Jeff’s Asia Tech Class: Daily Update 10.30.19

This is one of the daily updates for my Asia Tech class. It builds off podcast / lecture 2 about what Starbucks China should have done about Luckin Coffee (located here).

Two main points for today:

  1. Luckin Coffee traded defensibility for scalability
  2. Are WeWork and Luckin blitzscaling? Or are they just in money wars?

1. Luckin Coffee traded defensibility for scalability.

I view Luckin Coffee as mostly a case of using new digital tools (smartphones, GPS, mobile payment) to create a new business model for retail coffee. And that’s something you should always keep an eye out for.

Digital and technology upgrades are common in business. It happens in every industry every year. Online banking replaces telephone banking. Airport check-in kiosks get better. Smartphone screens get bigger. And so on. It happens all the time and the value created by these tech advances usually just gets passed on to customers The competitive dynamic stays the same.

But digital and tech tools can sometime enable a whole new type of product or service – or a new business model. For example, the emergence of the App Store enabled mobile phones to become smartphones. And it is often not a new technology that matters as much as the falling cost of an existing one. For example, the falling price of DVDs enabled the Netflix business model.

What got my attention early on about Luckin was their attempt to create a new business model for retail coffee. They tried to use digital-enabled ordering and pick-up as a way to reduce the real estate footprint of a typical cafe. And that’s really clever. Because Starbucks is mostly a real-estate company. And you aren’t going to beat them at that.

But if you can get customers to order on their smartphones and then pick-up at smaller and cheaper locations, you can eliminate the cost of high-traffic and high visibility locations. And lots of staff. You basically replace the connection with consumers through convenient real estate to one through smartphones.

And this digital-centered (not real estate-centered) business model would have a couple of advantages.

  • It would have much lower upfront costs for outlets (store build-out, real estate deposits).
  • That would let you scale faster and with less capital.
  • It would reduce the ongoing operating costs of each outlet (rent and staff would be lower).
  • That would let you lower your prices.
  • More locations overall would increase convenience to consumers.

And this is pretty much what Luckin did. Their digital-first business model was able to scale up very rapidly (2,000 outlets in year one, maybe 4,000 total year two). It took Starbucks 20 years to open that many. Luckin also lowered their coffee prices by about 20% relative to Starbucks. And they pitched increased convenience.

That’s all really interesting.

But this innovative business model has one glaring problem. Retail coffee is mostly a commodity. And mobile apps and software in of themselves are commodities. There are only two sources of real strength and advantage in retail coffee:

  • Having have high traffic and high visibility locations (i.e., real estate), which are hard to replicate and make you more convenient for consumers.
  • Having some degree of customer capture, usually through brand awareness, brand loyalty, membership cards and/or habit formation (it helps that caffeine and sugar are addictive).

Of these, real estate is the bigger strength. And that is just what Luckin gave up with their innovative business model. They basically traded defensibility for scalability.

  • What is stopping me from creating a mobile app for fresh brewed coffee and then putting up 5 small booths in my business park for pick-up? I could start competing with Luckin in my neighborhood in about a week.
  • What is stopping street food stalls (which often offer coffee) from doing the same?
  • What is stopping other retailers like convenience stores (which sell coffee) from creating a mobile app that lets you order and pick-up fresh brewed coffee? If Luckin is arguing low-price and convenience, doesn’t that sort of sound like a convenience store?

So Luckin has a couple of big challenges.

  • The first is it’s not clear how much consumer adoption they are really getting. Do they have a popular product?
  • The second is how are they going to protect their business from competitors? Absent high traffic and high visibility real estate, what is their competitive advantage?

If I were advising Luckin, I would say focus on your strength in software. Try to build in switching costs, loyalty and a membership program ASAP. You need some degree of customer capture. I would also recommend they partner up with another digital giant (ideally Tencent). They make a lot more sense as a service than a stand-alone company.

We’ll see what happens.

2. Are WeWork and Luckin blitzscaling? Or are they just in money wars?

On the podcast, one idea I talked about was fastscaling vs. blitzscaling vs. money wars. This can get a bit confusing.

Blitzscaling (often discussed by Reid Hoffman, founder of LinkedIn) is when you are in a winner-take-most or winner-take-all market – and the biggest risk is not getting to scale first. Once a company gets to scale in these types of markets, the business collapses to them and everyone else is shut out.

This is often due to network effects (which we will discuss at length later) and that’s how you got eBay, Alibaba, Didi, Uber and many other digital companies. But it can happen in other businesses where there is a scarce resource or intellectual property. For example, whoever gets the beachfront land locks up the market (because there’s no other land left).

The argument for blitzscaling is that in these types of situations, your risks of growing too fast, of wasting or running out of money, and of market uncertainty are smaller than the risk of not being first. So once you have product-market fit, you hit the afterburner and spend a ton of money trying to grow as fast as you can. Think about it like that movie the Fast and Furious. You are racing someone to the finish line and you hit your nitro button to cross the finish line first.

That is different than a money war, which is just using capital in the short term to hurt your competitor. To take market share. To make them lose money. Ideally, to put them out of business.

I’m not talking about a normal ongoing operating spending advantage. For example, Huawei is currently outspending Nokia and Ericsson in R&D in telco equipment dramatically. They are spending about $15B per year but this is part of their normal budget (about 15% of revenue). It’s one of the reasons I don’t think anyone can beat them right now.

A money war is a more short-term tactical move. If you have more cash on the balance sheet, you take that and spend it on a marketing surge to steal customers. Or to subsidize prices. Or to build out extra capacity in your factory and get a lower per unit cost. Or you just accept selling your products at break-even or a loss for a while. Either way it hurts financially. But it hurts your competitor too. And you hope they can’t take it.

Sometimes this is done using greater access to outside capital or loans. We saw this in solar manufacturing in China in 2003-2010 when all the manufacturers used government loans to add tons of capacity and everyone had razor-thin margins or losses.

And we see this in venture capital in digital China frequently. A company (like Mobike) raises a bunch of venture capital money and then subsidizes prices to get usage and take market share. Their market leading position enables them to raise more money more cheaply, which they then do and keep subsidizing. Competitors who aren’t market leaders find it harder and harder to match the fund raising and spending of the leaders. And they drop out.

When I look at Luckin and WeWork, I’m not sure whether these are cases of blitzscaling, money wars or just being really aggressive with cash. Not all business decisions make sense.

But if the prerequisites for biltzscaling are product-market fit (i.e. we know customers really like it) and a winner-take-all (or most) market, then neither Luckin nor Wework qualify for blitzscaling. Retail coffee and short-term office rentals are very fragmented markets. Neither company has even 10% of their market. I also think it’s unclear whether Luckin really had product-market fit before it started growing so aggressively.

And if it’s a money war, who are they trying to kill off or take customers from? Luckin doesn’t really have another competitor growing rapidly. And Starbucks isn’t at risk.

So maybe they are just being aggressive with their access to capital. Or maybe they are just playing the private-public market spread. You raise capital to show growth and then go public and cash out. Private equity people often make money by taking companies private, splitting them up, M&A’ing them back together and taking them public again.

Anyways, I’m watching both to see what they do next. And we are going to have classes about short-term and irrational competition. And about dirty tricks.

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That’s it for today. Have a great day.
-jeff

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