This article first appeared in Jeffrey Towson’s blog. KrASIA reposted it here with modifications.

There is a lot of buzz around “new retail” coffee chain Luckin Coffee in China right now.

They are opening at a blistering rate – about 500 outlets since their launch earlier this year. That’s 2-3 new stores per day (including weekends).
They are focusing strongly on digital and delivery – a “new retail” version of retail coffee.
They are generating lots of press, especially by directly challenging Starbucks. They are also suing Starbucks regarding competitive behavior.
They are raising money rapidly. Their recent Series A round reportedly raised $200-300M at a +$1B price – making them China’s first coffee unicorn.

Altogether, the A team of China has finally turned its attention to retail coffee. They are executing fast and effectively. Make no mistake. This is a serious competitor playing to win.

Why Starbucks has no serious competitor in China before?

A couple of years ago, I started to ask this question. Every other company in China (foreign and domestic) fights ferociously against a sea of competitors, against rapidly changing consumer behavior and against a ton of investment capital.

Nike and Adidas fight Li-Ning and Anta. Apple fights Xiaomi (and many others). Wal-Mart fights tons of players. Uber fought Didi. Google fought Baidu. Ebay fought Alibaba. And so on. China is a tough market and tough competition is the norm.

Yet Starbucks has sort of been cruising along, opening stores and growing steadily. They have some smaller competitors like Costa Coffee and UBC coffee. And there are lots of tea places and take-out stands. Plus there is McCafe at McDonald’s.

But none are what I would consider serious China competitors. Starbucks is strangely unbloodied in China.

Plus, Starbucks has also been pretty open about its growth and profits in China. They are opening 500 stores per year (about 3,300 now). And these are apparently some of their most profitable stores. This sort of commentary is loved by Wall Street analysts but it breaks the number one rule of China business. If you are doing really well, keep it quiet.

But Starbuck’s almost unbridled China growth comes to a halt after the emergence of Luckin from late 2017.

Can Luckin Coffee take 20% of Starbuck’s current China business?

My answer is yes. They could. And I will give you my arguments below.

First, my take on retail coffee in China.

On my way to visit several Luckin outlets in Beijing, I passed lots of other coffee shops. I passed a Costa Coffee, a Bo Coffee and a Caffee Bene. And they all had nice seating areas, free wifi and lots of good coffee.

On the way, I also passed tons of tea kiosks and bubble tea places. And then there are the all the McCafes at all the McDonalds.

So while Starbucks doesn’t have a major competitor in China today, there are certainly lots of smaller companies. So what is Luckin doing differently? And will it make a difference?

If you read the Starbucks 10k’s, the phrase you will see is “high visibility and high traffic locations”. Getting these locations is a big part of their strategy. Yes, Starbucks is selling a product (coffee with lots of sugar and caffeine). But it is also selling an experience, a “third location” in your life to sit and relax and chat.

And the key to both the product and the experience is getting these “high traffic and high visibility” locations. People aren’t that loyal to retail coffee. They may like Starbucks (I go every day) but if a Costa is 2 blocks closer people tend to go there. If Starbucks is on the third floor of the mall and a Bene is on the ground floor, people tend to go there. Brand matters but having the convenient, high visibility and high traffic location is more important.

And these locations tend to be more expensive so the bigger player tends to outspend smaller rivals on real estate. Over time, this superior spending on locations draws more and more of the traffic. The bigger player tends to grind down the smaller players over time. Go to any big developed retail coffee market (New York, London, Hong Kong, etc.) and you’re going to see 2-3 major chains dominating – and not 10-15 smaller chains with equal market share.

So it is not surprising that smaller chains like Costa and Bene coffee don’t seem to be catching up with Starbucks in China. They tend to be on the third floor of the mall and not the ground floor entrance. They tend to be a little away from the walking street and not at the prime location. And their stores tend to be smaller. Starbucks, the dominant player, continues to pull away over time.

How is Luckin different?

I said Luckin’s strategy appears to be: digital + lower prices + tons of locations

I think that matters for two reasons.

First, their 20% lower price point could bring the Starbucks experience (coffee plus a third location in life) to a massive, still largely untapped China market.

Starbucks is expensive in China, approximately same prices as New York, despite being having 1/6th of the GDP per capita. They are an indulgence, a type of affordable luxury. That is a good strategy. But it also means you are waiting for most of the population to rise in wealth and to grow as a coffee drinking demographic (both in number of coffee drinkers and in cups per capita per year).

By offering a similar experience at a lower price point, Luckin could bring a luxury product downmarket. That approach really worked for Xiaomi vs. Apple for the iPhone (more on that below).

Second, digital may matter a lot in retail coffee.

Luckin appears to be betting that they can build a stronger hold on their customers through digital – and that they won’t have to go head-to-head with Starbucks in getting the best real estate. This is a fascinating question. Can software and connectivity trump “high visibility and high traffic” locations in the physical world?

So Luckin is focusing a lot on digital and is opening tons of locations for pickup, sit down and delivery. And they appear to me to be in office parks and 1-2 blocks off from the big shopping malls and walking streets. They don’t seem to be playing the Starbucks game of getting the best locations and opening the biggest outlets. I think they are betting they can use technology plus tons of locations to increase convenience, to capture customers, and to pull their customers to their locations – rather than relying on high traffic and high visibility real estate.

Both of these, if they work, are powerful moves. They could work.

Assuming I have their approach right (just my impression. I could be wrong), I think there are some other things they could do to accelerate growth.

Copy Xiaomi: Be a cool company with a lower cost version of a luxury brand.

The iPhone is a luxury brand in China. It is expensive for almost everyone. And it stays above the ongoing smartphone wars of Vivo, Oppo, Huawei and such.

Xiaomi entered with a product that was similar to Apple, but at a lower price and with some very cool marketing. They soared rapidly by bringing a lower cost version of a luxury product to a much bigger market.

As mentioned, Luckin could do the same. They could offer the Starbucks product plus experience at a lower price. And could access a much bigger market. This however would require that they have a lower cost structure. Xiaomi was able to do this with low-cost Chinese manufacturing. Luckin would likely have to find a way to drop the real estate and marketing costs (as discussed).

The other thing Xiaomi did was to be very innovative and cool in their marketing. They had flash sales. They generated buzz. They were just seen as cool. And Chinese consumers do tend to jump after the cool new thing. Luckin appears to be doing the same. They are generating a lot of buzzes. Everyone knows about them. They could get a lot of customers very quickly.

Copy Alibaba: Build and franchise a “new retail” ecosystem for coffee.

Alibaba is currently digitizing and re-imagining supermarkets. The Hema supermarkets are their flagship for this. They are also doing the same for RT-Mart.

However, Alibaba is ultimately not going to be running a bunch of supermarkets. They are developing digital tools that will eventually be rolled out to lots of other grocery stores. They are a data technology company, not an operator.

Luckin could do the same. Once they have perfected their “new retail” model for coffee, they could open up their services and tools to other coffee outlets. That would make them an ecosystem – as opposed to just an online retailer with physical sites. That would let them scale dramatically faster. JD basically did the same thing. They began as an online retailer and then later added a marketplace and ecosystem (about 50% of their GMV now).

This may or may not make sense. It depends on the question of whether there are enough aspects of retail coffee that you can improve with digital tools. Supermarkets have complicated operations and supply chains. Plus you tie in the logistics and delivery. It may be that “new retail” coffee outlets can’t really do that much more than traditional retail coffee outlets.

Partner with Alibaba or JD/Tencent: Be the retail coffee part of their ecosystem.

The digital giants of China are fighting to build out the infrastructure of new retail. They are rapidly moving into supermarkets, department stores, convenience stores and mom-and-pop shops. And they are competing ferociously.

Luckin could just partner with one of them (or both?) and be their infrastructure for retail coffee. That could be a game changer for Luckin. Suddenly they would be getting tons of traffic online (hello Wechat) that they could drive to their rapidly increasing number of outlets.

And would Starbucks ever sell 20-40% of their China business to Alibaba or Tencent / JD?

However, this isn’t really necessary. As their CEO Qian Zhiya has said, coffee consumption per capita in China is about 4-5 cups per year. While it is 750 in Europe. And about 400 in the USA. So the big opportunity is increased consumption. They don’t need to beat Starbucks to win big in China. They just need more people to drink coffee.

Which brings us back to the three most important things I think Luckin is doing:

1. Cost innovation: They are dropping the price from 35RMB to 25RMB for a typical drink.

Cost innovation is really a powerful approach for China. You take a product or service that is affordable to a small part of the population and make it available to a lot more. Xiaomi did this with the iPhone and quickly became the top smartphone maker in China (for a while). China Mobile did this with a lower price mobile service and increased their user base by over a hundred million people in about a year.

Starbucks is selling a luxury product, a comfortable location and an experience (going to get a coffee with friends). It is not just the product. It is the experience.

Luckin is dropping the price of this product plus experience and bringing it to a much larger population. Keep in mind, 35 RMB for a latte is very expensive for most of China. These are basically the same prices as in New York and London but China has a GDP per capita 1/6th that of the USA.

Luckin is offering a much lower price point – and this could open up the market dramatically.

2. They are opening lots of stores, pushing digital and making it really convenient.

By opening a lot of outlets and selling to customers through their smartphones, they are making it really convenient to order, pick-up and delivery. Low price plus increased convenience is a great strategy for consumer China.

You see this strategy in a lot in digital China. JD and Amazon make it simple to order, pay and get your product. And of course, you can do it all from your phone. Mobike really pushed convenience by literally putting millions of bikes on the streets. Luckin putting in +500 stores similarly will increase convenience. There is always one near you.

3. Price effect: They are using capital to acquire customers.

One of the first things you see in the Luckin app, outlets and advertisements are offers to buy two and get one free. Or to buy five and get five free. And as people don’t normally drink two cups of coffee, this is about getting customers to bring in other customers (and get a group discount). I’m assuming they using a lot of their raised capital for this (and to open outlets).

It’s a typical digital play. Pinduoduo gives customers discounts based on getting friends to buy along with you. Paypal famously signed up people by offering them $50(?) free in their new accounts.

For retail coffee, there are probably a couple of benefits to this.

You get more customers drinking coffee. Many for the first time?
You get them used to caffeine and sugar, which are addictive (think coffee, Coca-Cola, Red Bull, etc.)
Maybe you get them into a daily habit of going to get a cup (habit formation is a big deal).
Everyone signs up and buys via the app so you build in customer stickiness via software.

Overall, you are going for what Warren Buffett calls a “share of the consumer mind”. You want your product or service to become integrated into people’s daily lives.

A couple of final points:

Retail coffee is not a winner-take-all business. You aren’t going to see only 1-2 winners like you do in ride-sharing, search and social media. We could easily have 5-10 big retail coffee chains across China. The biggest problem these companies have is not fighting each other. It is opening lots of stores and increasing coffee consumption by Chinese consumers.

What Luckin really needs is a way to open 3,000-4,000 stores quickly and get lots of consumer attention. And they seem to be doing the right stuff in this regard.

They are generating lots of press. They seem to be particularly good at this.
They are opening tons of outlets quickly. They seem shockingly good at this.
They have picked a fight with a big famous (and foreign) company. That is a great way to get noticed. The lawsuit also probably helps in this regard.
They are raising lots of money and focusing on consumer usage. They are not behaving like a traditional business that is planning on growing based on positive cash flow. They are operating more like an internet company funded by venture capitalists. They are raising rounds and going for scale, traffic and market share. The profits will come later.

I think this will work in the short-term. Chinese consumers will try them out. They are fickle and love new stuff. What will happen in the longer-term is less clear.

Maybe they will get lots of adoption, build a national chain and end up with a stable, profitable business?
Maybe they will get acquired by a bigger company? Perhaps as part of a “new retail” strategy?
Maybe they will inspire lots of copycats and we will see a wave of competitors?
Maybe the hype will fade over time and Chinese consumers will move on to the next cool thing?

Who knows? Consumer China is immensely profitable. But it’s also pretty unpredictable. We shall see. In the meantime, I’m going to take advantage of investor subsidized coffee.

This article was written by Jeff Towson, a private equity investor, Peking University professor, best-selling author and speaker. His writing and speaking are on Chinese consumers and digital China.

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