Luckin Coffee faces price war

Luckin Coffee (LKNCY.OTC), which is engaged in a fierce battle with Kudi Coffee, has demonstrated through an unexpectedly strong earnings report that it still has the ability to continue this price war.

Recently, Luckin released its third-quarter earnings report, with revenue reaching 7.2 billion yuan, a year-on-year increase of 84.9%. Under the US Generally Accepted Accounting Principles (GAAP), operating profit reached 962 million yuan, with an operating profit margin of 13.4%, a decrease of 5.4 percentage points compared to the previous quarter.

After the release of the earnings report on November 1st, Luckin initially fell more than 7% in the pink sheet market, but eventually closed in the green.

The rebound may be attributed to Luckin's profitable performance, which has made the market optimistic. After nearly half a year of price wars, Luckin still achieved a net profit margin of 13.7% in the third quarter. In comparison, Starbucks (SBUX.NASDAQ) had a net profit margin of 10.92% during the same period, indicating that Luckin still has room for further price reductions.

However, Luckin's deep involvement in the price war has come at a cost.

According to information obtained from sources close to Luckin, nearly 1,100 stores were opened intensively in September, accounting for 45% of the total number of new stores opened in the third quarter.

Combined with the impact of the 9.9 yuan promotion, Luckin's same-store sales growth has slowed down, and the store operating profit margin has also declined.

But in the eyes of Luckin's management, it is all worth it. Previously, Luckin CEO Guo Jin Yi publicly stated that the 9.9 yuan coffee promotion would last for at least two years. It is clear that they intend to use their existing scale advantage to squeeze the prices of newcomers.

Holding Strong in the Price War

The price war has indeed had an impact on Luckin's gross profit margin.

In the third quarter of this year, Luckin's gross profit margin decreased by 4.3 percentage points to 56%. However, the promotional activities have also had a significant stimulating effect on Luckin's user data.

In June of this year, Luckin's transactional membership exceeded 50 million for the first time, and the average number of paying users in the second quarter reached 43.1 million. In the third quarter, this number increased significantly to 58.48 million, a year-on-year increase of 132.9% and a quarter-on-quarter increase of 35.8%.

Clearly, Luckin's "quantity over price" strategy has achieved remarkable results.

It can also be inferred from the fact that Luckin's material costs increased by 28.5% in the third quarter compared to the previous quarter that the number of cups served by Luckin is growing rapidly, and the growth rate is much higher than the 16.1% increase in revenue, indicating that the proportion of 9.9 yuan coffee is not small.

According to information obtained from sources close to Luckin, since August, the frequency of the 9.9 yuan promotion has changed from daily to weekly. The discount measures that affect the gross profit margin have been somewhat controlled. However, on platforms such as Meituan and Douyin, Luckin is still promoting through continuous coupon distribution.

Promotions are just a means for Luckin to participate in competition. Opening more stores and acquiring more "future transactions" and potential users are the ultimate goals.

In the third quarter of this year, the number of new directly operated stores opened by Luckin far exceeded that of franchised stores, reflecting a strategy of faster market coverage. In the third quarter, Luckin opened 2,437 new stores, with the number of self-operated stores nearly twice that of franchised stores, adding 1,619 and 818 stores respectively. The number of stores is expected to reach 15,000 by the end of the year. Private equity investors in the southern region have expressed concerns to TradeWind01 that some newly opened stores are facing insufficient sales volume, which is dragging down gross profit margins. In comparison, when competition in the industry was "not so intense" in the past, Luckin Coffee was not in a hurry to open stores. However, now they need to increase the number of stores and conduct brand cultivation through promotional activities such as selling coffee for 9.9 yuan.

Winning in the supply chain?

Since the second quarter of this year, Luckin Coffee has surpassed Starbucks China in revenue for two consecutive quarters, becoming the "new king" of the Chinese coffee market, while Luckin's challenger, Kudy Coffee, led by Lu Zhengyao, is widely regarded as a strong contender for the throne.

Just a week before Luckin Coffee released its third-quarter report, Kudy Coffee's Chairman and CEO, Qian Zhiya, stated in an internal memo that Kudy's global store count has exceeded 6,000 and called for a goal of 20,000 stores worldwide by 2025, doubling the previous target of opening 10,000 stores in three years.

In addition to offering more 9.9 yuan coupons near Kudy Coffee stores, Luckin Coffee has also focused on its supply chain.

Whether in the new tea beverage or coffee market, Luckin Coffee is a "master of collaborations," creating obvious differentiation within the industry through partnerships.

They have consistently maintained the rhythm of launching a new product or collaboration every week to keep the momentum going. However, this places higher demands on the supply chain, especially with a network of thousands of stores.

Because whether it's the Soy Latte or the Cream Cheese Latte with Mascarpone, new ingredients need to be added, and there are also updates to packaging materials, store signage, and other materials.

According to insiders close to Luckin Coffee, the preparation time for the Cream Cheese Latte exceeds two months, while another "annual blockbuster" product, the Soy Latte, was approved as early as the beginning of May this year and has undergone continuous research and development.

In terms of the supply chain, Kudy, as a latecomer, is slightly lacking. According to 36kr, citing insiders from Luckin Coffee, the biggest support for Luckin's ability to sell new products long-term is a stable supply chain, "while Kudy's new products will soon be discontinued."

Private equity investors in the southern region have also expressed that some Kudy franchisees engage in irregular behavior such as not purchasing through official channels. This year, there have been cases of sold-out inventory of the Rice Milk Latte in certain cities in Shandong, but the packaging bags were not available, so the franchisees had to temporarily buy a batch of plastic bags from supermarkets as a temporary solution.

TradeWind01 sought confirmation from Kudy Coffee regarding the statements made by the aforementioned individuals. The response was, "This is false information. Currently, Kudy Coffee's new product launches and supply chain are operating normally. Our international supply chain base has just settled in the Anhui Pilot Free Trade Zone, and there will be many new industry products launched in the future."

Price and scale are two sides of the coffee industry. Although participating in price wars is more conducive to expanding scale, it can have a significant negative impact on store profitability.

When franchisees realize that opening a store is difficult to make money, the growth momentum will stagnate. This is the challenge currently faced by Kudy, which relies entirely on franchisees to open stores. And for Luckin Coffee, which is still profitable at the moment, investors may need to think more about their expectations for gross profit margin.