China coffee shops: Out of Luckin?

In the space of about 12 months, Luckin Coffee has grown from a start-up with no assets into one of China’s largest coffee shop chains with over 2,000 outlets and $400 million in private equity funding. GIC Private, Centurium Capital and Joy Capital are among the investors, having been impressed by the company’s technology-oriented business model and bold plans to unseat Starbucks.

But as Luckin grapples with the rising costs tied to its ever-expanding footprint, questions are being asked about the sustainability of the business model. Can the combination of technology and scale really deliver acceptable margins?

“We will never become the next Ofo,” Fei Yang, the company’s chief marketing officer, told Chinese media in January, referring to the embattled bike sharing business. “Our management team comprises veteran entrepreneurs, who are cautious and rational, but not some fresh university graduates.”

Premature judgment?

It is true that Luckin’s leaders have extensive resumes. The company was founded by the former COO of chauffeured car service provider Ucar, which was, in turn, the brainchild of the team behind China Auto Rental (CAR). Both companies received substantial private funding and then went public, on the National Equities Exchange & Quotations (NEEQ) and on Hong Kong’s main board, respectively.

Yet to some, comparisons with Ofo are apt. Between 2015 and 2018, the bike-sharing player raised $2.2 billion across eight funding rounds. This capital was pumped into inventory (bicycles rather than coffee shops) and services were sold at low prices in a battle for market share with a powerful competitor (Mobike rather than Starbucks). Hopes for an early IPO at a high valuation came to nothing and now Ofo is on the verge of bankruptcy.

The business models are not identical and there are those who argue that Luckin can successfully apply technology to a mass-market consumer need as an “expandable, shelf-less 7-Eleven.” To non-believers, the company’s ambitions might seem like a recipe for disaster. It plans to open another 2,500 outlets in 2019 and overtake Starbucks – which has about 3,300 shops in China – in terms of footprint and daily sales volume. 

“Luckin needs to think about how it can manage its growth and the pace of opening new stores, as well as the best way to manage its supply chains. Companies like Starbucks have global operations and well-established management teams – I think is a key differentiating factor between the two companies,” says Mariana Kou, head of China education and Hong Kong consumer research at CLSA.

Asked for their response to these concerns, investors in Luckin point to the company’s technological capabilities. 

“It is trying to combine a specialist coffee shop chain with digital tools, offering a more customized service to clients. Consumers can decide if they want milk or how much sugar they would like to add to their coffee through an online ordering system. It is hard for offline stores, that don’t have the technology, to achieve this,” says Erhai Liu, a founding and managing partner at Joy Capital.

Innovation in action

Luckin claims that technology is central to every aspect of its business. These product customization initiatives are the responsibility of a R&D team with over 100 members. Everything from the app interface to the layout of individual stores to the design of coffee cups is based on studying massive amounts of user and industry data that the company collects. 

Receiving orders via app also facilitates the launch of loyalty programs, whereby users can enjoy discounts if they introduce new customers or buy Luckin’s mobile coupons. And once an order is placed, customers can get their coffee delivered or collect it in person from a “pick-up spot.” These smaller format stores account for more than 80% of Luckin’s shops. Cash payment is usually not permitted.

Customers who order via the app and collect in person are guaranteed to receive their coffee within 30 seconds of their arrival. Meanwhile, deliveries are guaranteed to be completed within 30 minutes. A live video stream is available of orders being prepared – largely with the intent of keeping users engaged on the app for longer and entertained while they wait for their coffee to arrive. 

Investors believe this online-to-offline approach can lower Luckin’s costs and improve its operating efficiency. Pick-up spots are small, so they command relatively low rent and require few staff. Headcount is also lower than for traditional coffee shop chains because orders are processed and paid for digitally. 

“Luckin is a completely new species of animal compared to traditional coffee shop chains in that it manages to achieve a reasonable scale while delivering a personalized experience,” adds Liu. “I call it ‘data-driven coffee.’”

At the same time, Luckin is competing aggressively on price. On average, it charges 30% less than Starbucks for a latte, while the delivery fee is RMB6 ($0.90), compared to RMB9 for the US-headquartered coffee shop chain. The company’s discount coupons accentuate the pricing differential. A cup of coffee can cost as little as RMB5, while a tall brewed coffee from Starbucks – the cheapest item on the US chain’s menu in China – is RMB18. 

“According to our research, the major reason customers are loyal to Luckin is the pricing of its coffee. While good delivery service is important, a lot of other restaurant chains including KFC, Macdonald’s and Starbucks offer these services as well. At the end of the day, it’s the price that drives the consumers for Luckin,” says Jack Chuang, a China-based partner at OC&C, a strategic consulting firm.

As Chuang notes, Starbucks has expanded into coffee delivery in response to the competition from Luckin. It now has a partnership with the food delivery arm of Alibaba Group that covers more than 2,000 stores. Moreover, Starbucks plans to double the number of outlets its has in China overall over the next five years. 

Counting the cost

According to Jiemian, a Chinese financial news portal, Luckin sold 85 million cups of coffee in 2018 and its revenue for the first nine months of the year reached RMB375 million. But new store openings and discount offers weigh heavily on the bottom line. When the net loss for the first nine months was reported to be RMB857 million, Luckin freely admitted the actual number was “way larger.” The company stressed that it was not in a rush to turn profitable and would continue with its aggressive expansion for the next three to five years.

The cost of this expansion will be enormous, observes Chris Tay, a co-founder at LTCV Investment Holdings and C2 Partners, who has experience as an entrepreneur in the casual dining ecosystem in China. Even if Luckin is paying less than the RMB1 million it costs Starbucks to launch a new outlet, he estimates it would still be spending at least RMB600,000 a time. On this basis, opening 2,500 stores would require an investment of more than RMB1.5 billion, without even considering maintenance costs.

Another obstacle to expansion is recruitment. The average coffee shop in Shanghai requires at least 16 employees, both part-time and full-time, to handle the everyday business. Recruiting and retaining talent is already a challenge in major cities because service industry work is unpopular among China’s younger demographic.

“I don’t think a company can develop a good corporate culture in such a short period of time and with such a rapid pace of expansion” says Tay. “If a company focuses on increasing the number of stores, it will have to make sacrifices in other areas, such as service. And the quality of service at some of Luckin’s chains is quite so-so.”

Although Luckin maintains that it is not worried about profitability, anecdotal evidence suggests it is coming under pressure. The company is said to have raised the minimum threshold for delivery from RMB35 to RMB55, which means customers must purchase at least three cups of coffee if they want the beverages brought to them. Discounts are also not as steep as before. 

Market watchers warn that any attempt to dilute one of Luckin’s most appealing propositions – its affordability – could have equally serious consequences for financial performance. One option might be to adopt a franchise model, shifting most of the upfront costs onto third parties and taking a licensing fee. However, Luckin would have less control over the pace of expansion and implementation of its operational standards.   

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• Topics
• Greater China
• Expansion
• Consumer
• Technology
• China
• Centurium Capital
• Joy Capital
• GIC Private
• Growth capital