Luckin Coffee's IPO Faces Significant Hurdles Toward Success

Will this be the next Starbucks?

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May 10, 2019
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Westerners normally associate China with tea, but the country’s youth is turning toward coffee. CBS News reported last year that coffee consumption in China has tripled over the past four years, fueled by a rising middle class that seeks to emulate Western habits. Starbucks (SBUX, Financial) has taken advantage of this trend, and posted stronger than expected second quarter results last month in part due to sales in China.

But the coffee giant has a new Chinese rival on the horizon. Luckin Coffee, a China-based company founded in 2017, already operates more than 2,000 coffee shops across China. Last week, it filed to go public on the Nasdaq under the symbol LK. While Luckin Coffee did not state how much it plans to raise nor its valuation, sources told Reuters that it is seeking to raise $500 million to $800 million and chase a valuation of between $4 billion to $5 billion.

If you are thinking that Luckin has perhaps risen too rapidly, you are most likely right. No value investor should touch Luckin with a hundred-foot pole. The problems with both the company and the IPO itself create risk that is wildly disproportionate with the company’s growth profile.

IPO Problems

We can begin discussing Luckin’s numerous problems by asking a single question. Luckin operates only in China, so why is it filing for an IPO in the U.S. and not in Hong Kong? Luckin says that it made this decision because it wants to compete with Starbucks directly, but it is just as likely that it wants to lure investors who are eager to hop on the next Chinese bandwagon without doing research.

But investors will not be investing in Luckin. Due to Chinese regulations, Luckin has created an offshore entity in the Cayman Islands, which is what investors will actually be buying shares of. Luckin will pay fees and royalties to said entity, but investors will have no voice in the company itself. And if that was not problematic enough, Luckin is using a dual class share model, where the shares sold would have limited voting power compared to shares held by top executives.

Luckin’s business model

When faced against a competitor like coffee behemoth Starbucks, Luckin has to do something different. The good news is that it is at least trying.

Starbucks aims to not just be a coffee shop, but a congregation point where people can come in, stay, socialize and do business. Maybe they will not buy anything, but being a hangout spot is good for Starbucks' brand.

As shown in its SEC report, Luckin has 109 “relax stores,” which are similar to Starbucks. But the core of its business are pick-up stores where people come in, pick up a coffee and leave. Furthermore, customers can order coffee not just at a cash register, but with an online app. This means that one can order coffee while they are on their way to Luckin and get it immediately when they arrive without having to wait. Luckin has 2,163 pick-up stores.

Luckin can expand by opening further stores, but it offers another avenue as well. China's coffee market is dominated by instant coffee. But if we look at the history of coffee in Japan, we see that instant coffee’s popularity has faded in favor of real coffee. Luckin offers not instant, but hot and freshly brewed coffee with Arabica beans. If Chinese coffee tastes change over the next few years, that offers an avenue of expansion without the expense of further stores.

Finances and valuation

We can expect China's coffee market to rise, and Luckin to take advantage of that growth. But that is not enough, especially when we consider Luckin’s dismal finances.

The first thing to note is that since Luckin is so new, it is hard to figure out exactly how much it is growing. Luckin did report that its revenue in 2018 was $125 million, followed by $71 million in just the first three months of 2019. This indicates that Luckin is growing rapidly, but it is harder to predict what its total 2019 revenue will be.

And while Luckin’s revenue is high, its other numbers are filled with problems. Many companies go public while making high net losses. But Luckin reports an operating loss of $363 million in 2018 and $149 million in the first three months of 2019. Luckin’s expenses in just “cost of materials” and “store rental and other operating costs” combined outstrips its revenue. Luckin also reported a negative cash flow of $195 million in 2018. Even for an IPO, this company is hemorrhaging money very quickly.

Concerns about these losses are further amplified when you remember that Luckin is not a tech company Concerns about these losses are further amplified when you remember that Luckin is not a tech company selling connected cars, but a coffee retail chainbut a coffee retail chain. Luckin’s ability to rely on economies of scale will be limited as additional stores mean additional expenses. It may be able to rest on product quality, but such a transition in coffee tastes will take years.

The last thing to understand is Luckin’s valuation, which is made more difficult by the lack of financial information. Let us presume that Luckin’s revenue will be around $280 million in 2019. A market cap of $5 billion gives us a price-sales ratio of 17.8, while a market cap of $4 billion gives us 14.2. Starbucks sits at 4.

Don’t even think about it

Chinese companies launching IPOs in the U.S. have not had an illustrious history, which means that Luckin would truly need to stand out to be a worthwhile investment. Far from doing so, there are several reasons for investors to stay away. This company does not have enough of a history. Its planned valuation is far too high. It is highly unprofitable. It will not be responsive to U.S. shareholders.

One to avoid.

Disclosure: The author does not have any stake in the listed equities.