For investors, financial fraud by listed companies is an unforgivable act, and Luckin Coffee (ADR).US has been carrying this stigma until now. Companies with a history of fraud are typically not considered by Dolphin, but Luckin's handling of the matter is still acceptable: The employees involved or aware of the false transactions were removed, the board of directors and management were adjusted, the original responsible person's equity was held in trust for acquisition, and institutional investors became the actual investors of the company.

Especially after external settlement and financial restructuring, Luckin has continued to optimize its management, gradually returning the company to the right track, and achieved a quarterly operating profit for the first time in the first quarter of last year, which is a significant breakthrough.

In my opinion, through the above measures, Luckin has already cut off from the past. After cutting off the malignant tumor, as the coffee retail company with the largest number of stores in China, Luckin has an market position that cannot be ignored. The company can indeed re-enter the observation range, which is why Dolphin has recently covered Luckin.

The in-depth report on Luckin Coffee (Part 1): Coffee Going to the Countryside, Can it continue to be popular in the counties? mainly discusses two questions: What is the source of growth in the freshly ground coffee market and how much potential space is there to open stores. Dolphin inferred that according to the current market situation, in the next three to four years (until 2025), due to market sinking and increasing the number of existing city stores, the potential number of stores that Luckin can operate will reach at least 14,000, with more than 60% of incremental space from now.

In today's part 2, Dolphin will focus on Luckin's future prospects, analyze the company's core competencies, explore its future growth trends, and make valuation judgments on Luckin.

Dolphin's conclusion is as follows:

1. Capturing the trend of milk coffee development, coupled with the creation of popular products, has brought Luckin an opportunity for a comeback. With digitalization and R&D optimization, the ability to push popular products is gradually maturing. Supply chain integration capabilities continue to improve.

After the crisis broke out, Luckin's profitability gradually improved. By splitting the single-store model and maintaining rapid expansion of the number of stores, the sales volume and price of products in single stores increased simultaneously, and the gross profit margin and operating profit margin improved significantly. Stores turned losses into profits, and confidence was restored. Currently, the average daily sales volume and ASP of a single store have been increased to a reasonable level, with a daily sales of 400 cups and an ASP of about 15 yuan. The probability of a significant increase in the future is small, and the company's main growth potential lies in market sinking and store encryption.

3. The first-mover advantage combined with digitalization genes forms Luckin's core competitiveness, and it holds scarce location resources to reinforce the company's competitive barriers.

After financial restructuring, Luckin has completed the cut from history, optimized its management structure, and strengthened supervision.
In Luckin's revenue, product sales are mainly from direct stores, while franchise income is mainly composed of raw material sales and franchise store gross profit sharing. Combining our understanding of the industry from the previous text, we expect that by 2027, the number of Luckin stores can be increased to nearly 17,000. Back then, the number of franchise stores will exceed 50% (currently only 30%). Without considering a substantial increase in per-cup price (which is unfavorable for market expansion), Luckin Coffee could potentially earn 29 billion yuan in revenue. Improving the net profit margin to 12% will boost the net profit to 3.4 billion yuan (by 2027).

By using the DCF valuation method, with the assumption of WACC=11.19% and perpetual growth rate of 3%, the fair price of Luckin Coffee would be $36.58, equivalent to a 30x PE in 24 years. This represents more than 30% upside from the current market price.

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1.1 The Birth of Explosive Products

From Luckin's exaggerated revenue of 2.2 billion yuan in April 2020 to completing its debt restructuring in April 2022, the company has spent the past two years resolving its debt and equity issues while continuing to increase revenue quarter by quarter. In 2022 Q1, it achieved its first-ever quarterly profit.

Apart from the number of stores, Luckin's revenue scale is also gradually catching up with that of Starbucks in China. Especially last year, Starbucks' revenue in China declined for three consecutive quarters, while Luckin managed to maintain a revenue growth rate of over 70%. So, how did Luckin manage to survive and thrive?

1.1 Capitalizing on the Milk Coffee Trend

Besides the common Americano and latte, do you know how many different types of coffee exist and what differentiates them?

Although the types may appear numerous, they are merely different combinations of a few basic ingredients, such as espresso, milk, cream, foam, and syrup, with different proportions, that make up the coffee variety. However, regardless of the specific type, traditional coffee often has a bitter and acidic taste which differs from the consumption habits in China.

Consumers in China prefer sweeter drinks; thus, promoting a beverage with a bitter taste to more consumers depends on the development of a coffee product with a universally pleasing flavor. The shift from functionalization to drinkability in coffee naturally broadens the boundaries of the audience. Various coffee brands have also noticed the trend of user transformation as the boundaries of coffee continue to expand. Some tea drinkers have started to turn to milk coffee. Mainstream coffee chains such as Luckin, for example, have the highest proportion of milk coffee in their product categories, and pure black coffee products account for even less than caffeine-free drinks.

In addition to adjusting to milk coffee, creative solutions can be found among several innovative raw materials, with the exception of coffee itself. The remaining milk, syrup, and so on can all be adjusted. For example, coconut milk can replace milk, and sugar varieties can be adjusted.

In April 2021, Luckin launched a "Coconut Latte" series, which became a sensation and sold over 100 million cups within a year of its debut. Luckin did not expect the coconut series to be so successful, resulting in a shortage of coconut milk for several months, and a trend emerged in the market for replicating Luckin's series.

Before the Coconut Latte series, the Meteor Latte in thick milk and Velvet in thick milk had also caught on to a certain extent. All these series are based on a latte as the basis for recipe improvement, and consumers' acceptance of milk coffee has become the cornerstone of Luckin's explosive success.

1.2 Digital support for research and development capabilities

Some people may question whether Chinese consumers have a good mass base for coconuts in the first place. (Coconut palm juice's annual sales surpassed 4 billion yuan.) Did the popularity of the Coconut Latte series just happen to hit consumer preferences on the mark? Apparently not. Luckin's four giants, Greek yogurt, thick milk, coconut milk, and velvet, are all common combination concepts in milk coffee, but they are flourishing under Luckin's care.

One year after the introduction of the Coconut Latte series, Luckin launched the Coconut Cloud Latte, which sold over 4.95 million cups in its first week, with total sales approaching 100 million yuan. Half a year later, the "Greek Yogurt Latte" was launched, which broke Luckin's "first-time release record" as the "single king of explosion." On the first day of its launch, sales reached 1.3 million cups, and in the first week, they exceeded 6 million cups.

It appears that Luckin does indeed have remarkable ability in product iteration and innovation. In recent years, Luckin has been the coffee brand with the most new product releases and the highest frequency. It mainly forms nine core product lines in the form of big hits + matrices, and the number of SKUs is also the highest among relevant competitors. As a result, Luckin's repurchase rate is the highest among all types of brands.

Frequent bestsellers suggest that Luckin might have found the logic for developing popular products. The vice president responsible for product systems and supply chain management stated at an investor communication meeting that the most critical competitive advantage of Luckin's product research and development is the mechanism. Massive data combined with a complete set of digitalization and innovation, giving rise to more comprehensive and detailed data.

For example, the company will digitize various raw materials and flavors and quantify the popular trends of beverages. Through data, various product combinations can be formed, and potential flavors that can be launched can also be identified. Luckin does not use words like "fragrant and sweet" to describe the taste. Instead, it all changes to numbers, which can search for corresponding raw materials through these numbers and determine whether they can be combined with the flavor of coffee while developing the product later.

Digitalization provides support for the entire product development system and maintains the continuous new product development capability of the product: Luckin's product intelligence department is divided into five parts, namely, product analysis, menu management, product research and development, testing, and optimization.

Through these five processes, Luckin's SKU number has now increased to more than 90, and the efficiency for launching new products has significantly improved. Digitalization has greatly helped Luckin improve the probability of forming explosive products, making the launch of them not just relying on chance.

1.3 Gradually improving the ability to integrate the supply chain

In addition to integrating research and development capabilities while following consumer trends, the formation of popular products also requires a very crucial ability, which is supply chain integration. As mentioned earlier, the Coconut Milk Latte sold out quickly upon launch, and coconut milk was always in short supply from April to July 2021. On the one hand, the epidemic in Indonesia and Vietnam worsened (China's second-class coconut importer), and existing suppliers couldn't purchase raw materials. On the other hand, the domestic processing capacity was still insufficient.

In hindsight, it was indeed embarrassing, and they did not expect the success of the Coconut Milk Latte. This also shows us that the company still had weaknesses during that time in terms of business operations. Apart from coffee, milk, and equipment, the suppliers for other varieties seemed relatively weak. Today, Luckin considers itself the largest commercial buyer of coconut milk products domestically and has established stable coconut milk supplies in Hainan, Shanghai, and Chuzhou. With the experience of the Coconut Milk Latte, Luckin is more adept at supplying popular products in later stages.

Apart from special ingredients such as coconut milk, Luckin Coffee is very strict when it comes to the categories of conventional purchasing and production processes. Among the three major factors affecting coffee flavor, the quality of coffee beans and roasting play a decisive role, and ensuring the stability of these two factors is particularly important for the company:

In terms of raw material quality, Luckin Coffee signs cooperation agreements with high-quality suppliers to ensure the supply of high-quality coffee beans;
In terms of roasting, Luckin Coffee ensures processing quality by establishing its own roasting plants (Ningde and Kunshan).

II. Profitable Stores, Restoring Confidence

In a previous article, Dolphin Jun mentioned that the compound annual growth rate of freshly ground coffee in China has exceeded 20% in the past few years and is still the target of capital. In addition to the existing brands continuously expanding their stores, there are also constant new brands emerging in recent years. For example, Kudix, whose core members were the original start-up team of Luckin Coffee, has a strategy and business model that is almost identical to Luckin Coffee's in its early stages. Since Luckin Coffee also burned money to survive, can't we just replicate another Luckin Coffee and compete with it by continuing to burn money?

Before considering the answer to this question, let's first look at the current operating status of the stores. We found that Luckin Coffee's operating conditions have been improving after financial reorganization since each quarter (using the self-operated single store model).

2.1 Popular Products Boost Single Store Sales

Thanks to the launch of multiple popular products, while continuing to expand the number of stores (directly operated stores have increased from 3,000 to 5,000), the daily sales of each single store continue to rise. The average daily sales of early directly operated stores was less than 300 cups, and the precipitation of popular products almost increased the daily sales volume each quarter. On the first day of the listing of Coconut Cloud Latte, the average daily sales volume of this variety exceeded 130 cups.

Summer is the peak season for coffee and other drinks sales. Luckin Coffee's self-operated stores can basically maintain a daily sales volume of 400 cups, while most franchise stores are in lower-tier markets and, due to low density, can even reach nearly 500 cups.

However, considering competition and other factors, it is generally not possible to allow single store sales volume to increase indefinitely. A mature store can maintain a volume of four to five hundred cups, which is already quite good. If there is still room for improvement, a better approach is to consider opening a new store, otherwise it is very likely to be diverted by other competitors. Dolphin Jun believes that the company's single-store daily sales volume will likely be maintained at around 400 (annual average), and further significant increases will face considerable difficulties in the future.

In addition, it is worth mentioning that Luckin Coffee has more than 600 stores in Shanghai. In the second quarter of last year, due to the impact of the epidemic, they were closed, but the overall daily sales volume of each single store did not decrease, but increased, which is indeed quite impressive.

2.2 ASP Increase, Doubled Gross Profit

2.1 Adjustment of Promotion Activities

After re-adjusting the promotion activities (reducing the intensity), the prices of single products in direct-operated stores have improved significantly, and the trend is still continuing (the trend slows down after 2022). At the same time, benefiting from the scale effect, the unit cost of raw materials has decreased, and the gross profit margin has improved significantly compared to the early stage.

From the perspective of direct-operated stores, the previous scattered promotion activities have been cancelled. ASP (including drinks and others) has gradually increased from about 10 yuan to 15 yuan, while the unit material cost has decreased from 6 yuan + to 4 yuan +, and the unit gross profit has increased nearly twice.

In the initial stage of activity adjustment, some customers who are sensitive to prices did leave due to price reasons. However, in the long run, on the one hand, the expansion of milk coffee consumption audience and the explosion of popular products overlapped with each other, and on the other hand, the quality of Luckin Coffee can indeed be significantly different from other brands with an average price below 10 yuan, so it has basically locked in high-frequency coffee consumers in first-and second-tier cities.

At present, the average price per cup of Luckin and similar competitive products is stable at 16-18 yuan/cup, equivalent to accounting revenue of more than 15 yuan. If the price continues to rise, it will touch the price range of boutique coffee and "large-store" coffee (about 25-30 yuan). Therefore, Dolphin believes that the probability of further online increase in the average price per cup is not very high, and the future of Luckin's main growth still depends on the sinking and densification of stores.

2.3 Amortization of Expenses

Overall, the largest expenditure item after deducting raw materials is the operating cost of the store. Actually, in terms of unit area, the cost is slightly increased, but the single-store revenue growth is faster (the rise of quantity and price), and the cost is quickly amortized. The transportation cost rate has been relatively stable over the years, and the amortization of depreciation and other expenses has also had a positive effect on the company.

2.4 Turning Loss into Profit

Overall, the single-store operating profit has turned from negative to positive, and the operating profit margin has increased quarter by quarter (because the report is not separated, this model does not consider the overall marketing and management expenses of the company). Dolphin has also learned from some industry exchanges that the operating profit of Luckin stores in the first quarter of last year was about 20%, and it has increased to 30% in the second quarter.

3. How to Establish a Moat

The turnaround of direct-operated stores into profitability not only lays the foundation for the company's future store expansion, but also brings confidence to investors. However, the improvement of stores is not achieved overnight. Luckin has two core advantages that have experienced a lot of ups and downs.

3.1 First-mover Advantages Cannot Be Ignored

Luckin does have unique resources to seize the first-mover advantage. In the era when capital was still willing to burn money, Luckin expanded to thousands of stores in China in a short time with business means that did not aim to make money. During the early stage of domestic competition, Luckin was a game-changer for the coffee industry, filling the price gap between instant coffee and the "third space" cafe.

The innovative model has given investors a high degree of tolerance, allowing the company to sustain losses in exchange for a rapid increase in market share for an extended period. The rapid expansion of the scale has brought Luckin scarce resources (store locations with geographic advantages) one by one. The advantage of doing this is that even during the pandemic, Luckin's stores can maintain sustainable profitability.

Nowadays, the market environment has changed, and brands are emerging in endless numbers, making the competition more intense. New brands that want to stand out must achieve extreme differentiation, which means they must bear more costs. In particular, Luckin's false revenue incident has sounded the alarm bells for the industry's investors. Unplanned expansion at any cost is difficult to yield good results, and burning money to gain traffic has been curbed.

However, Luckin, because of the financial crisis, cleaned up its stores. After the crisis broke out, the company adjusted its business plan. The number of new stores added in 2020 was at an all-time low, and the number of store closures increased significantly. A large number of unprofitable stores were cleared out so that the company had several months of net store closures, until the trend began to turn in 2021.

The counter-cyclical expansion in 2021-2022 actually gave Luckin another chance. Especially last year, due to the impact of the pandemic, first- and second-tier cities restricted their opening hours for a long time. Starbucks could not resist, and revenue declined for three consecutive quarters. Some independent coffee shops were even forced to go out of business. Commercial real estate was basically in its lowest position in recent years, so some relatively scarce locations were redeveloped, giving strong brands more opportunities for expansion (similar to the logic of chain hotel brands expanding against the trend during the pandemic).

Enhancing advantages through digitization:

As mentioned earlier, digitalization enhances research and development capabilities. However, Luckin has almost embedded digitalization in its bones, and digitization is Luckin's most original gene. Most of the company's founding team and current managers come from the core proponents of digitalization in the car rental industry (except for the founder's car rental system, other executives are all big players in the consumer goods or internet industry).

Cao Wenbao, the current vice president responsible for national store operations management (formerly the vice president of McDonald's China), summarized Luckin's characteristics as having traditional retail industry standardization and industrialization features, while having stronger internet attributes. From choosing store locations to store operations, everything is data-driven.

For example, to open stores, the company combines data and applications to generate a heat map of takeaway orders to improve location quality. Luckin goes wherever its customers are, ensuring that customers don't have to search for stores but rather the other way around. This is Luckin's core weapon for victory at this stage, after all, a store selling 400 cups a day is not something that can be found casually.

Some brands like to open stores next to their competitors. By understanding the digital advantages of their competitors, they try to learn and imitate so that they can defeat their opponents using different methods (this is another story that will be discussed later).

In terms of operations, by implementing a systematic management function, automatic scheduling, automatic ordering, automatic material thawing, etc., operating costs can be minimized through big data driven operations and continuous management iteration.

For marketing, according to Dolphin's communication, A/B testing is commonly used in product sales. It involves dividing user traffic into several groups and having them see different design solutions. Based on the actual data feedback of these user groups, data effectiveness is verified.

Luckin's digital architecture is very conducive to the implementation of A/B testing. By leveraging their own store and private domain data, they can complete city-level A/B testing within 24 hours, far exceeding industry competitors. For individual users, label analysis and granulation are more refined, all thanks to digitization.

IV. Gradual Resolution of Historical Issues

In Luckin's Governance Report, "Transformation and Reshaping: The Governance Report of Luckin Coffee Company," released in November 2022, it was mentioned that the company has completed the separation from historical issues and returned to the right track.

The company's debt restructuring and SEC settlement have been basically resolved, and the former responsible persons have left the company. The board of directors has re-adjusted personnel structure, and Dazhong Capital is currently the controlling shareholder of Luckin. The company has also ended its bankruptcy protection. Other minor lawsuits are expected to be gradually resolved in the first quarter of this year (including convertible bond investor lawsuits and ADS investor lawsuits).

In addition, the Governance Report mentioned the company's values: seeking truth and pragmatism, quality first, continuous innovation, non-other than self, mutual trust and win-win. Among them, "seeking truth and pragmatism" is at the core of values judgment and choice. In terms of attitude, it can be seen that the management team is more honest and diligent after the leadership change.

V. Performance & Valuation Estimation

5.1 Expansion of Stores?

Combined with the previously released in-depth article on Luckin, and considering the expected compound growth rate of the industry to exceed 20%, Luckin is expected to have 14,000 stores within the next three years (adding about 2,000 stores annually until around 2025).

However, Luckin's own stores make up a higher proportion (70%), and downgrading is expected to adopt more franchise forms, forming a pattern where self-operated stores and franchised stores each account for 50%.

From the perspective of income classification, it can be divided into two categories: self-operated and franchised:

Self-operated stores: the sales revenue (after tax) is all included in the income, and the current daily sales volume is 370 units. According to industry experience, when it reaches 400-500 units, franchising will be considered. Taking into account that the opening of new stores in the sinking market may reduce the average sales volume, it is not assumed that the growth will continue for the next 3-4 years.
Franchise stores: Ruixing does not charge franchise fees, but collects gross profit sharing from franchisees. The company will collect raw material costs from franchisees according to the gross profit rate level of around 16-18%. After deducting the material, the gross profit will be distributed between the company and the franchisee according to different levels. The standard clause is that there is no commission below 20,000 yuan, and the commission rate for 80,000 yuan or more is 40% (the specific proportion is shown in the figure below, and there is a certain discount for the commission rate during the preferential period). A monthly gross profit of 80,000 corresponds to a daily sales volume of more than 300 cups. Mature stores can basically reach this level.

In addition, a certain equipment fee will be charged for the first-time franchise stores (around 250,000 yuan for a single store, and franchisees also have other investments such as decoration, rent, and deposit).

Average price per cup: After the financial crisis, the company's cup price has stabilized at 15 yuan +. As analyzed by Dolphin earlier, a higher cup price is not conducive to the current sinking model, so the cup price is not adjusted in the profit forecast.

Therefore, the potential revenue of Ruixing in the long term (2027) is about 29 billion yuan.

Assuming that the unit raw material cost is unchanged (with limited room for further decline) and other expenses are reasonably amortized, Ruixing's net profit level in 2027 will reach 3.4 billion yuan, and the net profit margin will be close to 12%.

5.2 Valuation Estimation

Finally, based on our previous judgments and forecasts of Luckin Coffee, Dolphin adopted the DCF valuation method this time. Assuming a WACC of 10.44% and a perpetual growth rate of 3%, the reasonable valuation of Luckin Coffee is USD 36.58 per share, corresponding to a PE ratio of 30 times in 24 years, with more than 30% upside from the current level.

Dolphin Research on 'Luckin Coffee' Historical Articles:

Earnings Season

March 3, 2023 Conference Call "<23-year target achieved>"

March 3, 2023 Earnings Review "<New Luckin 'Reborn in Fire'>"

In-Depth Report

February 14, 2023 In-Depth Report "<Luckin Coffee Part 1: Can the Rural Coffee Craze Continue?">

Risk Disclosure and Statement in this article: