The opportunity in front of Luckin Coffee (NASDAQ:LK) admittedly is enormous. The company quickly has become the leading coffee retailer in China, and as of late, investors have noticed. LK stock now has risen 152% in a little over two months since a blowout third quarter earnings report in November.
The rally does make some sense. Q3 earnings admittedly were impressive, and valuation looks enormously stretched looking backward. However, the quick pace of store expansion makes forward-looking multiples more reasonable, at least relative to revenue.
At the same time, there are enormous risks here. It’s still unclear what type of profit margins Luckin can drive over the long term. Competition from Starbucks (NASDAQ:SBUX) will be intense, even if the two companies admittedly are targeting different markets. Furthermore, we’ve seen Chinese growth stories stall out before.
Earlier this month, I argued that LK stock was a 2019 winner that looked likely to reverse in 2020. With shares up 22% YTD, that call looks short-sighted already. But, I’m not sure the gains in recent sessions are sustainable, and I would expect shares to give back at least some of those gains as the year rolls on.
Is LK Stock Expensive?
The simple case against LK stock is that it’s simply too expensive. After the stunning rally of late, Luckin Coffee now has a market capitalization over $11.6 billion. 2019 revenue, based on analyst estimates, should come in at around $739 million — implying a price-to-sales (P/S) multiple above 15x.
In this bull market, that figure perhaps doesn’t sound all that high. But Luckin Coffee stock of course isn’t a tech company. Gross margins in the third quarter were just 53%, well below the 70%+ at similarly-valued, high growth SaaS (software-as-a-service) companies. With Luckin Coffee still unprofitable and likely to remain so through at least this year, valuation on its face seems far too high.
But to be fair, valuation is more acceptable looking forward. Luckin Coffee is expanding at a phenomenally rapid pace. The company announced last week that it finished 2019 with 4,507 self-operated stores. That’s more than double the 2,073 at the end of 2018, according to a past regulatory filing.
Combine that growth with same-store sales increases, and revenue will rise sharply in 2020 and beyond. In face, SeekingAlpha expects sales to jump nearly 168% in 2020. Even after the huge rally, LK stock only trades at a little over 6x this year’s sales — a far more reasonable multiple. SBUX stock, in fact, is valued at about four times fiscal 2020 revenue.
The Margin Question
That said, it’s an interesting argument as to which sales are more valuable. Luckin Coffee’s growth opportunity obviously is much larger than that of Starbucks on a consolidated basis.
However, Starbucks is targeting the China market, too. And, has about 4,300 locations, nearly as many as Luckin Coffee. But, Luckin’s unit growth will vastly exceed that of its American rival, and there’s still the possibility of expansion elsewhere in Asia. That longer runway to growth would seem to suggest that LK stock should receive a premium — and perhaps a substantial premium — to SBUX stock on a P/S basis.
The bearish argument, however, is that even at maturity, Luckin Coffee won’t see the margins that Starbucks does. Starbucks’ adjusted operating margin for fiscal 2019 was 18.9% on a consolidated basis. The company combined its China and Asia operations into its international segment at the end of the year, but through the first three quarters of that year China/Asia Pacific segment operating margins were 18.8%; China accounted for the majority of locations in that region.
After all, Starbucks sells its coffee in China for an average of $4.30, while Luckin charges about $1.50. Even with Luckin rolling out “unmanned” locations and focusing on pick-up sales generated through mobile apps, that pricing discrepancy suggests much lower margins — even once upfront spending on marketing and new locations slow.
Margins obviously are going to improve sharply, but there’s a real question as to how far they can go. If Luckin’s peak margins are half those of Starbucks, investors are paying a still-high multiple for a business that simply isn’t going to be that profitable. And that’s a real problem, and a real danger to LK stock.
The Rally for LK Stock
Trading in Luckin Coffee stock since its initial public offering in May suggested investors saw that risk as significant. The revenue opportunity doesn’t completely offset that risk.
Margins aren’t the only issue, either. The parabolic gains in recent session certainly look like a potential short squeeze, but squeezes fade as shorts cover. Early trading on Tuesday, in which LK stock fell 4%, suggests that fade might be occurring. Short squeezes are trading phenomena, not part of an investment thesis.
Finally, there’s the not-insignificant country risk. Investors have bid up Chinese stocks in recent months on the back of perceived optimism toward a trade deal. But, that optimism can reverse. Even that near-term issue aside, we’ve seen growth stocks in that market reverse quickly. The likes of JD.com (NASDAQ:JD) and iQiyi (NASDAQ:IQ) pulled back sharply from their highs, even with little on-the-ground change in their operations.
Collectively, those factors suggest that this rally simply may have gone too far. Again, valuation isn’t as unreasonable as 2019 numbers suggest, but it still leaves little room for error. Execution will be paramount as Luckin executes a growth strategy at an unprecedented pace. Chinese stocks have seen significant volatility in the last few years.
There’s simply a lot that can go wrong here. Perhaps those risks are overblown; perhaps LK stock will be more like Shopify (NYSE:SHOP) than Luckin’s fellow 2019 IPOs that have struggled. Valuation alone isn’t a reason to short; in this market, it hasn’t even been a good reason to sell. However, there other risks here that suggest investors may be too optimistic toward LK stock at the moment.
As of this writing, Vince Martin has no positions in any securities mentioned.