Luckin Coffee IPO: Here We Go Again

Benjamin Graham argued that a long-term investor will almost never participate in an initial public offering (IPO) because the animal spirits that are triggered by the IPO will almost never coincide with sensible pricing. Warren Buffett elaborated on this concept by saying that, if there are over ten thousand publicly traded companies in the world, the odds that the best deal out of any of them is the company going public is extremely slim. I think he went even further and said that he has never before invested in an initial public offering on behalf of Berkshire Hathaway.

I have been close attention to Luckin Coffee, the Chinese-based coffee startup that is opening up about 100 new stores across China per month. It is anticipated that it could become the most significant rival to Starbucks because it is rapidly expanding in a country with 1.3 billion people it is currently charging McDonalds-style pricing to establish a customer base.

As far as new business opportunities, Luckin is one of the more intriguing companies to go public in the past decade. It is much smaller, currently earning approximately $125 million in revenue while losing $243 million per year, and much of the growth is yet to come. In that respect, it is the opposite of what Uber did, allowing insider investors to get rich over the past decade, only to have a May 2018 public offering that contained the hypo without the growth possibilities.

Much has been talked about on Friday when Luckin’s IPO took the price of the stock from $17 to $25 per share. This value the fast store-opening coffee company at $5.5 billion.

Typically, coffee companies make 20% net on revenues when they are mature. Optimistically, let’s assume that is operating on an Amazon-type model and will be able to reverse those $243 million losses accordingly. Assuming that Luckin could earn 20% net on its $125 million in revenues, we are looking at present earnings power of approximately $25 million.

The current valuation of the stock at $5.5 billion is 220x earnings. For what it’s worth, Starbucks had its IPO in 1992 at $17 per share (that is why, I suspect, Luckin set its IPO price at $17 per share, to evoke memories of the Starbucks IPO for long-in-the-tooth investors who wish they could have bought Starbucks but missed it and now have the opportunity to seize what was once neglected).

When Starbucks had its IPO, it traded at 53x earnings. It delivered 19.75% returns since that date. If Starbucks were to have traded at 220x earnings, or about 4x its IPO price, the returns would be 12.8% through the present day. Still darn good, and even superior to the S&P 500 index by almost four percentage points annually, but it came with two caveats.

First, if Starbucks were to have traded at 220x earnings in 1992, it would not have been until 2001 when it would have “burned off the overvaluation” and traded at its hypothetical IPO price. Put plainly, it took Starbucks around 9 years to quadruple in value, and if it traded at quadruple its actual IPO price at the same valuation as the present day Luckin, there would have been almost a decade of 20% earnings growth but no stock price appreciation. Very few people can deal with that.

The second caveat is that Starbucks’ stock fell to $4 per share in 2009. If Starbucks were valued like Luckin at the time of its IPO in 1992, it would have only compounded at 4.9% during the 1992-March 2009 time period. Overvaluation does not age well when exposed to adversity.

You have to adjust for the fact that China gets its caffeine from tea culturally and it would be overly generous to expect that the Chinese would ever consume coffee at rates seen in the United States and parts of Europe. I don’t think you can look at China’s market as 1.3 billion possible coffee drinkers. Figuring out the expected market size will be a major component of valuing the stock.

I expect that potential Luckin investors will get an opportunity to buy this stock in the $10-$13 range within the next three years, or alternatively, in the $20s range sometime between five and ten years out. It would be a far more intriguing speculation at such a price point.

Even in its fast-growth days of the 1990s, Starbucks stock rarely traded for more than 7x revenue. With a valuation of $5.5 billion and revenues of $125 million, we are looking at 44x revenue. In that respect, Luckin is 7x more expensive than Starbucks’ stock during its heady growth days.

Coffee has been responsible for making obscene shareholder wealth over the past thirty years. Pretty much any caffeine product has made for a lucrative investment, except for mall-based Teavana which Starbucks bought and neglected because it didn’t know what to do with it. As far as speculative excess that comes across my desk each day, Luckin is more interesting than most because it is in an industry that produces shareholder wealth and, if you revist this article a week from now, Luckin will have opened several more stores.

Some excess valuation is to be expected. But $5.5 billion for a company with $125 million in revenues and -$243 million in profits would require absolutely everything to go right in order to generate double-digit returns. You do not want to walk into situations where an ordinary recession or modest cultural shift leads to 70% losses. I don’t think Luckin becomes a candidate for the enterprise investor unless it falls to the $10 or so range in the short term or trades in the $20s five to ten years from now while maintaining revenue growth north of 20%.

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