Luckin Coffee is just the tip of Starbucks’ China woes

Shuli Ren, Bloomberg

As Starbucks Corp.’s new Chief Executive Officer Brian Niccol engineers a business turnaround, what to do with its operations in China must be on the top of his mind. The American coffee chain is exploring strategic options, including a possible stake sale.

China is becoming a drag. The country accounts for less than 10% of revenue, even though nearly 20% of its outlets are located there. In the September quarter, same-store sales tumbled 14% from a year earlier, even worse than the 6% decline in the US.

Much media focus has been on home-grown brand Luckin Coffee Inc., which has staged an amazing comeback after being delisted from the Nasdaq for accounting fraud in 2020. Luckin’s 9.90 yuan ($1.40) coffee is taking away business from Starbucks’ basic drinks, just when the Chinese economy is weak and consumers are wary of spending.

But for Starbucks, Luckin is only the tip of the iceberg. The Chinese brand itself is drawn into a relentless price war with arch-rival Cotti Coffee. Serendipitously, Cotti was set up by Luckin’s disgraced founders who were exiled after being embroiled in the accounting scandal. Mirroring Luckin’s approach, the two-year-old startup is expanding rapidly, luring young coffee lovers with cheap brew. It already has 10,000 stores, more than Starbucks’ 7,600.

Indeed, Luckin’s financials are suffering, too. Same-store sales have been declining this year. Meanwhile, Cotti’s management is showing no sign of slowing down. The company plans to operate 50,000 stores by 2025. In other words, the price war will continue.

For a big market still new to drinking coffee, penetration is key in China. The reason why Cotti — and to a lesser extent Luckin — can grow so quickly is that they rely heavily on the franchise model. Young people who don’t want to brave the dismal job market are happy to set up Cotti Express, often bare-bone storefronts in shopping malls and subways, because the break-even point is so much lower. By comparison, Starbucks operates its own outlets, which slows down the speed of its store openings.

In recent months, Starbucks has been following in the footsteps of other global brands and venturing into smaller cities, where retail sales are more resilient and the penetration rate lower. But the verdict is still out on whether this strategy will pan out — in small towns, Starbucks’ novelty can wear off quickly.

Meanwhile, Starbucks’ most lucrative offerings — Frappuccino and cold, sugary refreshers that American teenagers love — are hitting the wall in China. The country’s milk-tea chains can easily satisfy sugar cravings. Big names such as Chabaidao and Chagee are rolling out new concoctions weekly, offering exotic fruit and herbal tea blends with whipped cream on top.

Seen in this light, allowing in a local, more entrepreneurial partner is essential for Starbucks’ survival in the world’s second-largest economy. Besides, historically, capital markets have rewarded restaurant chains that are willing to spin off or sell non-core businesses. This is because for brands, franchising is more profitable, and a stake sale allows the company room for larger share buybacks.

Niccol plans to visit China in early December to better understand what’s happening there. If he ends up selling the business, it’s not a retreat. Starbucks, founded in the 1970s, needs to foster and monetize its brand rather than laboriously opening one physical store after another.

Courtesy Bloomberg/Shuli Ren