Riding the wave, how much longer can Luckin Coffee keep up the good times?

Before the US stock market opened on the evening of November 1st Beijing time, Luckin Coffee.US announced its performance for the third quarter of 2023. Overall, the performance was undoubtedly impressive, but it was basically within expectations (revenue growth of 85%, operating profit growth of 64%). However, there are still flaws compared to Dolphin Research's previous expectations.

The key points of this earnings report are as follows:

1. Continuous expansion of stores: The number of stores is the most intuitive data reflecting Luckin's growth status and is also the indicator that the market is most concerned about. At the end of the third quarter, the total number of stores reached 13,300, with a net increase of 2,437 compared to the previous quarter.

In the third quarter, both self-operated stores and franchised stores accelerated their pace of opening. Previously, Luckin had raised its target for this year to 15,000 stores, and with this opening speed, achieving the target this year should not be a problem.

2. Popular products attract users: The net increase in average monthly paying users in the third quarter was 15.43 million, reaching 58.5 million. Luckin, deeply rooted in first and second-tier cities, has already established a relatively stable user base through its existing stores. Generally speaking, if the number of average monthly paying users is still increasing rapidly, it is mainly due to new stores, especially those in lower-tier markets. However, the "growth rate of paying users in the third quarter (+133%)" compared to the "growth rate of store expansion (69%)" is significantly higher than that of the second quarter, indicating that the popularity of the joint-branded "Maotai Latte" has catalyzed and brought new user traffic to old stores.

Slowing growth in same-store revenue, beware of its impact on the pace of store openings: The growth rate of same-store total revenue in the third quarter was 19.9%, which is significantly higher than the growth rate of the number of old stores (27.7%). Our calculations show that the average growth rate of individual old stores has declined by 6%, compared to a decline of 2.3% in the second quarter, which represents a certain expansion.

There are two main reasons behind this. One is the impact of intensified competition, and the other is the impact of new stores diverting customers from old stores as the number of stores approaches the platform period. Regardless of which point it is, it may disturb the company's subsequent pace of store openings.

3. Revenue still relies on store openings: Despite the "Maotai Latte" in the third quarter, as well as the wider range of 9.9 yuan discounts and intentionally lowered prices, what drove the total revenue growth of 85% was still the addition of new stores, which grew by 70% compared to the same period last year.

Therefore, if the aforementioned factors such as competition and temporary market saturation have a significant impact on store openings, the company's subsequent performance may weaken.

4. Low-price strategy disrupts the trend of profit optimization: In the third quarter, the company achieved an operating profit of 962 million, and the operating margin weakened by more than 5 percentage points compared to the previous quarter, dropping to 13.4%. Apart from the relatively high year-on-year increase in sales expenses (141%), there was not much increase in other expenses. Therefore, the main reason for the impact on the profit margin is still the low-price strategy, which has compressed the gross profit margin (a decrease of nearly 6 percentage points compared to the previous quarter).

Dolphin Research's overall view:

Luckin Coffee now has more than 13,000 stores nationwide, which seems to indicate that it is still in the expansion dividend period. Although KFC's aggressive attack in the first half of the year was fierce, its new products have average taste and the momentum of hot sales seems to have quickly passed. On the other hand, Luckin Coffee's promotion of its "Sauce Fragrant Latte" has clearly had a more significant effect.

Judging from the current speed of store openings, it is not a big problem for Luckin Coffee to enjoy a slightly higher valuation at this time. Considering the current growth rate (+80-90%) and giving a premium for being a leader, it is estimated that Luckin Coffee will have a post-tax profit of 3.2 billion RMB ($440 million) in 2023, with a matching 30x PE ratio, resulting in a valuation of 96 billion RMB ($13.2 billion) for Luckin Coffee, which is not excessive. Even if we discount it by 20% due to the poor liquidity of the pink sheet, there is still a 20% upside compared to the current market value.

However, all good things must come to an end, and the flowering period of catering stocks is even more fleeting. For Luckin Coffee, which has already passed the halfway mark in its store opening frenzy (institutional optimistic estimates suggest that it will have 20,000 to 25,000 stores in the long term), when is the turning point in valuation that needs to be vigilant?

Generally speaking, catering stocks that have gone through the store expansion period often experience a valuation decline first. At the same time, as the driving force of store openings declines, linear extrapolation of performance expectations becomes difficult to sustain, leading to a double blow to valuation and performance.

However, tracking store opening data is relatively lagging. In addition to removing the higher-frequency store opening data, Dolphin Research pays more attention to forward-looking indicators [changes in same-store data for individual stores]. From the perspective of corporate business strategy, when the revenue of old stores declines and the UE model deteriorates, it represents a certain stage of store saturation (or intensified competition). If this situation does not improve continuously, then the company is very likely to choose to slow down the pace of opening new stores and prioritize the profitability (/sales volume) of old stores.

Therefore, Dolphin Research believes that in the short term, Luckin Coffee may still be undervalued, and opportunities can be found around the above-mentioned neutral valuation. However, it is also necessary to pay attention to the consecutive decline in same-store revenue growth for two quarters, in order to prevent an early encounter with a period of valuation and performance double blow. We recommend listening to the management's outlook on store openings during the conference call and continue to pay attention to the same-store data in the fourth quarter.

Here is a detailed analysis:

1. Store Openings, Luckin Coffee is not slack

In 2023, "rapid store openings" are the main theme for Luckin Coffee. Due to the successful execution of the "downward strategy" and the "franchise model with store support," the annual store opening target has been increased from 10,000 at the beginning of the year to 15,000 after being completed ahead of schedule in the first half of the year.

In the third quarter, there was a net increase of 2,437 new stores, of which 1,619 were self-operated stores and 818 were franchised stores. The speed of store openings for both types of stores has accelerated, exceeding market expectations.

2. In addition to opening new stores, popular products have also attracted new users

In the third quarter, the net increase in average monthly paid users was 15.43 million, reaching 58.5 million. Luckin Coffee, deeply rooted in first and second-tier cities, has already established a relatively stable user base through its existing stores. Generally speaking, if the number of average monthly paid users is still increasing rapidly, it is mainly due to new stores, especially in lower-tier markets.

However, the "growth rate of paid users in the third quarter (+133%)/the expansion rate of stores (69%)" is significantly higher than that of the second quarter, indicating that in addition to the effect of the 9.9 yuan discount, the popularity of the "Maotai Latte" co-branded with Moutai has also brought new user traffic to existing stores.

3. The growth of individual existing stores continues to decline and needs attention

Although the overall same-store revenue of existing stores in the third quarter still grew by 20%, if we exclude the growth in the number of existing stores over the past year and only look at the average performance of individual stores, there was no improvement in the third quarter, and it continued to decline by 6% compared to the same period last year.

The decline in the performance of individual existing stores is either due to intensified competition or the excessive density of newly opened stores, which diverts some of the user demand from existing stores. However, fortunately, the 6% decline is not particularly significant at the moment. Considering that the competitive impact of KFC on Luckin Coffee is slowing down, we suggest not to panic excessively and continue to observe the situation in the fourth quarter. If the situation continues to deteriorate, it may be necessary to re-evaluate the pace of store openings for Luckin Coffee next year.

However, considering that the potential scale of Luckin Coffee's stores in the market is estimated to be between 20,000 and 25,000, and currently there are 13,000 stores, with the target of reaching 15,000 stores by the end of the year, more than half of the growth has already been achieved. Even if the competition continues to slow down next year, it will be difficult to maintain the momentum of rapid store openings seen this year. Where will the future growth drivers come from? Without the logic of opening new stores, can the frequency of user consumption and the increase in average selling price (ASP) proceed smoothly? These are the issues that the management of Luckin Coffee needs to consider.

Of course, in the short term, Luckin Coffee is still enjoying the sweet period of benefiting from the opening of new stores.

4. The logic of opening new stores is the core driving force for revenue growth

In the third quarter, Luckin Coffee's total revenue was 7.2 billion yuan, a year-on-year increase of 85%, and there was no obvious slowdown compared to the second quarter. Of course, the 70% year-on-year increase in the number of stores is still the core driving force.

Looking at the details, due to rapid expansion, the revenue growth from franchised stores is higher (+105%), while the revenue growth from self-operated stores is 79%. At the end of May, Luckin Coffee launched a new franchise model, encouraging store owners who are still in the lease period or own their own properties to join Luckin's franchise partner group through a joint venture approach, similar to the franchise model of telecom operators and convenience stores. This model allows Luckin to penetrate the market at a faster pace.

5. Low-price strategy cut profits

In terms of profitability, Luckin Coffee's profitability in the third quarter declined compared to the previous quarter, mainly due to the low-price strategy in response to competition. As the majority of material costs are rigid, it naturally compresses the gross profit margin of individual products. The overall gross profit margin in the third quarter was 36.2%, a decrease of 5.6 percentage points compared to the previous quarter.

Since Luckin Coffee has control over the terminal pricing of all stores, the impact of the low-price strategy is not only reflected in self-operated stores but also in franchised stores. However, the sales volume of franchised stores is relatively lower, so the impact on the change in material cost rate is slightly smaller.

According to Dolphin Research's calculations, the gross profit margin of self-operated stores in the third quarter was 39.5%, a decrease of 6 percentage points compared to the previous quarter, while the gross profit margin of franchised stores was 26.7%, a decrease of 3 percentage points compared to the previous quarter.

In terms of expenses, except for slightly higher marketing and promotion expenses in this quarter, other expenses basically change with the change in revenue, and there is not much optimization in the allocation of headquarters expenses. Some expenses still have room for improvement due to scale, such as management expenses, which have a slight decrease in proportion to revenue this quarter. Therefore, the profitability of individual self-operated stores is consistent with the overall profitability of the company, both showing a decrease of 6 percentage points compared to the previous quarter.

However, overall, Dolphin Research believes that there is limited room for further optimization in terms of profit. For a company in the catering industry, achieving a stable operating profit margin of nearly 20% before tax is already quite good. If they want to further improve, they will have to rely on price upgrades brought about by product quality/brand upgrades, but that's another story.

Dolphin Research "Luckin Coffee" related readings

Earnings Season

August 3, 2023 Conference Call: "Luckin Coffee: Frequent New Releases, Rapid Store Openings, and Increased Buyers (Summary)"

August 3, 2023 Earnings Report Review: "Luckin Coffee: "Running Wild" with Ten Thousand Stores, Mastering the Dominance"

May 2, 2023 Conference Call: "Luckin Coffee: Expected to Achieve the Ten Thousand Stores Goal Ahead of Schedule"

May 2, 2023 Earnings Report Review: "Luckin Coffee: Rapid Store Openings, Full Recovery"

March 3, 2023 Conference Call: "Achieving the Ten Thousand Stores Goal in 2023 (Luckin Coffee Performance Meeting Summary)"

March 2, 2023 Earnings Report Review: "New Luckin Coffee: Reborn from the Ashes"

In-depth Analysis

March 14, 2023: "Striking the Cancerous Tumor with a Sword, Luckin Coffee Wins the Battle of Redemption"

February 14, 2023: "Luckin Coffee (Part 1): Bringing Coffee to Rural Areas, Can the Boom in County Towns Continue?"

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