Luckin Coffee: A Case Study and Analysis of China’s Coffee Industry

At the Nasdaq headquarters podium, in a hot pink blazer, donning a navy shirt the same colour as the logo behind her, Jenny Qian stood brazenly as a commander does with her troops. She claimed unequivocally that “this is the start of equality for Chinese coffee consumers”. With such palpable exuberance, the faintest of believers could be converted into vouching for her mission. This essay will explore the coffee industry, Luckin Coffee’s miraculous rise, subsequent fall and lessons it teaches about business in China.

Coffee in a Tea-drinking Nation

Coffee is not new to China, historians believe that it was first introduced in a village called Zhukula by French missionaries in the 19th century. Despite this heritage, today the average Chinese only drinks 3 cups of coffee a year, significantly lower than the 363 and 250 in the U.S. and U.K respectively. However, between 2004–2013, Chinese coffee consumption has experienced a 16% year-on-year growth; 8 times the global rate. According to research from the University of Kentucky, this aforementioned growth is comparable to that of another East Asian nation, Japan, in the years 1964–1974. With such trajectory, we can assume that China is still in the premature years of coffee development and has three decades left to reach peak levels. With a population of over 1.3bn, China has the potential to become the largest market for coffee in the world.

Starbucks was the first to gain a foothold, opening its first store in 1999 in Beijing. Other brands have joined this market, including Costa Coffee, Maan Coffee and Caffé Bene. Starbucks, the market leader, tripled its store count in the period 2013–2018, and pledged to add 500 more stores annually in the next 5 years, Dunkin’ Donuts followed suit by declaring an expansion of its Chinese footprint by establishing 1400 more stores over the next 2 decades. Moreover, since 2015, we have seen McDonald’s McCafé expanding rapidly across China, and KFC seeking to become a “lower-cost” counterpart in the freshly ground coffee market. Accompanying the international megacorporations, we have seen innumerable independent coffee shops spurring up across China in the last two decades. These players aim to offer a higher quality alternative. But some have also sought to capitalise on the popularity of the western aesthetic, sporting logos and décor reminiscent to that seen in places such as Starbucks.

In late 2017, with the help of Chinese technology titan Alibaba, Starbucks opened a two-story, 30,000-square-foot roastery in Shanghai. This quickly built up further excitement for the brand, with crowds eager to take selfies and queue up to experience the largest Starbucks Roastery in the world. Utilising Alibaba’s Mobile Taobao app and augmented-reality, the collaboration integrates “real-time, in-store and online customer experience” with features such as interactive menus and delivery services.

A New Blend

In steps Luckin Coffee, a different type of coffee shop. Founded in October 2017 in the coastal city of Xiamen, Jenny Qian established the company, raising $150m with the help of angel investors — including her former boss Charles Lu. Qian worked in Lu’s car rental businesses, Car Inc. and UCar — serving as the chief operating officer at both, before stepping down to launch her own start-up. Many of Luckin’s future directors and executives would come from Lu’s companies or his close connections. With world- concurring brands already occupying the Chinese coffee market, Qian believed that this was only the beginning for the coffee industry, and the market was still largely untapped. Qian sensed that something was brewing; a consumer-driven economy — fuelled by changing desires of an expanding middle class. Coffee in China hits a sweet balance, it is still considered a luxury — but a rather attainable one, and Qian sought to make this luxury even more accessible for the masses.

A typical Luckin Coffee store is a stripped-down version of everything one has come to expect from a modern, exciting coffee shop. There are no showboating baristas with aprons matching their certified skill level; there is just a simple counter, a couple of coffee makers, and a few bar stools. All of the standard coffee products you would expect are served, in addition to salads, noodles and snacks specifically tailored to Chinese preferences, such as green tea KitKats and Taiwanese salted egg yolk cookies. The Luckin experience is completely paperless; menus are digital, orders are made and paid through downloading the dedicated Luckin app or by running its mini programme. Orders are then delivered to the customer or collected in a nearby store. Delivery is promised to be under 30 minutes by SF Express, whilst a pickup order will be processed and ready to collect within 3-minutes. 90% of Luckin stores consist of two types; the aforementioned minimal Kuai Qu (fast pickup only) stores, and those offering more decorative features, and eat-in space stores. The remaining stores serve as kitchens for delivery riders to pick-up the orders and deliver them to customers.

In December 2018, Luckin Coffee disclosed a total net loss of $125.1m. Qian justified this by claiming that heavy investments in marketing are necessary for winning recognition, rapid attainment of new customers, and ultimately market share. Subsequently, Luckin raised a further $550 million to support this business model for the next 3–5 years.

A True Chinese Champion?

Just as Qian had promised, expansion was rapid, entering its second year, the Luckin had 2073 stores across China, having sold over 89 million cups to 16.8 million customers. It had successfully overtaken Costa Coffee to become the 2nd biggest brand in China. With 2,500 stores still to open in 2019, Luckin was well on its way to become the biggest coffee chain in China. In May 2019 Luckin successful went public on the U.S. Nasdaq stock exchange, helping it raise a further $651 million in funding. Valued at $2.9bn, this was the first time since the dotcom bubble in the early 2000s that a company had been able to achieve such a public valuation less than two years after its launch. With over 4,500 stores, in early January 2020, Luckin proudly announced that they had overtaken their biggest competitor, Starbucks. At its peak, Luckin was valued at $12.7bn and was opening a store every three and a half hours.

Luckin Coffee’s perceived market success was possible due to the characteristics of Luckin’s technology-driven new retail business model. This was concentrated on rapid expansion of its store networks and engaging with as many users as possible via its app. Stores at every corner of major cities and a sophisticated user-friendly app can only help a business grow so far, and it is the coffee itself which helps cultivate a loyal following for brands. The company sought to address this by designing a menu catered towards the Chinese palate. They hired Hidenori Izaki, the 2014 World Barista Champion. In addition to their classic coffee-based offerings, Izaki introduced exclusivities such as the ‘mandarin soda americano’, and the ‘black gold soda americano’. Izaki expressed the belief that since the Chinese taste tendencies are ever changing, Luckin is regularly researching flavours and taste trends all across mainland China, in order to offer products specifically aimed at accommodating its Chinese consumer base. To further diversify its menus, Luckin introduced its own tea brand, 10 products with novel twists to its traditional tea collection; an example of this is the Guava Cheese Ruby Tea — this was also aimed at snapping at the heel of rival start-up HeyTea. In 2018 and 2019, such efforts appeared to have paid off, with Luckin winning gold medals at the IIAC International Coffee Tasting competition. In order to further compete with rival Starbucks, the Xiamen-based company launched Luckin Bakery in mid-2019, this would further diversify the business model – placing it in firm competition with chains such as Tous Les Jours and Paris Baguette.

Having a digital-first and only strategy, Luckin Coffee is arguably a technology firm as much as it is a coffee chain. According to the company itself, the centralised technology system employed by Luckin allowed the company to boost its operational efficiencies and thus been a major contributor to its rapid expansion. Transactional data collection of every purchase through its app, allows the company to leverage big data and artificial intelligence to gain a better understanding of consumer buying habits, hence helping to make strategic decisions such as targeted and dynamic pricing — further aiding in consumer retention. Moreover, such data collection allows the company to optimise its branch offerings based on the preferences of consumers of a specific region — this is important for a country of China’s immense geography and diversity. This technology can also be leveraged in optimising operational efficiency in the sense of managing supply chains and inventory. Furthermore in 2018, Luckin signed a partnership with Chinese tech giant Tencent — helping it gain 50,000 orders per day. This would further aid Luckin’s understanding of user traffic and data management.

With over 90% of Luckin’s locations essentially being small kiosk pickup stores, it is clear that the company has a clear strategic focus on grab-and-go for their business model. These stores are located in areas which Luckin has identified as having a higher relative demand for coffee (Universities, commercial districts, and office buildings). For example, in Zhongguancun, the technology hub in Beijing, there are 7 Luckin coffee location points just within a quarter of a mile radius. Expansion in these areas provides convenience and ease of access to those who are most likely to become Luckin customers. A digital-only, paperless system means that the company does not need to spend excessive amounts on designing, printing and updating menus, or hiring additional staff to take orders – this is all automated. With a 100% cashier-less environment, most of these stores are low maintenance, lack seating, have low rental cost, and are ultimately minimalistic – explaining the inexpensive and brisk expansion. According to analysis from Thinknum alternative Data, by the end of 2019 the company had changed its strategy. Turning its focus on remote locations, Luckin looked to gain first-mover advantage to places yet introduced to the famous two-tailed green mermaid. These included transit hubs, and China’s “second and third-tier” cities. In January 2020, the company took a large step in further broadening its coverage across China by launching “Luckin Coffee Express”, a smart unmanned coffee machine, as well as “Luckin PopMini” a smart vending machine. This particular addition further helps drive forward Luckin’s ambitious strategy of being the most accessible coffee in the 3rd largest country in the world. Expansion into airports, bus terminals, residential communities and highway service stations can now be done at an even greater rate, as well as being more cost-effective for the company and reducing transaction costs for the consumer.

Much of Luckin’s swift and effective growth can be attributed to its willingness and tolerance to accrue large losses in building outlets across the country and offering significant discounts on its products. Qian borrowed from her experience in the ride- hailing industry by adopting an aggressive marketing strategy – over the course of the company’s first two years, Luckin’s expenditure was 3 times that of its revenue. Luckin offered various deals all year-round in order to attract new users and retain loyal customers, such schemes included “first cup free” and “latte season” where all Lattes are half-price. This helped Luckin gain an advantage in the price department over its competitors. A typical cup of coffee in Starbucks is priced at 32 Chinese Yuan, considerably higher than the 25 Yuan offering at Luckin. Thanks to the higher rental and labour costs associated with its emphasis on an in-store experience, a cup of coffee in Starbucks could cost substantially more than a simple dinner for one. With offers promoted on Tencent’s WeChat, such as “buy 2, get 1 free”, “44% off snacks”, and a chicken wrap being priced at just 10 Yuan – the Luckin offering makes a lot of sense for its target consumers: students just looking to get a caffeine rush and a snack to get them through writing papers, Luckin made that a very easy choice with on-campus accessibility. Analysts have estimated that based on the heavy discounts offered, the average Luckin item sold was priced at just $1.54.

Fair Trade?

The fortunes of Luckin Coffee would change forever. Days after the shares of Luckin had peaked on the Nasdaq stock exchange, a cryptic email from an anonymous author called “GLEN” was found in the inboxes of a number of short sellers in the United States with the title “a new generation of Chinese Fraud 2.0 has emerged”.

On the 31st of January 2020, Muddy Waters Research, a short-selling firm famous for betting against Chinese start-ups in the past, and debunking fraudulent cases, released the anonymous report via Twitter. They alleged that Luckin Coffee had inflated their revenue by as much as 69% in the 3rd and 88% in the 4th quarter of 2019. The extensive 89-page report was supported by a thorough operation — recording 11,260 hours of store traffic footage, customer counts and 25,843 receipts, gathered by 1510 people who covered over 600 of Luckin’s stores throughout China. In a series of statements, the company denied all wrong-doing and slammed the report as slander, while its stocks fell 27% on the next day of trading. However, on April 1st, Luckin’s own internal investigation found that its former Chief Operating Officer, Liu Jian, had inflated revenues by $310.5 million in the six months leading to the 30th of September 2019. Following this, the China Securities Regulatory Commission began its investigation into the firm, raiding Luckin’s headquarters in Xiamen. On the 8th of April 2020, as a result of the anti-fraud probe, all trading of ‘LK’ stock was stopped on the U.S. stock market — the stock fell more than 80% in April alone. After Charles Lu had defaulted on a $518m margin loan, Goldman Sachs declared that they would confiscate and sell off his shares in the company.

In May, Qian was fired from the company as the probe deepened. Nasdaq formally delisted the stock from the market, the shares stood at $1.38, giving the company a market capitalisation of around $350 million. The formal conclusion made by the U.S. Securities and Exchange Commission was that by creating fake operation databases, altering accounting and bank records, the company had intentionally exaggerated its sales and costs, while explicitly downplaying net losses in the publicly available financial statements of 2019 following the company’s IPO – Luckin was fined $180 million as a result. The market was shocked at the news of the blatant fraud because many notable financial institutions had backed the company, these included Louis Dreyfus, Lone Pine Capital, BlackRock, and Credit Suisse. It is clear that the management at Luckin had been corrupt from the very beginning, but it is also unwise to ignore the role of foreign stock markets and auditors such as Ernst & Young, which often turned a blind eye to the company’s financial reporting.

Luckin had clearly failed to sustain their business model. According to Luckin’s false financial statements, they had booked $74.4 million in net losses in the third quarter of 2019 — this was 9.7% worse that Q3 of 2018. A major contributing factor for this deterioration had been the 147% increase in sales & marketing expenditure when compared to the same period in 2018. With such a tunnel- visioned focus on capturing market share and expanding at any cost, the company had turned a blind eye to making profits and instead relied on heavy discounts which ultimate proved unsustainable. In order to provide the illusion of rapid growth, meet earnings expectations and provide investors with desired returns on their shares, Luckin had no other choice but to cook their books.

Lessons about Business in China:

At the turn of the millennium, only 4% of the urban population in China was considered middle class, by 2018 this had grown to over 30%. According to researchers, this trend will accelerate, reaching 76% in the coming decade. With increasing disposable income and purchasing power comes a thirst for new leisure activities. Spending time in coffee shops with brand new drinks is an element of this. The fact that Luckin’s grab-and-go focussed strategy failed, while Starbucks’ successful model concentrated efforts on investing heavily on things like its roastery in Shanghai, illustrates the appeal of large, landmark-esque, touristic features of the brand in China — attracting coffee enthusiasts and general consumers alike. Contrary to what is seen in the west, coffee shops in China are not just considered as a place to grab-and-go coffee, but somewhere to enjoy and experience it. This younger generation contributes 53% of total Chinese consumption, with this expenditure set to grow 14% annually, thus their share in the overall consumer base will likely dominate — this will ultimately be in the benefit of those accommodating the evolving Chinese lifestyle of the upwardly-mobile residents of cities such as Shanghai and Beijing.

The case also demonstrates the significant impact of technology in China, allowing a start-up to expand at earth-shattering rates by utilising big data and A.I. to cut costs. Such technological advancements and wide-spread adoption are striking and notable. This makes it easier than ever for entrepreneurs in a wide array of industries to pounce on opportunities and gain a foothold in markets previously inaccessible. Luckin demonstrated this by using automated order-taking and payment systems to quickly expand in remote regions of the country. The upsurge in the emergence of this phenomena has been helped along by the rapid growth in the use of smartphones in China over the past decade - apps are used for everything from booking a doctor’s appointment to paying for utility bills.

The low-cost strategy adopted by Luckin was based on the premise and traditionally assumed idea that all Chinese consumers are frugal and price is king. But this does not explain Starbucks’ resounding success in the Chinese market over the past two decades. Starbucks’ undeniable brand recognition in Chinese pop culture and the rapid emergence of independent, yet high quality, organic coffee brewers across China’s large cities demonstrates a changing attitude among consumers. With the aforementioned increase in the standard of living, and with more Chinese youth travelling around the world than ever before — this new generation does not fit the previously assumed characteristics of frugality. They seek the highest calibre of product, no matter the increased costs — quality and taste have become more important. This may be worrying for many manufacturers and businesses who have at times focussed on driving down the price in operations as much as possible, often at the cost of quality. This can be seen in Luckin’s low market success.

Furthermore, Starbucks’ coffees in China are priced at a 20% premium to elsewhere in the world, even though labour costs are much lower. Yet, the brand remains hugely popular. At this price, most average workers in China are priced-out — however this is done intentionally. The company has chosen to set up shop in some of the most affluent areas and luxurious shopping malls in the whole country. This signifies the average Chinese consumer’s perception and attraction to luxury and the lifestyle associated with it. Such tactics used by Starbucks have allowed it to add social value to its offerings, whilst Luckin failed to keep customers coming back after the heavy subsidies on its products stopped. Having said this, Luckin coffee, a brand targeting the lower end of the market, and claiming to bring equality for Chinese consumers, had a lopsided distribution of its stores in China. Stores were mostly located in urbanised, wealthy cities or districts. This polarisation is emblematic of China’s growing inequality and wealth gap. The aforementioned growing middle class still only represents around 15% of China’s population, whilst the rest of the country remains poor by global standards. This suggests to us that China is divided when it comes to those looking to do business there, and the consumption behaviour discussed in Luckin’s case only applies to a small minority of the country as a whole.

The fraud aspect of the case highlights a dark risk that exists for foreign investors looking to have a share in China’s booming economy. Luckin is not the first Chinese company to be delisted from the U.S. stock market due to alleged fraud. The problem often lies with auditing firms, they effectively provide cover and legitimacy to fraudulent businesses. Companies are usually audited by the Chinese franchise of one of the ‘Big Four’, this allows them to overlook unethical behaviour more frequently. This occurs due to the internal politics of China, such firms are discouraged to untangle the financial statements of Chinese companies, in order to prevent negative stigma being associated with the wider business environment, and hence damaging foreign investment prospects — this ultimately results in foreign investors accepting the management’s word and being none the wiser. This is further emphasised by the fact that the 89-page Luckin report was distributed anonymously, suggesting a risk element for those which conducted the investigation, and possibility of prosecution if their identities were to be revealed. Guanxi plays an important role here, with executives across China’s biggest companies having decade-long established relationships with officials at various levels of government. Allegations about fraud or underperformance, such as with the Luckin report are quickly denounced – this places many Chinese executives beyond the reach of the law. This is further reinforced by China’s refusal to grant access for foreign accounting oversight boards to the financial and accounting documents of firms, such denial is attributed to China’s state secret laws.

If companies such as Luckin Coffee, which are effectively under a microscope compared to other private companies in China, are being so brazenly fraudulent, it raises a question mark on the wider Chinese economy, and how dire the situation might really be across industries, and whether much of the so-called Chinese miracle is just a big fraud.

However, despite this, it is wrong to label China and Chinese business as a rotten apple, where everything is fraudulent, whilst the rest of the world is law-abiding. Such issues arise in China more frequently due to the reward and incentives structures in place. With reduced transparency and investigatory powers vested to audit firms as a consequence of soft pressure from outside players in the wider Chinese political- economy spectrum, executives at firms such as Luckin Coffee face little to no consequence for their malpractice. They either get away with it or make as much money as possible in the process, paying a negligible fine as transaction cost for their ‘troubles’.

The Luckin case is in many ways emblematic of business in China. It was supposed to be the domestic counterpart to Starbucks, just like Baidu had been to Google and Xiaomi to Apple. It was supported by financing across the Chinese economic system and praised by state-affiliated media. Its listing on U.S. stock markets posed a viable route for international investors looking to be a part of the bright Chinese future. Moreover, the case demonstrated a growing middle class with changing consumer habits. However, it also illuminated widening inequality and proven tolerance for unethical conduct by an environment with persistent opacity and complex entanglements of business and politics.