990s as middle-aged baby boomers were trying to balance work life and family life.
Starbucks' business model addressed this market with a three-fold strategy:
- Market segmentation: Target upper-scale of the coffee market, competing on comfort and amenity rather than speed and convenience, which is the case with its closest competitors, McDonald’s (MCD, Financial) and Dunkin’ (DNKN, Financial).
- Focus: Its original product package that includes mixed espresso drinks, quality service and a nice environment to hang around.
- Innovation: Develop innovative products to keep the hype for the brand alive.
At the core of Luckin’s business model isn’t a “third place.” It’s the fast delivery of coffee everywhere, which makes it a commodity—a product that can be easily replicated by the competition that is.
Business strategists know very well what that means: a price war and declining profits to the point where the return on invested capital is equal or below to what capital can earn elsewhere.
| Company | ROIC | WACC | Economic Profit (ROIC-WACC) |
| Luckin Cofee | -197.47% | 0.00% | -197.47% |
| Starbucks | 55.13 | 4.70 | 50.43 |
| Dunkin | 13.52 | 5.46 | 8.06 |
Source: Compiled from GuruFocus on April 27, 2020.
That’s certainly not the right way for Luckin to beat Starbucks.
While Luckin's business model doesn’t beat Starbucks, its shares are still overvalued, according to equity analyst John Zolidis.
“We revised our financial forecasts to the greatest extent possible using sketchy revised figures from the company,” he said. “Note that revised total revenue for 2019 (a number we have with some confidence) is only $400M USD and the market cap is $1.3B in USD.”
Back in February, Zolidis was bearish on Luckin shares.
“We are sellers of LK shares,” he wrote in a brief about the company. “Recent Price $ 38.33 EV/ NTM EBITDA 61.5 NTM EBITDA margin 6.1% Market Cap $B $ 9.2 Short Interest 12% NTM EPS growth NM.”
He’s still bearish today, recommending that investors sell or short Luckin’s shares.
Disclosure: I own shares of Starbucks.
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