AnalysisU.S.

3 ways Starbucks will take advantage of Luckin Coffee’s RMB2.2 billion scandal

Luckin Coffee’s shares took a 75% plunge on 2 April 2020 and it certainly wasn’t a late April Fool’s prank as it was revealed that Luckin’s COO Liu Jian had allegedly faked RMB2.2 billion worth of sales from the second quarter of 2019 to the fourth quarter of 2019.

The Chinese company’s aim was to dethrone Starbucks (at least in China first) by pursuing an aggressive growth strategy — from developing an app-based purchasing model to selling wireless keyboards and Beats headphones at their coffee chains. The expansion of Luckin Coffee in China has been so rapid that by the end of 2019, it already had 4,500 outlets in China. In contrast, Starbucks had 4,300 stores then in China despite entering the Chinese market as far back as 1999.

Pre-scandal, Luckin looked increasingly like a threat to Starbucks with its tremendous revenue growth. From Q1 2018 to Q1 2019, revenue grew from RMB13 billion to RMB479 billion, a growth rate of 3,585%!

Source: Luckin Coffee

However, note that Luckin’s net revenue figures for the second and third quarter of 2019 as shown in the chart have alleged to been fabricated. Hence, Luckin’s prima facie revenue growth after the first quarter of 2019 may not be what it seems after all.

Luckin’s apparently strong revenue growth was due to the aggressive strategy it used — ranging from mobile payments, steep discounts for its coffee, low-cost delivery services, and the rapid expansion of its pickup stores throughout China.

Not waiting to be outdone by Luckin, Starbucks has countered the start-up by venturing into areas which had initially enabled Luckin to chip away at Starbucks’ market share in the Chinese coffee market. We will look at how Starbucks is eroding several of Luckin’s value propositions that led to the latter’s hitherto growth.

1. Mobile order and pay

One of Luckin’s value propositions is its grab-and-go concept. Unlike Starbucks which has traditional sit-in cafes, 91% of Luckin’s stores come in the form of pick-up stores. Luckin’s customers make their customised orders via Luckin’s app and are notified when their drinks are ready for collection. They would then collect their drinks from the nearest Luckin pick-up store which is 100% cashierless. This increases Luckin’s profitability as staff and rental expenses are minimised.

Luckin’s pick-up stores have proven popular among the Chinese – Luckin clocked a 142.9% compounded quarterly growth rate in the cumulative number of transacting customers from the Q1 2018 to Q1 2019 pre-scandal.

Starbucks recognised that the convenience of Luckin’s grab-and-go concept appealed to the Chinese. In May 2019, Starbucks rolled out its ‘Mobile Order and Pay’ experience to 300 select stores in Beijing and Shanghai. Starbucks has plans to introduce this feature in their stores throughout the mainland in 2020, though this rollout will now most likely be disrupted by the COVID-19 crisis.

Like Luckin, Starbucks Mobile Order and Pay allows customers to place an order in advance of their visit and pick up their beverage and food at a Starbucks store. Starbucks’ traditional cafes now essentially double up as a pick-up store. While traditional cafes can double up as a pick-up store, the reverse is not true. On this point, Starbucks has the edge over Luckin, who only has 86 ‘relax stores’ in China as of 31 March 2018.

Having said that, Luckin’s pick-up stores are strategically positioned in areas with high demand for coffee like office buildings and commercial areas. According to a Frost & Sullivan report, most of Luckin’s pick-up stores are located within 500 metres of populated areas.

2. Delivery

Luckin has provided delivery services to its customers since its inception in late 2017. Clearly, Luckin recognised the essentiality of delivery services in China’s modern economy first, providing Luckin an edge over Starbucks. But Starbucks soon ventured into the delivery space by announcing a tie-up with Alibaba’s delivery platform Eleme in Aug 2018. The battle between Luckin and Starbucks to capture market share of China’s delivery market does not end there. Here’s a brief timeline of the delivery war between Luckin and Starbucks:

Of note, Starbucks opened its first express retail experience store — Starbucks Now — in Beijing’s financial district in July 2019. It is a combination of the company’s ‘Mobile Order & Pay’ and ‘Starbucks Delivers’. Clearly, Starbucks is digitising its customer experience and venturing into store formats which emphasises convenience. The company plans to open similar stores across high-traffic areas to go head-to-head with Luckin.

Starbucks has responded well and promptly to Luckin’s aggressive growth strategy in the delivery space and eroded one of Luckin’s key value propositions.

3. Brand equity

Another of Luckin’s value propositions lies with its much cheaper coffee compared to Starbucks. Luckin’s prices are around 20-30% cheaper than Starbucks in China. Despite Luckin’s growth, its heavy discount strategy has been described as unsustainable by Starbucks CEO Kevin Johnson. The Chinese company has yet to turn a profit and with the alleged scandal now in the mix, Johnson’s view may turn out to be true.

According to Financial Times, Starbucks accounted for half of China’s revenue share in the specialty coffee market in 2018. In comparison, Luckin’s revenue share was only 2.1%.

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Source: Financial Times

Starbucks commands such a large revenue share because it can charge a higher price for its coffee due its brand equity, especially in China where local consumers perceive foreign brands to be of higher quality. In essence, Starbucks is the equivalent of Apple in China’s coffee market. (Similarly, the tech giant also commands around half of all mobile phone revenue share worldwide.) Hence, although Starbucks coffee is more expensive than Luckin’s, the rapid rise of the prosperous Chinese middle class means that demand for Starbucks coffee might still be sustained.

The fifth perspective

Luckin’s financial scandal has certainly put the integrity of its management to question. It has also led investors to wonder if Luckin’s financials from April to September 2019 were so bad that it had to be falsified.

Nevertheless, Starbucks has the financial resources and capability to withstand all the value propositions Luckin has offered that would threaten Starbucks’ dominant position in the Chinese market. Luckin cannot rely on steep discounts forever. Unless it discovers new value propositions, the underpenetrated Chinese coffee market is Starbucks’ to take.

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Dean Goh

Dean has written and published investment articles since he was 18. Investing primarily in the U.S. and Chinese equity markets, he bases his investing decisions on good old Buffett-inspired fundamental analysis. He will be studying Philosophy and Economics at the London School of Economics.

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