Description

Luckin Coffee Inc: Uplisting Will Unlock Significant Upside

Investment Thesis

An acccounting scandal or fraud of a public company typically would mean sudden death or at least a downward spiral for the company. Luckin Coffee Inc. (LCKNY) is a very rare case where the company has managed to survive and thrive despite its highly publicized “transaction fabrications” by successfully addressing its legal, financial and operating issues.

The company has accomplished a series of key milestones this year that we believe are underappreciated by the market. The stock price has not done much over the last few months despite significant progress. We expect this to change due to several upcoming catalysts: final approval and enforcement of the restructuring deal by the Cayman court and US bankruptcy court, and relisting of the company's stock on a big board exchange. Over the long term, we believe Luckin should be a core holding to gain exposure to the fast growing coffee and tea market in China.

We believe that Luckin has a potential upside of at least 75% in the next 12 months. This conservative target is simply assuming that Luckin will trade even with its peers after uplisting.

Luckin Price History: IPO till Now

Source: Bloomberg.

Near Term Catalyst

Luckin’s valuation has been driven more by technical factors, such as legal, restructuring milestones and the OTC listing, than by the fundamental fact that the company’s operations are solid and improving despite the scandal and the pandemic.

As of now, scandal-related uncertainty is significantly minimized or eliminated after a string of recent positive developments:

1)      Legal and regulatory settlement. Luckin reached a $180 million settlement with the SEC in December 2020 and a $187.5 settlement in a US securities class action lawsuit in September 2021. Both outcomes were better than expected. Also the settlement amount with the SEC could be used for debt restructuring payments, one stone, two birds.

2)      Convertible debt restructuring. Luckin has reached an agreement with convertible bondholders which only needs to be approved by year-end 2021.

3)      New investment. Luckin obtained a $250 million investment from Centurium and Joy Capital, shoring up its cash position significantly.

4)      Financial filings. On October 21, 2021, Luckin filed its first half 2021 financial results (following the release of its 2019 and 2020 annual results), in compliance with the RSA, as well as the uplisting requirements.

The final step for making the restructuring deal binding and effective is for creditors to vote and approve the Scheme of Arrangement. According to the latest filing (see weblink below) dated November 4, 2021, the proposed schedule for the process is as follows:

Source: https://dm.epiq11.com/case/luckin/dockets

In other words, we should hear approval news around mid December. We would expect the approval by the US bankruptcy court shortly after that.

With the restructuring deal out of the way, Luckin should have a very clear path for uplisting to the big board, NASDAQ or NYSE. Since Luckin traded on the NASDAQ previously, we do not see major hurdles to meeting the listing requirement. We will be very surprised if the company has not already prepared for or even engaged in dialogue with the exchanges. For the NASDAQ listing requirement, please see the link below:

https://www.nasdaq.com/solutions/list-your-company

We expect the process to be completed within six months. Since the private equity firm Centurium is the largest shareholder in terms of both economic interest and voting power, and a portion of the debt restructuring deal is in Luckin common shares, it is in these shareholders' and creditors' best interests to get the company relisted on the big board to further unlock upside.

Competitive Advantages

Though the company’s near term valuation is driven by the timely completion of the restructuring deal and uplisting, fundamentals will be the key long term driving factor. We believe the company has an advanced business model with unique competitive advantages that will support long term growth and profit generation. Its core competitive advantages are its technology-driven online/offline retail model, large store network and unique client focus.

1)      Online Offline Model

Luckin’s online-offline model is built upon its mobile and store networks. The table below summarizes both the online and offline interface for its customers. As the company states in its website: "Our mobile app and presence on other third-party platforms cover the entire customer purchase process, offering our customers a 100% cashier-less environment. This enhances our customer experience, improves our operating efficiency, and allows us to stay connected with our customers and engage with them anytime, anywhere. Our store network is comprised of pick-up stores, relax stores, and delivery kitchens, which enable us to maximize convenience for our customers, improve our brand recognition, and achieve broader delivery coverage.”

Source: company filings.

Per our conversations with our local industry contacts, Luckin built its technology team before it launched its first physical store. This is very different from other retail chains which tended to have a physical store network first and then caught up with digitalization and technology upgrades.  The Luckin team developed a rigid process on how and how quickly a specific drink should be made and its average service time per drink is faster than most of its competitors. Also the customers can actually see from their mobile app in real time as their drinks are being made.  Per the company website, “Our technology covers every aspect of our business, from customer engagement and storefront operations to supply chain management. We leverage our big data analytics and AI to analyze the huge volume of data generated from our operations and continuously improve our systems. Our focus on technologies has enabled us to efficiently optimize the customer experience and grow rapidly while maintaining quality control.”

2)      Store Network

Despite the accounting scandal, the now removed founders deserved some credit for quickly expanding the company store network to above 5000 across China. No other coffee or tea chains in China, except Starbucks (not a direct competitor), are anywhere near that store count. It would take years and a lot of capital to get to that threshold.

With the coffee market saturation in first and second tier cities in China, Luckin has started to open new stores in lower tier cities via mainly franchising to reduce cost and capex. This will further widen its moat against its competitors in China.

3)      Client Base

Luckin does not really compete head to head with Starbucks for two reasons, firstly, Starbucks positions itself as a third space between office and home, emphasizing the socializing effect, and secondly, Starbucks charges a high premium on its products. Luckin, on the other hand, focuses on coffee drinking, not socializing, and charges prices 40-50% lower than Starbucks without compromising quality. Given this business model, Luckin’s clients are mainly regular coffee drinkers with high appreciation for time cost and coffee affordability. Not surprisingly, the majority of its clients are white collar and college students. That also explains why its newly opened stores are primarily delivery stores (see picture below), not relaxation stores. The delivery store is essentially a store or a space in a building lobby with one counter, ideal for online order and offline pickup.

Per our local contacts, the latest development for recruiting and engaging clients is that Luckin started to sponsor a talk show hosted by a famous pop singer and a standup comedian. The show is produced by Tencent, the parent company of Wechat. The streaming platform, Tencent Video, has a DAU of over 380 million. This is the first high profile advertising campaign by Luckin since the accounting scandal and we expect the campaign to drive traffic for Luckin over the next few months.

Valuation

Year to date, Luckin is up 75% (see chart below) though most of the move was in the month of June. Since June, the stock price has plateaued in a very narrow range despite the release of multiple positive news by the company (see Key Events table below).

Luckin Price History: 2021 Year to Date

Source: Bloomberg.

Key Events/Catalysts 2021

Source: Company website.

In fact, Luckin underperformed S&P 500 since August and as shown in the chart below its price trajectory has been highly correlated with the iShares MSCI China ETF (MCHI) and KraneShares CSI China Internet ETF (KWEB). This seems to suggest that Luckin was considered mistakenly as one of the Chinese high tech or education companies which suffered from the government crackdown in China. This becomes a perfect setup for the next leg of the runup for Luckin over the next six months.

Luckin vs MCHI, KWEB and SPY (August 2021 till now)

Source: Bloomberg

As explained earlier, we do not see Starbucks as a competitor for Luckin, nor a trading comp, as SBUX serves a different market segment with a different market model. We prefer using Tim Hortons China and Dutch Bros Inc as its China and US comparable. Based on both the P/S ratio and market cap per store, Luckin is significantly undervalued vs the two comps even after running up 75% year to date (see table below).

Trading multiple vs BROS, and Tims Horton China

*Tims Horton information is from its SPAC merger investor deck: https://www.sec.gov/Archives/edgar/data/1826553/000110465921105459/tm2124848d2_ex99-1.htm

**Luckin revenue forecast range is from JPLs first reports dated December 17, 2020.

Source: Bloomberg.

If we assign a 10x P/S multiple on the low end of the 2021 revenue forecast, the implied market cap should be $6.7 billion, implying 76% upside. We believe this price target should be easily achieved after the company is uplisted on a big board. By any measure, Luckin should not trade at a discount to Tim Hortons China which will have only 733 stores by the end of 2022. Since Tim Hortons China is still in the process of completing its SPAC merger, we will only see the real market valuation after the deal is officially closed. Based on Luckin’s financials for the first half of 2021, its six month revenue was already $493 million suggesting that the full year revenue could be at or above the high end of its forecast range: $905 million. If that is the case, Luckin’s trading multiple is even lower compared to Tim Hortons and BROS.

Risk Factors

1)      Political risk. In 2021, equity market return certainly is not ranked high on the Chinese government’s priority list, evidenced by its recent crackdown on the high tech companies and the elimination of essentially the entire for profit education sector. It is highly unlikely that LKNCY will suffer a similar fate because it does not pose the same kinds of the threats as those Chinese high tech companies (anti trust) or education companies (key driver of high education cost).

2)      Delisting from the US stock market. Theoretically this is possible, but highly unlikely because the company has successfully addressed its legal, regulatory and restructuring issues and there won’t be a strong case to force the company to delist.

3)      OTC trading. LKNCY is currently traded on the OTC which has led to several unfavorable consequences for the company. First, the vast majority of institutional investors will not be able to invest in an OTC listed company. Secondly, several online brokers provide limited access to the names listed on the OTC, including LKNCY, which means many retail investors cannot trade the stock either. Thirdly, due to the lack of the market making mechanism of the main board, OTC names tend to be more volatile regardless of company fundamentals.

Catalyst

• Creditors to approve the Scheme of Arrangement: hearing December 13, 2021
• Uplisting to the Nasdaq (likely) soon after