Luckin Isn't The 'Starbucks' Of China, But It Doesn't Have To Be To Get Big Returns - Luckin Coffee Inc. (NASDAQ:LK)

The market may be skeptical about Luckin’s ability to compete with Starbucks in China, but given an underpenetrated market, and rapid demand growth, this may not matter.

Luckin Coffee (LK) is the most recent Chinese IPO hitting American markets this year. Unlike other "Unicorn IPOs", Luckin seemingly came out-of-nowhere, a largely unheralded coffee company that rapidly grew from a few stores just years ago, to thousands currently.

Luckin is trying to disrupt Starbucks (SBUX) as the premier coffee destination for the Chinese consumer, but the market appears somewhat skeptical about this possibility. Stock prices have remained near IPO levels, in stark contrast to the success of other "industry disruptors" such as Beyond Meat (BYND) and Zoom Video Communications (ZM).

Uniform Accounting highlights that at current prices, markets are pricing in expectations for Luckin to become a below peer-median restaurant brand. However, if the firm can execute on a number of its key value drivers, and become a viable challenger to Starbucks, upside is likely for the name.

The PVP chart below reflects the real economic performance and valuation measures of Luckin Coffee Inc. after making many major adjustments to the as-reported financials to make them more reflective of economic reality. The rationale behind Uniform Adjusted Financial Reporting Standards (UAFRS) or "Uniform Accounting", and theory supporting this model can be found here.

The four panels explain the company's historical corporate performance and valuation levels plus consensus estimates for forecast years as well as what the market is currently pricing in, in terms of expectations for profitability and growth.

The apostrophe after ROA', Asset', V/A', and V/E' is the symbol for "prime" which means "adjusted" under Uniform Accounting, and these metrics will be referred to as "Uniform" throughout this report. These calculations have been modified with comprehensive adjustments to remove as-reported earnings, asset, liability, and cash flow statement inconsistencies and distortions. To better understand the PVP chart and the following discussion, please refer to our guide here.

LK currently trades at a 4.7x Uniform P/B (Fwd V/A'). At these levels, the market is pricing in expectations for Uniform ROA to inflect positively, improving from -28% in 2018 to 7% in 2023, accompanied by 60% Uniform Asset growth going forward, as the company continues to invest heavily into its mobile application, store openings, and new product offerings. Although this growth may seem aggressive at first glance, considering the Chinese coffee market's growth rate (as discussed further), as well as LK's potential to at least double its share (which was fairly immaterial at the end of 2018), these expectations are justifiable.

As a start-up coffee chain, operating exclusively in China, LK has seen grossly negative, yet improving profitability. Uniform ROA increased from -108% in 2017 to -28% in 2018, as the firm has aggressively expanded its store count, but LK still has a lot of ground to cover before becoming a profitable company. Meanwhile, LK's Uniform Asset growth has been off the charts, as the brand has grown from a few pop-ups to a chain with thousands of locations.

For context into the reasonableness of the above forecasts, estimates can be compared against its closest peer and largest competitor in China, Starbucks. In contrast to LK, SBUX is an already well-established and highly profitable firm, both in the region and internationally, with an estimated 59% market share, and well on track to achieve its goal of 6,000 stores, across 230 cities, by the end of 2022. At current valuations, its Uniform ROA is projected to expand from 18% in 2018 to 21% in 2023, accompanied by 9% Uniform Asset growth going forward. In comparison, market expectations for LK are muted, as valuations have been hampered by somewhat bearish sentiment.

Specifically, markets may be skeptical about LK's ability to take market share from SBUX and fend off competition from convenience stores and small grocers who may offer coffee products. Moreover, markets may be skeptical about LK's ability to sustain its rapid expansion, and reduce its losses, as the firm has relied heavily on promotional discounts, including offering free coffee, in order to build its brand. Furthermore, markets may be skeptical about risks surrounding the Chinese government and general bureaucracy, and the demand for more coffee chains in China, an admittedly tea-oriented beverage culture.

However, China's coffee market is severely underpenetrated, with inconsistent product quality, high prices, and often inconvenient service. With a population of over 1.3 billion people, and rapidly expanding coffee consumption trends, estimated at 20-30% annual growth, China's total addressable market is large, and consistently growing, which should allow for ample growth opportunities for global coffee giants, as well as domestic players. Currently, Chinese consumers drink 5 cups of coffee on average a year, as opposed to 360 cups in Japan, and over 400 cups in Europe, suggesting China has the potential to become one of the largest consumers of coffee globally.

In addition, LK's business model provides certain advantages that may not be currently priced in, and if management can capitalize on a few of its potential value drivers, upside for the name may be warranted. While SBUX focuses on higher-end offerings, including a dine-in experience, LK is looking to differentiate itself by focusing on lower-cost products and a takeaway model, likening itself to SBUX's most successful American competitors, such as Dunkin' Brands (DNKN) or McDonald's (MCD). Moreover, all of LK's sales are currently conducted through their mobile app, further driving their focus on mobility and convenience, and allowing them to leverage AI to analyze customer behavior and create products and services that better cater to Chinese consumer needs.

Thus, given these potential growth drivers, coupled with their aggressive expansion strategy, LK has the ability to gain share in China and become a formidable challenger to SBUX. Even if it is unable to surpass SBUX (which may be in a league of its own), when comparing against a broader set of comps, namely non-franchise-oriented restaurant brands, expectations are still reasonable, if not cheap, at current prices.

LK owns all of it stores, and although other coffee sellers such as DNKN and MCD seem like close comps, their franchising models produce higher ROAs, as a result of a significantly smaller asset base. Instead, using other restaurants who generally focus on corporate-owned stores as a comp group provides a stronger basis for reasonable long-run profitability expectations. Firms in this group include Chipotle Mexican Grill (CMG), Cracker Barrel Old Country Store (CBRL), Bloomin' Brands (BLMN), The Cheesecake Factory (CAKE), Greggs (LON:GRG), and Shake Shack (SHAK).

As shown in the chart above, corporate-owned restaurants have Uniform ROAs that range fairly tightly from 7% to 11%. At current valuations, LK is priced to have profitability reach levels towards the low end of this range, well below the peer group median, suggesting a bearish case for the firm.

Given the aforementioned growth drivers, as well as political tailwinds from the barriers to entry in China, LK should likely be able to comfortably meet these expectations. Even if potential headwinds prohibit the firm from reaching their goal of surpassing SBUX as the premier coffee shop in China, LK could beat their current expectations by remaining #2 and achieving peer median-levels in the long-run.

To justify valuations, LK just needs to be a lower-end profitability restaurant firm that slightly exceeds corporate averages. If LK were to only compete on price, it should be able to join the large number of companies that perform at these levels, but if it is able to leverage its AI capabilities to improve customer retention rates and lower customer acquisition costs, then it may be able to challenge Starbucks as the barista-of-choice in China.

Based on the market's base scenario, if LK can just achieve peer-low Uniform ROA of 6-8% and grow between 55-65% annually, representing the ability to capitalize on Chinese coffee market growth, while doubling or tripling its market share in the next five years, the stock can see anywhere from 26% downside to 34% upside. Even this base scenario provides a neutral, if not slightly positive, risk-reward relationship.

However, keeping growth expectations stable, if LK can reach peer-median Uniform ROA of ~10% or even hover near peer-highs of 11%, their stock has the potential to see prices rise to $25-$35 levels, representing between 30-87% upside from the current price of $19.23, at the time of this analysis. Even without reaching the levels of SBUX, LK can be a portfolio gem simply by becoming a viable competitor.

But what if Luckin can replicate the success of Starbucks in China?

At Starbucks- level profitability, assuming approximately market-level growth of 30-35% (with minor market share gains), LK stock price can rise to ~$22-$27 levels, representing 11-40% upside. However, if the firm can reach its primary competitor's profitability levels, while also maintaining the market share gains and growth assumed in the other scenarios, valuations can reach $45-63 levels, representing an extremely attractive 130-220% upside.

Across virtually all scenarios, assuming LK remains operationally viable, upside is justifiable at current prices. Although LK would be an absolute home-run if it were able to continue its growth and reach Starbucks-level profitability, its risk-reward trade-off remains favorable, if only it can become an average performer in the long-term.

Luckin Coffee may not be the "Starbucks" of China, because there already is Starbucks in China, but it does not have to be in order to capture real upside. If LK can just become an average restaurant chain, it should be able to see material stock price appreciation.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in LK over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Seekingalpha.com

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