Luckin Brews Up Tumbling Margins, Falling Profits As Competition Overheats

Key Takeaways:

• Luckin’s revenue rose 35.5% in the second quarter as it nearly doubled its store count, but plunging same-store sales caused its margins to drop sharply
• The company is facing a double challenge from growing consumer caution as China’s economy slows and competition intensifies from upstart rival Cotti

By Doug Young

China’s coffee wars are scalding a lot of companies these days. The overheated landscape, which has seen companies slash prices to a new norm of just 9.9 yuan ($1.37) per cup of premium brew, is on the front burner in the latest quarterly results from market leader Luckin Coffee Inc. LKNCY, which reported falling profits and plunging same-store sales.

Luckin certainly isn’t the only one suffering in China’s coffee wars, as former market leader Starbucks SBUX disclosed equally dismal trends for its China operation in its own latest quarterly report also released this week.

Somewhat ironically, Luckin itself and Luckin clone Cotti Coffee are largely to blame for the current overheated market, as the pair have become locked in a race to see who can open the most stores in the shortest time. That pair alone added nearly 2,000 new stores during the second quarter, including 1,371 opened by Luckin.

Cotti opened its first store less than two years ago after being started by Luckin’s pair of disgraced co-founders, who were forced to leave the company after a massive fabricated sales scandal in 2020. That pair, Charles Lu and Jenny Qian, now seem intent on recreating the Luckin they were forced to leave, including a globalization push that has seen the chain expand to 28 countries, according to its website.

In a symbolic milestone, Cotti officially passed Starbucks in the second quarter to become China’s second largest coffee chain in its race to catch Luckin. But with more than 7,500 stores worldwide, the vast majority of those in China, Cotti still has a ways to go to catch up with Luckin, which passed the 20,000-store milestone in July.

Cotti hasn’t released any financials, and, given the scandalous past of its founders, it’s unlikely to be welcome on any stock market anytime soon. But the company is almost certainly losing massive money, though it’s unclear exactly who is funding its rapid expansion. Luckin is still profitable despite the intense competition, meanwhile, though it seems like just a matter of time before it falls into the loss column if the current competition doesn’t ease.

Luckin’s shares, which are still traded over-the-counter in New York after being delisted from the Nasdaq, fell 6.7% the day the results came out and continued to weaken for the rest of the week. They were down nearly 10% through Thursday’s close, and have lost 25% of their value so far this year.

Despite all its woes, the company’s stock still trades at a surprisingly strong price-to-earnings (P/E) ratio of 23, ahead of the 21 for Starbucks and far higher than the 9 for recently listed Chabaidao (2555.HK), a leading Chinese seller of premium bubble teas. The valuation premium probably reflects Luckin’s position as China’s market leader.

As a purveyor of affordable premium coffee, Luckin is also well positioned for at least the next two to three years as China’s slowing economy causes consumers to gravitate towards its cheaper products over pricier fare from companies like Starbucks.

Plunging Same-Store Sales

With all that background in mind, we’ll spend the second half of this review taking a deeper dive into the latest Luckin report that shows most of its metrics struggled after excluding gains from its rapid expansion. That expansion saw the company nearly double its store count in the space of just a year, with the figure up 84% to 19,961 stores at the end of June from 10,836 a year earlier.

Despite the opening of so many new stores, Luckin was only able to record 35.5% revenue growth for the quarter, or less than half the growth rate for new store openings. That figure came in at 8.4 billion yuan for the quarter, versus 6.2 billion yuan a year earlier.

The major factor behind the big discrepancy in store and revenue growth rates was same-store sales, which plunged 20.9% year-on-year during the quarter. That continued a trend that saw the metric fall 20.3% in the first quarter, reversing double-digit gains in each quarter last year as Chinese life returned to normal following the lifting of pandemic restrictions.

Starbucks also reported falling same-store sales for its China stores, though its figure was down by a milder but still worrisome 11% for the quarter, even as it boosted its store count by 13%. Starbucks reported that its average order value and total number of transactions in China both fell 7% year-on-year. Luckin cited falling prices several times as a main factor behind its slipping performance in the second quarter, though it didn’t say how much exactly they fell.

Luckin’s profitability also took a hit from a 46% year-on-year increase in its operating expenses due to its rapid expansion, which far outpaced its revenue growth rate. As a result, its operating expenses rose to 87.5% of its total revenue from 81.1% in the year-ago quarter. If that trend continues, the company is almost certain to fall into the red in the next year or two.

As a result of that toxic brew of soaring costs and falling prices and same-store sales, Luckin’s operating margin fell more than 6 percentage points to 12.5% from 18.9% a year earlier. Its net profit fell by a milder 13% year-on-year to 871 million yuan from 999 million yuan. Despite its deteriorating performance, Luckin didn’t need to dip into its large cash reserves, which were roughly unchanged at 3.8 billion yuan at the end of June compared with six months earlier.

The bottom line is that Luckin isn’t exactly in trouble just yet, as it has plenty of cash reserves and can still operate profitably despite the intense competition from an extremely aggressive Cotti. But Luckin got to where it is now largely because of the foundation laid by its co-founders, who now look quite intent on repeating their original mission to create the world’s largest coffee chain with Cotti. That means the competition at the lower end of China’s premium coffee market is unlikely to ease anytime soon.

This article is from an unpaid external contributor. It does not represent Benzinga's reporting and has not been edited for content or accuracy.