The Motley Fool

Why Starbucks and Luckin Coffee Can Both Win in China

China’s two biggest coffee chains aren’t the cutthroat competitors the market assumes.

Much ado has been made of Luckin Coffee‘s(NASDAQ:LK) incursion into China.

The Middle Kingdom has long been Starbucks’ (NASDAQ:SBUX) turf as the java giant essentially introduced the cafe culture to China, starting with its first store there 21 years ago. However, Luckin has blanketed China since it opened its first location a little more than two years ago, and as of the end of 2019 it had 4,500 stores, slightly more than Starbucks at 4,300. With its rapid expansion, Luckin’s sales have been booming as well, up 558% in its third quarter. After a successful IPO last May, Luckin’s market cap ran up as high as $13 billion before fears about the coronavirus pushed it lower. Still, the company is the most valuable publicly traded coffee chain after Starbucks, even ahead of Dunkin’.

Though Luckin appears to be a unique threat to Starbucks, investors shouldn’t overreact here. Here’s why both companies can win in the world’s second-biggest economy.

Apples and oranges

China is a huge market with over a billion people, and there’s room for more than one kind of coffee chain. Luckin seems to understand this as its business model is much different from Starbucks. Rather than focusing on the cafe experience and being a “third place” as Starbucks does, Luckin’s business is built around pick-up and delivery. Most of its stores have limited seating and do not accept cash, requiring payment through an app. Starbucks, by contrast, has built its business as an upscale brand that offers a desirable and comfortable location for dates, business meetings, meet-ups with friends, and other kinds of gatherings.

Rather than functioning as a Starbucks copycat, Luckin Coffee is more like a 7-11, according to local reports. While its prices tend to be half that of Starbucks, Luckin’s quality in both food and beverages is believed to be worse. It’s a no-frills chain, while Starbucks is offering a high-end experience.

Asked about new competition in China, CEO Kevin Johnson said on the recent earnings call, “If you look throughout history there is a consistent pattern. In most all cases our competitors shift to focusing more on the value play and you see that time and time again. And I think we continue to see that trend. So the lesson for us is continue to amplify those unique differentiators that make us Starbucks.” In the case of Luckin, there is a clear gap in its value proposition from Starbucks, as Johnson understands.

Starbucks has expanded its own pickup and delivery options in China and partnered with Alibaba in order to capture some of the demand for those conveniences, but in general, Starbucks and Luckin are much different brands, targeting different kinds of customers.

There’s plenty of opportunity for Starbucks and Luckin

In Luckin’s own prospectus last year ahead of its IPO, the company argued that the coffee market in China had enormous potential, saying, “China’s rising urbanization and disposable income have been and are expected to continue to be the main growth engines of its coffee industry, and more and more people in China have begun to consume more coffee in their daily lives.”

However, compared to the other East Asian countries, per-capita coffee consumption in China is minuscule. In 2018, the average Chinese person drank just 6.2 cups per year. That compares to 209.4 in Taiwan, 249.5 in Hong Kong, and 279 in Japan. If the traditionally tea-drinking country goes the way of some of its neighbors, coffee demand could grow by 30 times or more.

Luckin believes that as China becomes more urbanized and disposable income grows, so will coffee consumption. By comparison, coffee drinking tripled in Japan between 1963 and 1970 during a similar period of urbanization, while Taiwan and Hong Kong also experienced coffee booms in the 1980s and 1990s.

In other words, a rising tide lifts all boats. If coffee-drinking goes mainstream in China, it will lead to more business for both Starbucks and Luckin, and both companies together can drive that market expansion. To the extent that Luckin introduces coffee to Chinese people who have never had it and expands the market for it, its presence could even help Starbucks.

The coronavirus factor

For now, investors may want to be cautious with these stocks and Chinese stocks  more broadly as the coronavirus outbreak continues to expand. The World Health Organization has declared it a global emergency; Wuhan, the city where the disease originated, remains on lockdown, and some airlines have canceled their flights to China.

Both companies have closed stores in China due to the outbreak. Starbucks stock slipped earlier this week despite a strong earnings report as the company said more than half of its stores in China were closed and that the closures would have a material effect on results for the year. Luckin Coffee shares have lost nearly half their value since their peak on Jan. 17 over coronavirus fears, but a short seller report out on Jan. 31 has also hastened the stock’s decline.

Still, over the long run it seems like a mistake for investors to view these two companies as pure competitors. Starbucks has continued to deliver positive comparable sales growth in China since Luckin’s launch, showing that it can grow even during Luckin’s whirlwind expansion.

Both companies offer different experiences and cater to different ends of the Chinese market. They also have the ability to expand the greater Chinese coffee market, creating a mutual benefit. This isn’t a zero-sum game. Starbucks and Luckin can both be winners here.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.