LKNCY - Luckin Coffee: A Good Business Model Promotes Resilience Against Adversity

2023-04-13 08:39:47 ET

Summary

• The restaurant industry has been battered and bruised by repeated COVID-19 outbreaks, but the company is optimistic that its negative impacts will continue to lessen for the foreseeable future.
• Luckin Coffee leverages its strengths and maintains a leading position as the largest coffee brand in China around its three business model pillars.
• The company completed two debt restructuring plans and is not subject to bankruptcy.

Investment Thesis

China began to open up in early 2022, lifting restrictions and thus encouraging normalcy in business. The massive outbreak of COVID-19 at the end of the year kept many people from going to work or leaving their homes. Consumer demand was low, and several stores even temporarily shut down as a result of how serious the outbreaks were. Such tendencies accounted for Q4 2022's below-par sequential performance.

Luckin Coffee's ( LKNCY ) financial performance was materially and negatively impacted in the fourth quarter as the COVID situation became very severe in mainland China. However, revenue growth remained strong compared to the same period last year. Brand promotion, a reliable supply chain, cutting-edge digital capabilities, and enthusiastic customers are all to thank for this development. Further, revenue and profit performance for the year 2022 remained strong, proving the effectiveness and resilience of Luckin Coffee's business model.

Regarding resolving historical issues, the company completed the debt restructuring. The settlements related to the overseas investor litigations are near completion, signifying that the overseas-related matters have largely been resolved. In its 2022 annual report, Luckin announced net revenue of RMB13.3 billion, up 66.9% from the previous year. And a net income was profitable at RMB488.2 million. During Q4 2022, the company achieved a positive operating cash inflow of RMB48.3 million, around $7 million, compared to an operating cash outflow of about RMB14.4 million in the same quarter of 2021. Given this promising realignment in the business, I am bullish on the stock and, as a result, rate it a buy.

Three-pillar Business Model

Luckin continued to leverage its strengths and maintain a leading position as the largest coffee brand in China around the three pillars of a business model: "people, products, and places."

People

The company increased its brand momentum In 2022. Luckin Coffee co-branded with well-known intellectual properties (Han Meilin), which consumers received well. The average number of clients that transact with the company each month has climbed from 16.2 million in Q4 2021 to 24.6M in Q4 2022, a year-over-year increase of more than 50 percent due to the rising demand.

Luckin Coffee is dedicated to the development of its baristas. The Coffee Quality Institute's Q-Grader certification is widely recognized as the industry's gold standard, and at present 48 R&D staff members hold it.

Product

The company launched nearly 140 new SKUs in 2022, including more than 100 new drinks through the continued strength product strategy of "professionalism" and "good flavor".

In the fourth quarter of 2022, Cheese Flavored Latte was launched as a new product and sold over 6.59 M cups in the first week. Luckin Coffee once again topped the new consumption trend in China's coffee market. When combined with effective brand promotion, the Cheese Flavored Latte took up the Better Life, Flavor Innovation Leading Award at the New Weekly Awards in 2022. The beans from Luckin Coffee have won the IIAC Gold Medal for the fifth year in a row.

Place

The company was one of the leading coffee chain brands in China as of the end of 2022, and its rapid expansion was anticipated to continue. The overall store number was 8,214, covering nearly 240 cities, with the addition of net new store openings 368. The strategic increased footprint across China stimulates presence while increasing brand awareness, revenue, and efficiencies of scale.

Core Competitive Advantages

The following aspects give Luckin Coffee a competitive edge.

Sustainable supply chain

Luckin Coffee's persistence in professionalism is also reflected in the effort to integrate the value chain. Further, the company pursues upstream value chain integration and works with coffee bean farmers to cultivate excellent coffee varieties. Additionally, the company closely monitors all processes, including roasting, to guarantee quality end products to customers.

In 2022, Luckin Coffee Jiangsu Coffee Roasting Facility started construction in Kunshan. The facility is the second fully automatic intelligent coffee roasting facility built by Luckin Coffee after the Fujian facility. It is anticipated that by 2024, the new facility will be ready for operation, having a capacity of 30,000 tons of coffee beans. The new Kunshan facility will fully implement a "zero emission" model and green and low-carbon operations throughout production.

Digital capabilities

The company is one of the first chains to go completely paperless. All orders are placed and paid via the Luckin app. Orders are then delivered to the customers' requested location or collected in-store. The effect on overall business efficiency is profound by improving customer service and insight into decision-making.

Financial Highlights

The company exhibited Strong full-year operational and financial performance despite being materially impacted by COVID-19 in the fourth quarter of 2022.

Luckin Coffee completed two debt restructuring plans, ending the cross-border bankruptcy proceedings. The plans included a USD460 million senior note with holders receiving a total of USD320 million in cash plus new bonds after the restructuring and a USD175 million settlement for a shareholder class-action lawsuit. It is no longer subject to bankruptcy.

The operating margin in Q42022 was positive at 8.5%, a historical fourth-quarter high, mainly driven by the strong business and improved efficiency from cost to control technology-driven operations. The drop in profitability compared with last quarter was contributed primarily to the adverse operating profit achieved in December due to the impact of COVID.

At the end of 2022, Luckin Coffee had over 5,650 self-operated stores and over 2,560 partnership stores. For the full year of 2022, the operating margin turned positive and reached 8.7%. The store-level profit margin of self-operated stores also grew year-over-year at almost 24% in the quarter compared to 21% in the same period last year. The store-level margin improvements were primarily due to our active approach to introducing new products, operating efficiency, and expanding the number of products sold.

During Q42022, the company achieved a positive operating cash inflow of RMB48.3 million, around $7 million. If the payment to equity litigants of about RMB122 million is excluded, the net cash provided by operating activities was nearly RMB170 million in the fourth quarter of 2022.

Regarding the balance sheet in 2022, It fully redeemed the offshore notes in Q3 following the restructuring and paid the federal class settlement. Thus, no interest-bearing debt, and the cash position remains strong with around RMB3.6 billion of cash and cash equivalents. The cash is retained for reinvestment, since the company is not paying out dividends currently.

Risks

In 2019 the company intentionally and materially inflated its revenue by $300M and materially understated its net loss in its publicly disclosed financial statements. After such misconduct, the company agreed to pay $180M as a penalty for the accounting fraud.

The company was among the few Chinese companies listed on the US NASDAQ exchange until it was delisted in 2020 due to alleged accounting misdealing. The company is trading on the OTC Currently, not the prestigious NASDAQ. Because of this, the criteria for auditing and inspecting are substantially lower than before the delisting. The accounting and reporting standards of the NASDAQ are more stringent than those of the OTC.

Conclusion

While uncertainties remain around the COVID-19 situation in China, the company is optimistic that the negative impacts on operations due to COVID-19 will continue to lessen for the foreseeable future. Given this promising realignment in the business, I am bullish on the stock and, as a result, rate it a buy.

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