The fraudulent rise and fall of Luckin Coffee will help Starbucks in China

Lucky Coffee‘s (NASDAQ: LK) The rise and fall has captivated investors. In the span of 18 months, it went from being a start-up with an interesting coffee delivery and delivery business digitally focused on China’s largest coffee chain by number of stores. Its rapid growth, fueled by margin cut promotions, helped bring coffee to the masses in China.

This breakneck growth caused some investors to worry that Luckin coffee would undermine Starbucks(NASDAQ: SBUX) position in China. However, this growth was not entirely genuine. Several Luckin employees, including top executives, conspired to fake hundreds of millions of dollars in sales last year. That makes Luckin seem much less of a threat to Starbucks in China. In fact, it looks more like a pipeline for acquiring subsidized customers.

A delivery man leaving a Starbucks cafe in China

Image source: Starbucks.

Luckin Coffee: myth and reality

Two years ago, Luckin Coffee operated only 624 stores. However, in the quarters before and after its May 2019 IPO, the company expanded its presence rapidly. The store count tripled to 2,073 by the end of 2018 and almost doubled again to 3,680 by September 30, 2019. Luckin has not reported an official store count since then; in fact, it hasn’t presented any financial results at all, but its number of stores increased to almost 7,000 at the end of May, according to Thinknum Alternative Data.

Despite adding stores at a breakneck pace, Luckin claimed that store productivity was also improving. It reported that it sold 34.7 million freshly prepared drinks per month in the third quarter of 2019 – an average of just over 10,000 per store. That compares to 13.1 million freshly prepared drinks per month just two quarters earlier – roughly 6,000 per store on average. Not surprisingly, improvements in store productivity of this magnitude lead to significant growth in store-level margins.

The secret to Luckin Coffee’s amazing performance came out in early April – much of it was fake. Luckin revealed that dishonest employees (including top executives) had increased revenue by approximately 2.2 billion yuan ($ 311 million) between the second and fourth quarters of 2019 by recording “manufactured transactions.” This represented nearly half of the company’s reported second and third quarter revenue and projected fourth quarter revenue.

Luckin Coffee has yet to present its 2019 annual report. However, based on the company’s estimate of the amount of revenue that was produced, it appears that average store sales decreased over the course of 2019, especially if it excludes sales of lifestyle products at great discounts.

The interior of a Luckin coffee shop

Image source: Luckin Coffee.

That is exactly what you would expect. By quickly adding stores and offering deep discounts, Luckin Coffee fueled strong sales growth (although not as strong as initially reported). But this came at a cost in terms of store productivity, which likely exacerbated the unprofitable nature of its business model.

The addressable market opportunity

Just over a year ago, I argued that Luckin’s rapid expansion could be good for Starbucks in the long term. By getting more Chinese consumers to develop a coffee habit, Luckin would expand the addressable Starbucks market in China, overcoming the impact of lower market share.

In fact, although estimates vary, annual coffee consumption per capita in China is quite low today: perhaps six cups. That compares to 180 cups per capita in Japan and even higher consumption in the United States and much of Europe. As a result, while Starbucks’ market share is much higher in China than here in the US, it still generates approximately six times as much revenue in the US as it does in China.

If annual per capita coffee consumption in China were to rise to 50 cups in the next decade or so and Starbucks would capture just 5% to 10% of that market, Starbucks annual revenue would increase more than $ 10 billion, and possibly even more than $ 20 billion. In comparison, Starbucks’ annual revenue rate in China was around $ 3 billion before the COVID-19 pandemic.

Grow the market, maybe for Starbucks

Luckin Coffee capitalized on its strong (falsified) second and third quarter results to raise $ 865 million of capital earlier this year. It issued shares at $ 42 per US depository share and five-year convertible debt at an interest rate of 0.75% and a conversion price of $ 54.60. For comparison, Luckin Coffee’s shares are now trading for around $ 3.

This cash infusion allowed Luckin to open more than 2,000 new stores in the first four months of 2020. (However, he appears to have closed a few stores in the past month.) In the short term, at least, the Luckin Coffee fraud gave him access to capital to continue his strategy of rapid cash expansion combined with deep discounts.

Indeed, growth-hungry investors who were duped by Luckin Coffee have subsidized a massive project to get Chinese consumers to develop a habit of drinking coffee. It is unclear if Luckin will be present to reap any of the rewards. He faces numerous lawsuits that could drain his cash, and it’s unclear if he’ll be able to stop his losses any time soon.

That makes it even more likely that some of these new coffee drinkers will eventually become Starbucks customers, allowing the coffee titan to continue its methodical growth in China. The battle between Starbucks and Luckin Coffee in China seems like a case where the race slowly and steadily wins.