Coffee Wars: How the arrival of Cotti has sparked a price war
Luckin vs Starbucks vs Cotti Coffee vs Lucky Cup
Things that caught our attention
Dada Nexus, consisting of delivery platform Dada Express and instant retail marketplace JD Daojia, has shown its first-ever profit on a non-GAAP basis in Q2 2023. (source) We wrote about the company in Need for Speed: Instant Retail last month.
SHEIN acquired 1/3 of the equity of SPARC Group, the mother company of Forever 21. The two fast-fashion players will use each other’s on and offline channels in the future. (source)
Alibaba's Hema (Freshippo) is opening a new format in September: Hema 'Black Label Store' Premier. Products sold are said to be "premium but not expensive" (source). We wrote about Freshippo in Redefining Fresh: Alibaba's Freshippo and the New Frontier in Grocery Business, and Ed wrote about the many Hema formats on ChinaTalk.nl.
As Douyin did with Taobao a few years ago, TikTok is starting to ban links to external webshops while it tries to build GMV for TikTok Shops. (source)
The GTV of Meituan’s in-store group-buying business in the second quarter exceeded 150 billion, a year-on-year growth rate of 120%. The GTV of Douyin’s local services in the same quarter was 66-67 billion, missing the 70 billion goal (source). We wrote about the local services battle between the two in Food Fight! Douyin’s local services business
PDD Holdings, reported 66% increase in revenue to RMB 52.3 billion ($7.21 billion) for Q2 2023, better than Alibaba's (12%) and JD's (4.85%) (source). According to our estimations, Temu saw about $2 billion in GMV in the same quarter. Temu has launched in Southeast Asia (Philippines) and the Middle East (Israel) in the past few days. It is now operating in 39 countries, one year after its launch. Read our full deep-dive on Temu: Temu: from $0 to $3 billion in 10 months.
Chinese baijiu producer Moutai and Luckin Coffee will jointly launch a latte product on Sept. 4, priced at about CNY20 ($2.74). The drink will be available for a limited time. (source) Not a baijiu fan? Maybe the ‘dopamine coffee’ we discuss in this newsletter is more your cup of … coffee.
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Introduction
This week, we are taking a deep dive into China’s coffee market, which has been seeing drastic changes ever since Luckin Coffee entered the scene in 2017. We unravel how Luckin’s fraud scandal eventually led to the rise of a new competitor, Cotti Coffee. We will explore Cotti’s franchise model and compare it with other market players. Next, we will descend into the ‘sinking market’ where Lucky Cup, a chain originating in Henan, gets involved in the battle for the consumers in lower-tier cities.
No story about coffee would be complete without Starbucks. We elaborate on the battle between the American chain and Luckin and how the latter has changed the strategies of Starbucks over the past five years. Finally, we zoom out and look at the coffee market as a whole and some of the newer specialty coffee chains that try to survive among the ‘big boys’.
We hope you enjoy this extensive deep dive.
The Luckin scandal
Luckin Coffee launched in 2017. What made the company unique, as well as interesting for tech watchers, was its online-to-offline integration. Instead of lining up at a Starbucks, coffee consumers could order in the Luckin app and pick up their coffee or have it delivered. As a matter of fact, you could only order and pay in the app. This made Luckin one of the frontrunners of a model that has become a standard in catering in China. It also allowed the company to have a complete picture of who their customers were, and use internet growth strategies by pushing promotions to them through the app and WeChat official accounts and mini-programs.
When Luckin launched, it used an aggressive strategy of discount coupons that lowered the average price of a cup to RMB 10, while Starbucks charged around RMB 30. As a result, Luckin quickly became popular and the pre-purchased coupons ensured that customers would return. At least until they ran out of coupons and had to make a new purchase decision.
As most of you will know, Luckin had its IPO in 2019, just 19 months after being founded, but would delist even faster in 2020 after a disgracing fraud scandal. Luckin was exposed to have made up RMB 2.2 billion ($310 million) worth of sales, a claim to which Luckin admitted in April 2020. It had sold vouchers worth tens of thousands of cups to companies that had ties to founder Lu Zhengyao (Charles Lu). A month before its IPO, a group of Luckin employees also engineered fake transactions by purchasing numerous vouchers. All this gave the company a much higher revenue than the actual stores generated. [1]
On the costs side, Luckin Coffee also made more than RMB 1 billion in payments by a fictitious procurement employee to newly set up suppliers. Like with the companies that bought large amounts of vouchers, many of these suppliers turned out to have links to Luckin, Lu Zhengyao’s friends and family or two of Lu’s earlier ventures, auto-rental firm CAR Inc. and a Chinese ride-hailing firm called Ucar Inc. Money circulated in and out of the company through this network, inflating sales and expenses. [1]
At the time, Lu Zhengyao said: “My style may have been too aggressive and the company may have grown too fast, which has led to many problems. But I by no means set out to deceive investors.” [1] But Luckin’s fraud case has damaged already frail trust in investments in Chinese companies and resulted in new calls for U.S. audits of Chinese companies listed on US stock exchanges.
Luckin settled fraud charges with a $180 million penalty fine and as part of its ‘rehabilitation’ process, Lu Zhengyao, CEO Jenny Qian, COO Liu Jian and six others were ousted, as we described last year in Luckin's Revival. So what do you do as an ousted founder?
Luckin Relax store in Beijing.
If at first, you don’t succeed…
After being kicked off the board of Luckin Coffee, Lu Zhengyao first started an unsuccessful noodle chain (Qu Xiaomian 趣小面). It failed because it could not secure capital (we wonder why).
Lu’s next venture was the ‘ready-to-cook’ food brand Shejian Yingxiong (舌尖英雄), which he started with some of his loyal team members from previous ventures, including Luckin. During the pandemic, young people could not go out to eat and realised they lacked cooking skills. The idea was that Shejian Yingxiong would help them with ready-to-cook products.
Lu’s new venture was founded in the second half of 2021 and signed up 6,000 franchisees in early 2022. It wanted to open 3,000 stores in 5 months but despite RMB 2.1 billion in funding it proved another failure because of the pandemic. At its peak, there were 300 stores and the project was shelved because of lack of scaling effects. Franchisees started complaining they couldn’t make money, and stores started closing one after another. [2/3] Currently, there are only 100 stores left and the concept is not developed anymore.
After two failed projects, Lu decided to return to more familiar territory. Early September 2022, he announced he was back in the coffee market with former Luckin Coffee CEO Qian Zhiyaa (Jenny Qian) and a new brand called Cotti Coffee (库迪咖啡 Kudi Kafei). On October 22nd 2022, the first store opened in Fuzhou, quickly followed by WeChat mini-programs. It offered 40 products, mainly coffee, tea, smoothies, etc., priced between RMB 18 and RMB 32. For example, an American coffee was RMB 25 and a latte was RMB 30. It offered RMB 9.9 coffee as a trial promotion. Cotti said it would also offered light snacks, meals during lunch and even alcohol in the evening. [4]
Part of Cotti’s brand launch brochure. [2]
The Cotti model
Lu Zhengyao’s common strategy is to have a fast start and quickly occupy and dominate the market before opponents can react. Because of difficulties in raising funding like Lu and Qian did for Luckin, Cotti has no finances to open a large number of self-operated stores. The founders chose a different business model this time: a form of franchising. A franchise model works well in this strategy because a franchisee can rely on local contacts and resources. By empowering the franchisee and supporting them with brand marketing and product supply, volume can be increased quickly and the brand can be exposed to many consumers.
Because of the pandemic, many people were unemployed or about to lose their jobs and looking for new opportunities. If they had connections and some capital, they could join a franchise model. Lu and his team also tried the franchise model with ready-to-cook meals of Shejian Yingxiong, with franchisees being regional agents. When this failed, they tried again with coffee, but in a different way.
Cotti provides ‘branding, product, supply chain and operation services’ to franchisees (affiliates) that open stores. In other words, Cotti doesn’t have to make the same high investments as its competitors that run self-operated stores. [4] As we’ve written in Luckin's Revival, Luckin has also been using a franchising strategy to grow in lower-tier cities, and more than 30% of its stores are now franchisees.
Cotti’s franchising model is labelled ‘profit-sharing joint operation’. It does not charge brand usage fees or franchise fees in the early stage. The franchisee finds a store and renovates it, requiring an investment for as little as RMB 138,000, according to Cotti. When the store is ready, Cotti sends a store manager, barista, etc., responsible for the daily operation. The affiliate does not need to worry about operations and procurement. [5]
The ‘joint operation’ franchise model of Cotti is similar to that of Luckin. Under a pure franchise model, franchisees can decide if they participate in promotions and have certain autonomy over pricing. With Cotti and Luckin, stores have to follow the company's policies and there are high requirements for operational and management capabilities.
Except for decoration, equipment, raw materials and other expenses, Cotti Coffee does not charge franchisees a fixed fee. Cotti adopts a direct management model: the store manager is trained and stationed by Cotti, and the salaries of employees and store managers are uniformly set by Cotti. Franchisees do not participate in operational decision-making; they just supervise. Before March, franchisees could choose between an affiliate-operated or direct-managed model, but after bad experiences with chaotic management, Cotti cancelled the affiliate-operated option. [6]
Cotti also had some self-operated stores. Of the 3,000 stores that had opened in May, the proportion of self-operated stores is less than 10%, with 5 or 6 per city. No additional self-operated stores will be opened in those cities. All other stores are franchisees. Cotti plans to convert all the self-operated stores into franchisees as well. On the one hand, Cotti does not want to invest resources in the management of staff at self-operated stores. On the other hand, in the future, Cotti wants to be listed as a supply chain company, not a catering company. It has adopted a similar model to Mixue Bingcheng 蜜雪冰城 (more on this later) in terms of supply chain. Its goal is to reduce the price of raw materials through extreme cost control, and to make profits through the supply chain, selling raw materials to its franchisees.
Each affiliate store has a cash flow bank account. Each month the difference in balance at the start and end of the month are determined, and the withdrawals by the store (RMB 30,000 per month on average) are added to calculate the store’s revenue. Rent, raw materials and labour are deducted and according to Cotti, 84% of stores see a positive cash flow. [7] But this does not take into account the affiliate's investments…
On a side note, Luckin Coffee also launched a ‘franchising with stores’ model in May 2023. It is based on the joint venture cooperation model, and it is a new mode launched for investors who are operating stores or stores with their own property rights during the lease contract period. Shops must be located in shopping malls, shopping streets, office buildings, universities, hospitals, transportation hubs, and scenic spots. [8]
Cotti Coffee store in Xi’an, July 2023.
The application process
Cotti’s franchisees first commit to paying an intent deposit of RMB 5,000 and upload pictures and videos of the suggested location. The primary criterion for location selection is the traffic flow. For instance, Cotti expects an office building shop to have a traffic flow of more than 1,500 or 2,000 people. For university stores, it requires 8,000 to 10,000 people. If a franchisee's application does not meet these standards the application will not pass.
Cotti also asks if the location attracts the main target group and how many people pass the exact store location. Aspiring franchisees must shoot at least two videos of the floor traffic passing the store’s door. Sometimes a Baidu Heat Map of the crowd density is also requested.
Another criterion is the presence or lack of, competitors’ stores (Starbucks, Luckin, milk tea shops) around the store location and the sales data of those stores. Especially when there is a Luckin store, franchisees should provide the number of daily cups sold. For milk tea shops, they need to provide 1-2 months of operating income data (e.g. RMB 150,000 - 200,000 for a Mixue Bingcheng or Coco Milk Tea).
Cotti seems to be closely following Luckin in its store location selection. But the number of remaining good locations might be limited, so Cotti might have to spend more on rent or settle for third-rate locations. Our own observations confirm this. Of the six Cotti locations we’ve seen in first- and new first-tier cities, three were relatively hidden in basements, dead-end streets and other spots with bad visibility.
A tucked-away Cotti Coffee.
If an application does not pass, the franchisee must resubmit it with additional information. After the location is approved by Cotti, the franchisee pays another RMB 295,000, which is the cost of opening a standard store. It includes a RMB 50,000 deposit (refunded when the store stops its operation), RMB 165,000 for equipment and RMB 57,000 for counters and bars. Decorations and rent come on top of these costs.
Initially, franchisees could arrange decoration by themselves and hire a third-party team, but Cotti found that this often resulted in substandard work with many irregularities. Even connecting water and electricity could come with quality issues. Therefore, from April onward, franchisees must use one of several decoration companies designated by Cotti. Decoration costs are RMB 1,500 per square metre.
Required investments per store type in RMB. Source: cotticoffee.com August 2023.
Because the barriers of entry are lower than with Luckin, Cotti attracts many young entrepreneurs. There are three types of people that tend to join Cotti as a franchisee: [7]
Former Luckin franchisees who made money with Luckin but moved to Cotti because of tightening franchise policies at Luckin.
Investors with no prior experience who want to try something but don’t know how.
People that are somewhere in between these two extremes.
Some franchisees have also switched from Lu’s previous project, Shejian Yingxiong, to Cotti.
Luckin doesn’t allow franchisees to open a store within 1 km of an existing store. It has experienced how two stores that were 1 km apart and sold 500 cups a day dropped to 400 when a new store was opened in between. That new store sold 300 cups a day. But a store in the suburbs might be able to sell 600 cups.
Still, many Luckin franchisees also opened a Cotti store because they were worried that others might open a Cotti store in the same business district. Since they can’t open in their own name, they will ask friends to do so and start a partnership. An estimated 10-20% of Cotti franchisees also run a Luckin business.
The costs of joining Cotti as a franchisee are much lower than Luckin's, ranging from RMB 160,000 to RMB 300,000, depending on the size of the store. Joining Luckin as a franchisee used to require an investment of at least RMB 700,000 and an area of 70 square metres. [9] More recently it has downgraded these required investments, but they are still higher than Cotti’s.
While Luckin has lowered its franchise thresholds from 70 to 40 square metres, decoration costs that franchisees need to pay have increased significantly. The overall costs of opening a store are relatively high: RMB 250,000 - 350,000, including a one-year deposit. Equipment costs are RMB 220,000, and signage and decoration are both RMB 30,000. The company’s total costs are about RMB 480,000, excluding rent and transfer fees.
According to Cotti’s brand manual, it will launch two store types:
Standard stores with an area of 80-200 square metres
Mini stores (for pick-up) with an area of less than 50 square metres
At the end of 2022 and early 2023, Cotti allowed some franchisees to open a few shop-in-shop stores and mini-stores, but now that it has sufficient franchisees it does not allow those models anymore.
A shop-in-shop Cotti Coffee in Xi’an, July 2023.
Explosion of stores
At its launch, Cotti said it hoped to open 2,500 stores by the end of 2023, 6,000 by 2024, and 10,000 by the end of 2025. On December 11th 2022, it had 50 stores, and 1,000 franchisees had paid the intention fee. [10]
Cotti considered the fast growth targets feasible because coffee consumption in China still grows steadily. In 2018 the average per capita consumption in China was 6 cups, one of which was freshly ground. In 2022 it had increased to 9 cups, 6 of which were freshly ground. Considering how annual per capita consumption in Germany is 800 cups, South Korea 400 cups and Taiwan and Japan each 300 cups, there is still a lot of potential in the new market. [5]
By early April, a little over five months after opening its first store, Cotti said it had 1,000 stores, a milestone that had taken Luckin 8 months. But only about 600 of these stores had actually opened. Cotti had some 1,300 stores in the pipeline that had signed franchising agreements and were being renovated. [6] The main thing slowing down openings is that stores must obtain local hygienic food licences. The specific processing cycle depends on local policies, and the approval time varies in different regions.
If Cotti is to be believed - and you never know with these founders - it had 2,500 stores in 7 months and 4,000 by the end of June. On August 4th, nine months after Cotti’s launch, it claimed to have opened 5,000 stores, more than double its original goal for the whole of 2023. Cotti was able to accelerate its store growth by changing its strategy in early 2023. It started focussing on allowing existing franchisees to open second and third stores. [11]
Even considering the acceleration, the number of 5,000 stores remains questionable since Cotti had about 400 stores in March and was opening stores at a speed of 100 per month at that time. [10] In April, a Cotti employee said they were opening 10-20 stores per day in North and East China and had 450 stores preparing to open.
Although it was reported that 5,000 franchisees had paid the intention deposit, on May 30th, the official information was that 3,000 stores had been opened. Some of these might already have been closed. Cotti claimed it had only ever closed 15 stores in its first seven months of existence. But independent media quoted data showing Cotti had opened 2,699 stores and closed 173 in the May-July period. [7]
Since the intention fee is paid after passing the application requirements, the 2,000 stores that have not ‘opened’ since must have been approved but not yet paid the investment of RMB 300,000 yet (see ‘The application process’), or are in the process of renovating. When travelling in China in June and July we came across several Cotti stores that were obviously still in the process of renovation.
Cotti stores under renovation.
The rapid expansion of the number of stores came with its own problems, e.g. shortages of counters and equipment. For instance, Cotti has completely grabbed the manufacturing capacity of the Thermoplan BW4C coffee machine, resulting in sky-high prices for the machine on the second-hand market. [7] In June, Cotti started tightening the application review of new franchisees and raised the price and profit share ratio of coffee machines.
With the focus on opening stores, Cotti’s human resources couldn’t keep up. At competitor Luckin, one manager is responsible for 50 stores. There are monthly plans, including number of visits to the stores, food safety inspections and daily communication with franchisees. Negative reviews, video surveillance and other operational KPIs are monitored and reported by the franchisees on a weekly or daily basis. Cotti doesn’t have such tight oversight and support (yet) and besides the process of opening, there is little guidance. This is a risk, especially if franchisees mostly care about sales and less about customer satisfaction and food safety, and may impact the development of the brand.
Cotti plans to sell all its self-operated stores in the second half of the year and transfer staff from those stores to positions involving store inspections. The focus will shift to increasing frequency of store visits, counselling and KPI tracking. Oversight will get more strict.
Cotti claims that the fast expansion isn’t their initiative but reflects the ‘market demand’. Fast expansion isn’t that difficult in the coffee market, especially with a franchise model, since the business is highly standardised and the complexity of equipment, raw materials and supply chain is relatively low. What’s more, Cotti can use years of experience with Luckin. [7]
‘Cuppycat’
A meeting with potential franchisees at the end of 2022 made clear that from the team to the product, to the equipment, to the site selection, Cotti almost exactly replicated Luckin’s model, up to including some of Luckin’s product innovations and flagship products like coconut latte. [9]
Cotti seems to have no shame in mentioning its connection to Luckin, which has proven an effective approach in recruiting franchisees. [6] Cotti’s sales staff even introduces the company as made by ‘the inventors of Luckin’. [9]
Cotti had 1,000 employees in May and 50% of its core staff came from Luckin. [5] Cotti had poached Luckin staff with higher salaries and hijacked several shop locations Luckin was working on. It also planned to acquire Luckin locations once their current contracts expire. [9]
Like Luckin before it, Cotti uses low-cost coffee coupons, large-scale celebrity marketing and sponsorships. Cotti has won the sponsorship of the Argentine National Football Team.
There are a few differences between Cotti and Luckin, though. Unlike Luckin, Cotti does allow the opening of franchises in first and second-tier cities. A franchisee who joined Cotti in the municipality of Tianjin said he did so because he couldn’t join Luckin. But in a third or fourth-tier city, he would have preferred Luckin and in a fifth-tier city Cotti because of the lower pricing.
Product innovations
Cotti is constantly launching new products like snacks and desserts, American hot dogs, and breakfast sets, keeping up with current trends and ideas, always meeting the changes in the consumption habits of the younger generation. [12]
Cotti’s product team of 40 people launches new products every two weeks. The team is divided into sub-teams that compete through China’s characteristic ‘horseracing’ mechanism. By May, Cotti already had 70 products. [5] The company can launch 40-50 new products yearly, while Luckin can launch 70-80.
Luckin once launched so many new products that store staff found it hard to keep up. Cotti might face the same challenge. It has no system that can track and manage product launches; individual stores need to track product performance themselves.
Classic products like lattes, Americanos and cappuccinos contribute relatively little to store revenue and often don’t even appear in the top 10 products. Instead, some of the new products are very popular and can account for up to 60-70% of sales. But at the moment it is difficult to calculate the actual contribution of individual products of a store.
Cotti menu, July 2023.
Art and Oats
As far as branding goes, Cotti used red instead of Luckin’s blue, but it still went for a trendy image.
For example, it teamed up with Swedish oat milk brand Oatley (active in China since 2018) to create three co-branded products, stressing the marriage between plant-based ‘milk’ and coffee that has become a trend among young consumers. [12]
Three co-branded Oatmeal Latte products by Cotti and Oatley: pure, brown sugar and osmanthus & oolong tea flavours. Image source: Cotti. [12]
In July, Cotti and Oatley created a special coffee art exhibition in Beijing’s 751 Area to promote the new products. Afterwards, it moved mini versions of the exhibition to flagship stores in Beijing, Hangzhou and Shanghai. The two also created co-branded coffee cups, canvas bags and other merchandise. [12]
Cotti also used the artwork of 20th-century Mexican artist Frida Kahlo. It has clearly positioned itself as an ‘art coffee’ brand.
Cotti uses the slogan "Drink Cotti, stay younger" (喝库迪，更年轻, He kudi, geng nianqing) to position itself as a young brand. It followed the ‘dopamine’ trend of very cheerful and bright colours that we’ve seen in China in recent months by launching bright fruit drinks. Sponsoring sports clubs like Argentina’s national team and events like the 2022 Chengdu Marathon are also meant to appeal to the young audience. [12]
Artful cups and ‘dopamine’ products.
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