Amid the much hyped but ultimately disappointing spate of initial public offerings stands Luckin Coffee (NASDAQ:LK). Unlike names such as Uber (NYSE:UBER) or Lyft (NASDAQ:LYFT), Luckin doesn’t deal with technology per se. Rather, it focuses on delivering a longtime crowd favorite, coffee, to an emerging economic superpower. But has the dramatic enthusiasm for LK stock reached the point of irrationality?
It’s a fair question for prospective buyers to ask. Since its IPO price of $17, LK stock has launched toward its present level above $45. Doing the quick math, that’s more than a 165% return. Even more impressive, shares haven’t even turned a year old yet. Still, fresh names in the markets have a tendency for volatility.
However, the investors that have bought in comfort themselves with Luckin Coffee’s underlying sector. Although China is traditionally a tea-drinking mecca, the Asian juggernaut has rapidly embraced Western cultural elements and products. And one of the longstanding traditions of the West is coffee.
Moreover, Chinese consumers have embraced the pick-me-up. According to one statistic, China’s coffee market will be worth something like $145 billion by 2025.
For perspective, the U.S. coffee market reached between $87 billion to $88 billion in 2018. Now you can see why so many early-bird investors are enthused about LK stock.
But should you dive into this name at this point in the game? Although the potential for upside certainly exists, here are three reasons why I’m cautious over the long run.
Margins for LK Stock Are Worrisome
Typically, investors give upstart growth firms like Luckin Coffee some leeway in terms of profitability metrics. They understand that some companies must eschew profits for growth. Once their expansionary strategy is complete, these firms can later switch back to returning value for shareholders.
However, not all businesses and industries are the same. For food and beverage companies, for example, I’d much prefer them to be profitable out of the gate. In this case, coffee is coffee — it shouldn’t cost that much to make relative to top-line sales.
And that’s not just my opinion. Experts in the food and beverage market suggest aiming for gross margins around 75%.
But for LK stock, the underlying gross margin was negative until the quarter ending June 30. Plus, in the most recently reported quarter ending Sep. 30, net income losses widened year-over-year.
Now, I’m willing to overlook such metrics for a tech firm that is developing a quantum computer for the masses. But Luckin is not in that business at all. Instead, it’s making coffee, which is hardly a unique product. Thus, to minimize my risk as a potential shareholder, I’d prefer profitability. Certainly, I don’t want to see deeper losses.
Luckin’s Playing a Dangerous Game
For the optimists of LK stock, they often point to the underlying company’s duel with sector giant Starbucks (NASDAQ:SBUX). In order to counter Starbucks’ dominant reach, Luckin is fighting fire with fire. By focusing on smaller shops that facilitate easy pick up, Luckin has expanded its physical footprint at an astonishing rate.
In fact, Luckin CFO Reinout Schakel told CNBC’s Squawk Box, “We have done what most people do in 15 or 20 years.” Naturally, many folks jumped on LK stock on the idea that Starbucks finally met its match.
I’m probably in the extreme minority here when I say this. However, when Schakel made his statement, I didn’t view it as a positive. If you’re growing that fast, you’re at least taking serious risks somewhere else.
And that somewhere else is Starbucks’ delivery initiative. Partnering with Alibaba (NYSE:BABA), Starbucks has added delivery options for over 2,100 of its China-based stores. Furthermore, China Daily reported that the country’s online food ordering and delivery market hit 441.5 billion yuan ($65.8 billion) in 2018. That was up 112.5% over the prior year.
Yes, Luckin’s expanding footprint is a positive for LK stock, don’t get me wrong. However, Starbucks is at least mitigating this advantage through its deliveries. Furthermore, Chinese consumers are willing to pay for this service.
With Luckin’s financials stretched for growth, it’s possible the company may have overextended itself with its footprint strategy.
Not Understanding the Audience
One of the biggest mistakes you can make in public speaking is not understanding your audience. By not doing your homework, you can quickly lose the purpose of your engagement. So it is with business.
Through its use of aggressive discounts, Luckin has presented the image of the everyday affordable coffee shop. But if that was the real intention, it’s off on the wrong foot. Based on the poor margins and steep net income losses, it will have to raise prices at some point. When it does, it will lose many of their budget-sensitive customers.
Moreover, the Chinese audience is different from the Western one in that it has no historical frame of reference for pleasures of modernity. As a result, things that we take for granted here in the U.S. are often considered luxuries in China.
Sure enough, one of those perceived luxuries is coffee. According to the University of Southern California’s US-China Institute, many well-to-do Chinese consumers prefer name-brand, high-priced coffee because of their status symbol. “For coffee consumers in China, Starbucks and other Western coffee brands enable them to show off their wealth and good taste,” Rebecca Harbeck writes.
You’re just not going to get that experience from and discount-brand Luckin Coffee. And when Luckin stops giving out those discounts because it can’t? I’m not sure if LK stock can reasonably compete against Starbucks or other premium, internationally recognized brands.
As of this writing, Josh Enomoto did not hold a position in any of the aforementioned securities.