(Tips: Download method is at the end of the article)

1 China's coffee demand is growing rapidly, with the potential demand for freshly ground products quadrupling

1.1 Coffee consumption is becoming more popular, and specialty brands are replacing coffee restaurants to dominate the market

Coffee, tea and cocoa are known as the world's three major beverages. According to data from the International Coffee Organization, the total global coffee production in 2017/18 was 10.08 million tons, and the total consumption was 9.9 million tons. The global coffee market has grown steadily.

China has been drinking tea since ancient times, and coffee culture has been in its infancy for a long time. For a long time, Chinese coffee shops have been dominated by two types of models: overseas chain brands such as Starbucks or niche independent coffee shops. The pursuit of brand is greater than taste, and the environment is more concerned than price, which is closer to the experience economy.

The development of coffee culture in China follows a similar trajectory to that in Japan, with new retail accelerating the popularization. Japan, which has a similar culture to China, has also experienced the process of specialty coffee gradually replacing instant coffee and the gradual rise of convenience store coffee. Although China's coffee market started 20 years behind Japan, it has developed rapidly. Although under current economic conditions, it will not reach the frequency of Japan in the short term, with the help of the new retail model covering online and offline, the popularization of coffee may be faster during the comparison period.

Internet coffee brands have effectively lowered the threshold of coffee culture. 14 years later, Internet coffee brands such as Lian Coffee and Luckin Coffee, which emerged, used "mid-range quality + low-end price" products, adapted to the rhythm of life, and took-out delivery methods and Internet marketing models, turning coffee from a cultural symbol that was not yet popular enough into a popular high-quality beverage for mass consumption. In 2018, China's consumption of raw coffee beans reached 229,500 tons, with a 7-year CAGR of 21.74%, far exceeding the global average of 2.53% . The average annual number of cups of coffee consumed by Chinese people was 6.2 cups, doubling in five years.

The market share of coffee restaurant brands is shrinking due to their vague positioning and strong substitutability. Coffee restaurant brands represented by Shangdao are currently focusing on providing other consumption scenarios such as business chess and cards, and tend to be positioned as "business clubs". However, there are many types of catering in China, and dining venues with the same price and decent environment have strong substitutability. On the other hand, since brands often use chain franchise models when expanding stores, far beyond the management radius, there is a potential risk of negative impact on the brand.

The balance between long-term and short-term interests and the degree of reliance on services determine the feasibility of the franchise model. Compared with the hotel industry, where services are relatively standardized, the entire service of the catering industry is basically in contact with customers, so the applicability of the franchise model is relatively poor. Our previous report also mentioned that the catering business can currently expand in the form of franchising, except for simple snacks such as milk tea and chicken steak. Even if most restaurants in China have very advanced standardized management concepts, they should still adopt the direct operation model as the main model.

With the popularization of coffee consumption (culture is not adapted to fast-paced urban life), franchise brands with better quality advantages are becoming more and more popular among Chinese people. In 2016, the turnover of coffee franchise brands exceeded that of coffee catering brands, and in 2018, the number of stores surpassed that of coffee catering brands. It is expected that by 2023, franchise brands will occupy more than 80% of the market share.

The coffee industry in China is highly concentrated, and overseas brands dominate the market. Compared with foreign countries, the concentration of China's coffee market is relatively high, with CR5 reaching 74.9% in 2018, and it also shows a trend of gradual concentration vertically. Overseas brands such as Starbucks and Costa still dominate the freshly ground coffee market in China due to their early entry into the Chinese market and their strong brand influence. In 2018, Starbucks' market share reached 59.2%, and it has maintained steady growth on a high base level in recent years.

The competition pattern in mature countries is relatively stable, and China is still a blue ocean for competition. Except for Japan and South Korea, where there are many local coffee brands, resulting in a fragmented market, and the specific share of each brand is small, resulting in frequent changes in the ranking, other countries and regions basically present a stable pattern dominated by leading companies. For example, Starbucks occupies 77% of the market share in the United States, and the top two brands in the United Kingdom have a stable market share of about 30%. The market share of each brand will not change significantly, and no new brands have appeared in recent years. However, China's freshly ground coffee market has just started, and the existing brands continue to develop, and local brands are beginning to rise. In the future, it may attract new market participants, and competition will become fierce. It will take time to form a stable competition pattern.

1.2 With the demographic dividend and the new retail model, the freshly ground coffee market has a potential of hundreds of billions

The United States is the world's largest coffee consumer. Japan and China are both tea-drinking countries, and their coffee consumption ranks first in Asia. Compared with the United States and Japan, the Chinese coffee demand is far from saturated, and the future market has great potential for growth.

China's overall coffee consumption is very different from that of developed countries, but it is growing rapidly. Judging from the absolute values ​​of coffee bean consumption, the number of coffee shops and trading volume, there is a clear gap between China and the United States and Japan. China's coffee bean consumption CAGR7 reached 21.74%, which is only a rapid recovery from a low base at this stage.

The low level of popularity and the large population base make the actual per capita gap in China more prominent. Urban working groups are the absolute main force of coffee consumption in China, while the popularity of coffee in the United States and Japan is high, and the audience is almost all citizens. When actually calculating the per capita demand scale, we need to take into account the imbalance of China's consumer population and the income structure gap:

According to the data from the National Bureau of Statistics, there were 434 million employed people in urban areas in my country in 2018. If we assume that this is the population of coffee consumers in China (excluding the elderly, children and rural population in the short term, even so it is higher than the total population of the United States), the actual per capita consumption of green coffee beans in my country is 0.53kg/person, which is still less than 15% of the general level in the United States and Japan. The actual number of cups of coffee consumed per person per year is 20 cups, which is approximately 20 times and 14 times the difference between the United States and Japan respectively. In addition, contrary to the overall situation in the world, instant coffee still dominates in my country, and the consumption of freshly ground coffee in my country is more significantly different from that in countries with relatively mature coffee culture. Even if a small part of the tea culture is replaced, there is still broad room for development, similar to Hong Kong (annual per capita consumption of 249.5 cups).

Thinking further, the demographic dividend and urbanization development are long-term manifestations of China's future consumption power, so there is also room for growth from the perspective of consumer groups.

The market for freshly ground coffee is expected to reach a scale of 100 billion yuan within five years, and the actual number of cups consumed per person per year will exceed 30. The market size of freshly ground coffee was 39 billion yuan in 2018, and according to Frost & Sullivan, it is expected to grow fourfold to 157.9 billion yuan in 2023. The actual number of cups of coffee consumed per person (taking into account the adjustment of the population base) will increase by 1.5 times to 31.67 cups, and the proportion of freshly ground coffee can exceed 50%, reaching 16 cups per person.

Furthermore, we consider the different coffee consumption demands of various industries: Assuming that urban employees in the information transmission, computer service and software industries can consume an average of 60 cups of coffee per year in the next five years, and considering the impact of wage levels and working hours on consumption demand, all urban employees can consume 29 cups of coffee per year. Based on Frost & Sullivan's forecast data, we believe that there is room for an increase of 150% in the number of cups consumed per capita in the next five years.

The price increase per cup is limited, and coffee will become a popular demand as income levels rise. We have sorted out the prices of Starbucks large cups of latte standard products around the world. China is $4.48 per cup, while the United States is only $4.45 per cup. If we take into account the different consumption levels of different countries/regions and compare them according to the per capita disposable income in 2017, the price of coffee in mainland China is significantly higher than that in other countries/regions. It is nearly 9 times different from the cheapest United States, and more than 4 times different from South Korea in Asia. Compared with other regions, the basic purchasing power of the United Kingdom, the United States, Japan, Switzerland and Hong Kong, China is consistent after conversion according to per capita disposable income, reflecting the weak correlation between coffee prices and income levels. That is, there is limited room for China's future coffee prices to rise, and the main space comes from the increase in consumption. Then for Internet coffee companies, the increase in customer unit price will mostly come from the reduction of subsidies and discounts, rather than the increase in consumption power.

There are a lot of freshly ground coffee brands in China, and the price ranges of each level are clear. According to the price, the freshly ground coffee market in China can be divided into three levels: high, medium and low. Among them, the price of a single cup of boutique coffee represented by Starbucks and Costa is concentrated above 30 yuan; the price of a single cup of Internet coffee represented by Luckin Coffee and Lian Coffee is concentrated in the range of 20 to 30 yuan; and the price of a single cup of coffee from convenience store brands such as FamilyMart and 7-11 is less than 20 yuan.

The high-end consumer group is relatively stable, and the mid-range market share is expected to increase. The high-end coffee customer group is relatively stable, while the mid- and low-end customers are highly price sensitive and have strong mutual substitution. Luckin Coffee and Lian Coffee, which are priced in the mid-range, are actually priced at the low end due to preferential promotions, so low-end coffee currently occupies the main market share. The mid-range market will benefit from the gradual development of Chinese people's coffee consumption habits and grow the fastest. It is estimated that by 2023, the high, medium and low-end markets will have a market size of 750+/450+/300+ billion yuan respectively.

Compared with Japan, Hong Kong and Taiwan, the diversion effect of the tea market is limited. For traditional tea drinks, there is still a gap of nearly 15 times in the number of cups of coffee consumed per capita between China and Japan, which also has a deep tea culture. At the same time, coffee is more popular among young groups, and China's aging problem is not as serious as Japan. For new tea drinks, non-traditional varieties such as milk tea and fruit tea do not have a strong refreshing function, and the consumption frequency and stickiness are far less than coffee. The popularity of coffee in Hong Kong and Taiwan, where milk tea culture is prevalent, is also very high. Take Hong Kong as an example. The total population is only 7.48 million. When the average annual per capita consumption of milk tea is 133.6 cups, it will also generate 249.5 cups of coffee consumption, which is more than 20 times the actual per capita level in the mainland. By analogy, China's upper limit of coffee consumption will not be affected by the tea market, but will be significantly lower than other countries.

Social needs will continue to weaken and give way to functional needs. We believe that coffee culture, as an imported culture, can bring differentiated social functions to some consumers in the early stages of the market, but with the increasing development of domestic culture, its attribute of "identity distinction" will continue to weaken, and finally it will be more of a place for functional beverages. The advantageous rent enjoyed by Starbucks now is the same as that enjoyed by KFC and McDonald's ten years ago, and the imported fast food restaurants at that time even assumed some business attributes, but Starbucks ten years later may have the same status as the current foreign fast food brands.

2. Freshly ground coffee is gradually gaining popularity, and new retail models are favored by multiple channels

2.1 Downstream circulation is the most profitable link, and there is still room for competition in the future

For coffee to be transformed from a mountain crop into a drink, it needs to go through the steps of "planting-picking-green bean processing-roasting-grinding and extraction". The coffee industry chain can be divided into three links: "upstream planting-midstream deep processing-downstream circulation".

The upstream planting link is limited by many factors such as land climate, and the profit margin is limited. Coffee planting is affected by climate, altitude, temperature and soil, and the production area is relatively concentrated. The cost items in this link mainly include irrigation, fertilization and labor. The amount of coffee beans used per cup is about 15g, and the corresponding Arabica coffee beans are 0.3 yuan, and the value contribution ratio is only about 1%. In recent years, there has been an oversupply of coffee beans and the price has fallen, further squeezing the profit margin of the upstream.

The payback period for heavy asset investment in the midstream deep processing link is long, and the existing production capacity has fully met the demand. The midstream mainly involves the process of roasting raw coffee beans into mature beans, and brand manufacturers occupy the main market share through large-scale operations. Building a coffee roasting factory requires heavy asset investment. Considering the cost of machine procurement and daily maintenance, as well as labor and material costs, the investment payback period is relatively long. In addition, the production capacity of existing manufacturers can fully cover the demand and still have surplus, leaving less market appeal for new entrants.

Downstream products have diversified channels and are the most profitable segment. Instant coffee is low-priced, ready-to-drink coffee is convenient, freshly ground coffee tastes good, and there is a certain overlap in the sales channels of different products. Downstream products have high added value, and there is still room for differentiated competition, which will also attract new participants to join.

2.2 Product side: With better quality and meeting higher-level needs, freshly ground coffee is gradually gaining attention among Chinese people

The unique refreshing effect of coffee is the primary reason for overtime workers to choose it. With the development of China's economy, the first-level demand still has a lot of room for development. The Tourism Research Center of the Chinese Academy of Social Sciences and the Social Sciences Academic Press jointly released the "Leisure Green Book: China's Leisure Development Report 2017-2018", pointing out that the results of the "China Economic Life Survey" jointly initiated by CCTV, the National Bureau of Statistics, etc. showed that, excluding work and sleep, the average leisure time of Chinese people in 2017 was 2.27 hours per day. In comparison, the average leisure time of citizens in countries such as the United States, Germany, and the United Kingdom is about 5 hours per day, more than twice that of Chinese people. In 2018, the average working hours per week of urban manufacturing employees in China was 48 hours, which is 2 hours higher than that in the United States in the 1940s. The role of coffee as a functional beverage in the increase in labor hours brought about by China's economic development will become more prominent.

Coffee meets three levels of consumer demand: physiological needs, emotional needs, and social needs. The higher the level, the smaller the audience and the higher the average customer spending. Instant coffee can only meet physiological needs, while freshly ground coffee can provide a better taste, partially replacing the first level of demand, and further meeting emotional and social needs through exquisite products and providing scenarios, which is in line with the trend of consumption upgrading, and the market share will increase rapidly in the future.

2.3 Channel side: Multiple players have their own advantages and disadvantages, and competition is becoming increasingly fierce

Traditional coffee shops: providing consumption scenarios to meet social needs, but with high store operation and maintenance costs

Operators of traditional coffee shops include: 1) Coffee and restaurant brands represented by Shangdao, which provide not only coffee but also full meals, with high average customer spending, but long dining time resulting in low turnover rate; 2) Specialty brands represented by Starbucks, which use coffee as their absolute core product and may sell other light meals and desserts. The average customer spending is lower than that of coffee and restaurant brands, but the consumption frequency is high; 3) Independent coffee brands, which are generally individually operated and focus on specialty brands, that is, differentiated competition, but have weak bargaining power with upstream suppliers compared to chain brands, and do not have an advantage in marketing operations.

The outstanding advantage of traditional coffee shops is that they can use physical stores to provide scenes to meet emotional and social needs. Starbucks, for example, provides a "third space" in addition to work and family. Among them, the social attributes brought by the sense of ritual are the key to giving customers an experience beyond their expectations and being willing to pay a premium. Stores are not absolutely standardized, which will partially meet the needs of local customers. In addition, selling music CDs or various promotional methods are all for customers to fully experience the coffee culture and integrate into the Starbucks environment. Consumers have a strong sense of experience and are prone to form a sense of belonging to the brand. Working hard on supporting facilities and service processes may not necessarily increase profit margins in the end, but it can increase competitive differences. However, due to factors such as high costs for barista training and salaries, and the large size of general stores and their distribution in business districts, the cost of physical stores is relatively high.

Internet takeaway coffee: rapid expansion driven by online, relying on large subsidies and discounts to attract customers

Internet coffee brands represented by Luckin Coffee and Lian Coffee use online cashless ordering + takeaway delivery methods, with a clear positioning of "allowing consumers to quickly drink cost-effective and delicious coffee."

Online-driven development with heavy Internet genes: 1) Store attributes are weakened . Offline stores are not commercial storefronts in the ordinary sense, but are only responsible for production and distribution. The site area, personnel and machine configuration can be dynamically adjusted according to the number of online orders; 2) Light social model, it is necessary to make full use of WeChat and O2O life platforms to transform traffic thinking, and use new media marketing methods such as new customer rewards and fission red envelopes to promote products. However, coffee culture is still developing and customer stickiness is not sufficient. A large number of preferential subsidies have led to a large demand for brand funds, affecting the company's profitability. If the subsidies are cancelled, consumer groups that are more sensitive to prices may turn to high-end or low-end product alternatives.

Convenience stores: Relying on the original supply chain and store advantages, coffee quality is a competitive weakness

Convenience store brands can cooperate with upstream large coffee manufacturers due to their scale advantages, and can make full use of the original complete logistics supply chain distribution system, and do not need to hire additional employees, so the price is relatively low. On the other hand, existing convenience stores are mainly distributed in CBD, communities and other crowded areas, and many of them adopt a 24-hour business model to fully realize convenience. It can save time and money costs for consumers with functional needs for refreshing.

For the sake of convenience and consistency in promotion, convenience stores usually choose fully automatic coffee equipment and pre-set parameters such as extraction temperature. However, these parameters will have a certain degree of error due to the quality of the equipment, resulting in the convenience store coffee production being not very stable. Compared with exclusive brands with professional baristas, the taste quality of convenience store coffee is still a relatively obvious shortcoming.

New tea drinks: Coffee and tea drinks meet the diverse needs of consumers, and the probability of becoming the main product is low

The coffee products launched by tea brands such as Heytea and Nayuki are mostly combined with existing specialty teas. Taking Heytea as an example, the use of freshly ground coffee and superimposed tea elements such as pearls and cheese milk cap has lowered the threshold for drinking coffee, but its ability to attract high-frequency consumer groups such as boutique coffee lovers may be limited.

The main purpose of tea brands launching coffee categories is to supplement their existing product portfolios and meet the diverse needs of consumers. However, coffee may blur the brand's own positioning as a "new tea drink", and the probability of it becoming a main product is low, so its substitution effect is relatively small.

Self-service coffee machines: The scenarios and costs are not advantageous, and they are currently only used to supplement the business model

In terms of scenarios, self-service coffee machines mainly target instant coffee and are currently mainly distributed in semi-enclosed spaces with large traffic such as schools and office buildings. However, convenience stores in related areas are generally densely distributed, posing a strong competition.

In terms of cost, the self-service coffee machine brand is relatively small, and has weak bargaining power with upstream suppliers. Most of the machines are purchased by franchisees and are maintained on a daily basis. The main brand only earns the difference between the machine purchase and sale price and the system usage fee. Generally, self-service vending machines sell a wide variety of products, but they still rely on advertising and other services to barely make a profit. The coffee market is more niche, and the profit margin of self-service coffee machines is relatively small. The market share is limited, and it will still be a relatively small supplementary format.

2.4 Adapting to the digital background, actively transforming to the "online + offline" new retail model

The origin of retail is to meet the ever-changing needs of consumers, and the essence of new retail is to improve efficiency and experience. New retail uses big data and other technical means to upgrade and transform the production, circulation and sales process of goods, deeply integrate online services, offline experiences and modern logistics, and reconstruct the three basic elements of retail: 1) People: online and offline purchases are integrated, consumer behavior is online, and precision marketing is carried out based on in-depth user portraits; 2) Goods: warehouses are sunk, and the supply chain of goods and services is more efficient and transparent; 3) Place: break the limitations of time and space to achieve unlimited consumption scenarios.

China's highly developed mobile Internet ecosystem provides both necessary and sufficient conditions for the development of new retail. In 2018, China's mobile Internet users reached 817 million, and it is expected to reach 1.085 billion in 2023. On the other hand, China's instant logistics services have basically matured, and young consumer groups in first- and second-tier cities have developed the habit of using food delivery services frequently.

Focusing on the coffee industry, the online model has large traffic, and the offline store experience is strong. Online users tend to form more stable consumption habits, while offline consumers will consider distance and time costs. This problem is particularly prominent in the context of longer working hours and faster pace of life, which is also an important reason for the demand for takeout. Therefore, offline stores are naturally in a relatively weak position in terms of traffic. However, online marketing costs continue to grow, and high attention requires continuous investment. From a psychological perspective, the online-driven interaction model conforms to consumers' curiosity and herd mentality, and relies on a huge social ecosystem such as WeChat, which has strong penetration. However, offline stores can meet intuitive and emotional needs, which is conducive to forming customer stickiness.

Online and offline are interpenetrating, and traditional and Internet brands are jointly promoting the development of new retail coffee. For traditional brands, Starbucks launched the takeaway service "Star Delivery" in 2018; convenience store brands such as FamilyMart and 711 have also begun to cooperate with takeaway platforms. For Internet brands, Luckin Coffee has begun to open offline stores on a large scale. According to statistics, in 2018, the proportion of all orders from coffee shops completed through online ordering and takeaway delivery has exceeded 70%.

Therefore, with the background of consumption upgrading and the support of data and algorithms, new retail can eventually realize consumers' consumption demands of "more, faster, better and cheaper". As traditional stores actively transform into digital ones and Internet brands further sink offline, it is expected that the penetration rate of new retail in the coffee industry will continue to expand.

3 Luckin Coffee’s business review and space estimation: The sustainability of Internet-style development remains to be verified

3.1 Overview: Efficient use of traffic and rapid expansion through Internet-based development

Luckin Coffee was founded by Qian Zhiya, the former COO of UCAR Group, in October 2017. Initially, it only provided online ordering and delivery within 30 minutes. In May 2018, it officially started operating offline direct stores, which can be picked up in stores. In September of the same year, the number of stores reached 1,003, making it the second largest coffee chain brand after Starbucks. The current product range has also expanded from coffee to tea, fresh fruit and vegetable juice, light meals, lunch and snacks.

We fully utilized the dividends and tools of the rise of mobile Internet to expand brand influence. In terms of price marketing, we launched promotional activities such as "first cup free, buy two get one free". In terms of building brand concepts, we hired two literary and artistic stars, Tang Wei and Zhang Zhen, as spokespersons, and increased our brand awareness and reached the target consumer groups through the layout of elevator advertising, precise targeted advertising in WeChat Moments LBS, entering the Forbidden City, and becoming the only official designated coffee of the Beijing Film Festival.

3.2 Competition: Coffee consumption is still at a low level, and convenience stores pose a strong competition

Store restrictions make it difficult to provide coffee social scenes, and there is no obvious customer overlap with Starbucks. In terms of price, considering subsidies, the current price of a single cup of Luckin Coffee is about 9 yuan, which is more than 3 times the price of Starbucks' 28-40 yuan range. From the perspective of scene experience, Starbucks relies on store sales space and experience, and at the same time opens selected stores in first-tier cities. By upgrading stores, it attracts high-end and deep coffee users and strengthens the company's brand sense and grade. (Considering Starbucks' strong positioning, its ability to obtain prime locations and low rents is currently unmatched by even KFC and McDonald's), while Luckin stores are mainly user-pickup, focusing on convenient positioning, and have weak contributions to social attributes, and can only meet limited emotional and social needs.

The demand for coffee caused by extended working hours is easy to meet, and potential customers are more price sensitive. Luckin's potential customers are not heavy coffee lovers, but mainly students and working white-collar workers, who are more functional and refreshing consumers. They are more sensitive to prices, and this physiological need can be replaced by convenience store coffee and instant coffee with more price advantages. In addition, Luckin's cache stores are concentrated in crowded areas such as office buildings and business districts, which has the same location logic as convenience stores; the peak consumption hours are in the morning and afternoon; and they all use preferential activities to favor young users in terms of price. Therefore, convenience store coffee is Luckin's actual biggest competitor.

Convenience store coffee sales are growing rapidly, and brand upgrades are underway. Convenience store brands have seen a surge in coffee sales by effectively attracting customers through existing stores and launching promotional activities in combination with other products. After FamilyMart China launched "Paike Coffee" in 2014, sales doubled year after year, exceeding 40 million cups in 2018; Lawson's Shanghai store sales of freshly ground coffee have also grown at a rate of 20% or even higher per year. On the other hand, convenience store coffee has also begun to upgrade its original brand by hiring spokespersons, increasing delivery services, and opening independent coffee shops in order to attract consumers with higher consumption demands.

3.3 Operation: Opening stores drives business growth, but customer stickiness still needs to be cultivated

Store construction: As of Q1 2019, the company has 2,370 stores, all of which are owned and leased, located in 28 cities and 16 provinces, mainly in first- and second-tier cities, of which Guangdong, Shanghai, and Beijing account for as high as 44.94%. 91% of the stores are pick-up stores, and delivery stores account for only 4.14%. Delivery stores only carry out delivery business, so the rent and decoration costs are lower. They are usually used as the initial store form for the company to enter a new promotion city. After confirming the sustainability of subsequent demand, they will choose to close and open other types of stores. The company plans to become the number one coffee brand in China by the end of 2019, with more than 4,500 stores.

Operating data: As of Q1 2019, the company had 16.87 million transaction users, corresponding to an average of 4.4 million monthly transaction users, a 1.76% increase from Q4 2018, and an average of 1,628 products sold per month, a -7.76% decrease from Q4 2018. The decline in growth rate was mainly due to the fact that Q1 included the Spring Festival, so coffee, which is mainly for business travel, was in the off-season.

Comparing the quarter-on-quarter growth rates of operating indicators in the past few quarters, it can be seen that the unit price per cup and the number of cups consumed per capita are not strongly correlated with the existing business growth, and they were clearly stagnant in 2018Q4 and 2019Q1. It can be roughly judged that the current growth mainly comes from store expansion rather than the increase in consumption conversion rate, so it still takes some time to cultivate user habits by relying on large subsidies.

Customer acquisition cost and retention rate: In 2018, 91.3% of new customers completed their first order through the Luckin app, but the mini program port is also very convenient. In addition to the free product promotion fee, the customer acquisition cost also includes advertising fees and other sales expenses (but does not include subsidies, which account for the largest proportion, and subsidies are directly deducted from income), which has dropped from 103.5 yuan/person in 2018Q1 to 16.9 yuan/person. In terms of retention rate, the first month is generally the highest because of coupons, and the second month drops significantly, and there is also a significant decline during the Spring Festival.

The current retention rate is showing a downward trend month by month. In January 2018, the customer retention rate was between 30-35%, and it dropped to around 20% in December 2018. Luckin's layout density in first-tier cities is already high, and consumer habits have not changed significantly. The decreasing marginal benefits of the retention rate reflect that the current business model does not constitute sufficient stickiness.

3.4 Finance: Short- and medium-term losses will continue, but long-term revenue has room for growth

Revenue: The company's revenue is mainly divided into freshly made beverages, other products (beverages, light meals, etc.) and others (delivery fees). In 2019, freshly made beverage revenue accounted for 75.4% of total revenue. Except for free product promotions when acquiring new users, which are included in sales and marketing expenses, all other offers are deducted from revenue.

Revenue space estimation: 1) Store perspective: Based on the company's public store opening plan and Starbucks' strategy, Luckin's store count is expected to exceed 4,500 by the end of the year. Considering the accelerated expansion after listing, the company will not reduce promotions for the time being. Assuming that the average customer price will rebound from 2021, there will be 8 times the revenue space within 5 years. 2) Market share perspective: Luckin currently occupies about 1.48% of the coffee market share, so the market space of 7 billion will correspond to the market rate of 18 billion in 2023, which will increase to 3.89%.

There are irregular large single expenditures, but the overall marginal cost is decreasing: 1) The average store revenue has not increased significantly, mainly because the store opening speed is fast and the single store cultivation time is still short. 2) The cost of raw materials is basically consistent with the growth rate of revenue, but the inventory and logistics costs are irregular. 3) The rent and operating expenses are basically consistent with the growth rate of store opening, while the labor and operating expenses are improving marginally. 4) Depreciation expenses have further increased, which is inconsistent with the growth rate of store opening. It is speculated that it is related to the store structure. 5) Sales expenses are irregular, advertising expenses account for a high proportion, but are decreasing, and the growth rate of freight is basically proportional to sales.

From the perspective of a single cup, the current price of a single cup is 9.80 yuan: 1) Material cost is 5.65 yuan, accounting for 57.6%. Considering the current high discount rate (30% off, 50% off are both very high). If the subsequent discount is reduced and the unit price rises to 20 yuan, the material cost will be reduced to about 30%, which can be compared with Starbucks. 2) Rent and operating expenses are 5.78 yuan, accounting for 59%. We believe that if sales revenue increases by 10 times, the relevant costs are expected to be diluted to half of the original, and the cost ratio will drop to 29%. 3) Depreciation expenses are 1.72 yuan, accounting for 17.6%, which can be diluted to 9% of the cost ratio. Starbucks is 5%, and considering the product pricing, this difference is more reasonable. 4) Sales and marketing expenses are 3.44 yuan, accounting for 35.1%. Advertising expenses are not included in the budget and will be diluted continuously in the future; if free promotion is cancelled, the proportion of delivery fees will be relatively stable, and finally the proportion of sales expenses will be compressed to 20%. 5) Administrative expenses are RMB 3.54, accounting for 36.1%. During the same period, Starbucks was 7%. Assuming the management level keeps up, it can reach 10%.

Finally, the theoretical operating profit margin = 100%-30%-29%-9%-20%-10% = 2% . This level of profit margin is greatly affected by the fluctuations of internal and external factors. Before the store expansion stops, it is a relatively ideal limit level. In the later stage, it is not ruled out that there is room for further reduction in rent and sales expenses through model optimization.

After its establishment, Luckin raised funds very quickly to maintain its daily operations, and faced a greater risk of tight cash flow. Since its establishment in 2017, Luckin has raised a total of approximately US$740 million from the angel round to the B+ round before its listing. In addition, it has raised a total of 1.285 billion yuan through shareholder loans and mortgage loans. After nearly two years of expansion, as of the end of March 2019, the company had 1.159 billion yuan in cash and cash equivalents, but at the same time faced a total debt of 1.08 billion yuan. At a time when daily operating activities still cannot generate positive cash flow, the company's cash flow is tight after the existing cash assets have repaid the relevant debts.

Catering and retail are both capital-intensive industries. Rapid expansion requires capital investment, which will also lead to the shrinkage of controlling rights. However, whether or not a company has core control is the key to a stable long-term development direction. This is actually difficult to achieve. The feasibility of the same shares with different rights commonly used by technology companies for catering companies remains to be tested. From the perspective of Luckin's equity structure, the Shenzhou Group still has absolute control over the company, but the company's current strategic direction still requires a lot of funds. With the addition of new funding parties, there is also a certain degree of uncertainty in long-term development.

4. Risk Warning

4.1 Food safety risk issues

For traditional coffee making, there are fewer ingredients and auxiliary materials, and semi-automatic or fully automatic coffee machines are mostly used. The process is relatively simple, and the food itself has a small safety risk. However, there are still disputes about the effect of coffee drinking. For example, at the end of March 2018, Starbucks was affected by the "coffee causes cancer" storm. In the context of informatization, negative comments may be significantly amplified through public opinion. On the other hand, other drinks such as freshly squeezed juice and milk tea are also included in the sales range. Ingredients and auxiliary materials such as fruits and cheese have high requirements for freshness and other conditions, and the risk of food safety problems also increases. For example, Heytea has been exposed to problems such as drinking foreign objects and the degree of cleanliness of tableware not meeting the standards, which has had a negative impact on the brand. Luckin has not yet encountered related problems, but as its expansion accelerates, similar situations of negligence in management of a few stores may occur.

4.2 Price and supply risks of upstream coffee raw materials

Coffee beans are the second largest global commodity after crude oil. The world's top two coffee producers are Brazil and Vietnam, which together accounted for 50% of the world's total production in 2018. China ranked 14th, with a share of less than 2%. Domestic production capacity can only meet 52% of demand, and there is still a gap of 109,500 tons. Therefore, my country's coffee beans are highly dependent on imports. Coffee planting is greatly affected by geographical factors. When major producing countries suffer from climate disasters, the price of coffee beans will change significantly. At the same time, factors such as demand and policies also make prices subject to certain volatility risks, which will also bring uncertainty to the profitability of downstream retailers. Starbucks, the industry leader, also raised product prices in North America in 2011 and 2014 due to rising raw material prices. Cost pressure is common in the coffee industry. As for Luckin Coffee, which exchanges its own profit margin for customer retention, it is more sensitive to the price of upstream raw materials and should be more vigilant about related risks.

4.3 Changes in market patterns and disruptions in capital flows caused by rapid maturity

: : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : : In 2018, the operating cash flow was -1.311 billion yuan, and in Q1 2019 it was -628 million yuan, far exceeding the -124 million yuan in the same period last year. As the scale expands, Luckin's loss scale is also expanding simultaneously. This value may approach -3 billion yuan in 2019. It is expected that the funds raised in this round can only maintain operation within 2 years at most, and there may be subsequent financial pressure.

Source of the report: Shenwan Hongyuan; Analyst: Liu Lewen/Yu Jiaqi/Wang Yue)