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A Chinese Coffee Company Could Be Set to Rally

A Chinese Coffee Company Could Be Set to Rally

In looking at initial public offerings, investors often look at US companies but, of course, IPOs happen all around the world. Bloomberg recently reported on one:

“Luckin Coffee Inc., (Nasdaq: LK) China’s second-biggest coffee chain, received two new bullish reviews from Keybanc and Needham, while Morgan Stanley added a note of caution.

Analysts who have weighed in so far like Luckin’s strategic store positioning, competitive coffee pricing compared to rival Starbucks Corp and expansion potential in the Chinese market.

Morgan Stanley analyst Lillian Lou was more cautious, seeing limited gains in the near future on “relatively low earnings visibility,” and noting that valuation already “looks fair.”

Shares of the Xiamen, China-based Luckin rose 8.5% from the May 16 initial public offering through Monday close, after dipping below the $17 offering price last month.

Morgan Stanley, Lillian Lou

Luckin may multiply sales 30x over from 2018 to 2021 as the chain opens more stores and wins over new customers.

“Coffee is one of the least penetrated and fastest-growing markets in China,” Lou said. “Urbanization and the increasing adoption of coffee-drinking by younger generations will underpin this growth.”

“We expect Luckin’s implied market share to grow from 1% to 23% in 2018-21. However, whether this is achievable is highly dependent on management’s execution, and intensifying competition or changes in consumer tastes could also increase earnings volatility.”

Luckin rated equal-weight, 12-month price target $21.

For KeyBanc, Eric Gonzalez noted:

“Luckin Coffee’s rapid ascent toward becoming one of China’s largest consumer brands has attracted its fair share of skeptics. However, we believe the company has several strategic advantages that should support its transition into a profitable business.”

Keybanc is positive on Luckin’s presence in China, limited direct competition and low budget model.

Luckin rated overweight, price target $22.

At Needham, Vincent Yu, told clients:

“Luckin requires customers to order their food on its app, thus gaining user engagement data to better tailor marketing, product offerings, and store location selection.

Its data driven demand ‘heat map’ leads to Luckin to open in-business lobby pickup stores providing maximum convenience to its customers.”

Needham expects Luckin profits to break-even in the third quarter, while it may take another year for the company to reach cash flow break-even. Luckin rated buy, price target $27.

The stock chart of this recent IPO shows excitement, a pull back, consolidation and now a potential rally.

LK daily chart

A Trade for Short Term Bulls

As with the ownership of any stock, buying LK can require a significant amount of capital and exposes the investor to standard risks of owning a stock.

To reduce the risks of a trade, an investor can purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options.

However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.

Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.

To further limit the risks of the trade, an investor can use a bull call spread.

This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call.

The spread strategy always reduces the risk of an options trade.

This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership.

The potential risks and rewards of this strategy are summarized in the chart below.

bull call spread

Source: The Options Industry Council

Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened.

The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.

This strategy can be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.

A Quick Note

Every day, we scan the markets looking for trades with low risk and high potential rewards.

These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.

When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this.

To help you evaluate the current opportunity, we show our math and explain the strategy.

A Trade in LK

For LK, the July 19 options allow a trader to gain exposure to the stock.

A July 19 $20 call option can be bought for about $1.70 and the July 19 $22.50 call could be sold for about $0.95. This trade would cost $0.75 to open, or $75 since each contract covers 100 shares of stock.

The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade.

“Creating a debit” means there is a cost to enter the trade. You can create a debit by simply buying puts or calls to open a directional trade.

In this trade, the maximum loss would be equal to the amount spent to open the trade, or $75.

The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.

For this trade in LK the maximum gain is $1.75 ($22.50 – $20= $2.50; $2.50 – $0.75 = $1.75). This represents $175 per contract since each contract covers 100 shares.

Most brokers will require minimum trading capital equal to the risk on the trade, or $75 to open this trade in LK.

That is a potential gain of about 133% based on the amount risked in the trade.

The trade could be closed early if the maximum gain is realized before the options expire.