Part 2: What could go wrong at Chagee (CHA)

Last week, I wrote a quick article flagging the seemingly absurd valuation discrepancy of Chagee vis-a-vis beverage peers on the HK stock exchange i.e. Mixue and Guming, as well as Luckin Coffee on the OTC markets.

Chagee currently trades around ~31 (doing extremely poorly on a good day), and at the bottom of its recent trading range; there is no analyst coverage and the firm has yet to report its Q1 25 results so it’s just really stuck in no-man’s land.

I postulated then that delisting risk was an overhang on Chagee, a Chinese ADR, but lo and behold, it appears that the market has shrugged off a large portion of it for the large cap Chinese tech companies. On this front then, it is now difficult to argue that delisting risk is a key overhang on this stock, in my view.

Speaking about IPO dynamics,

Apart from having no key cornerstones (in my view) such as Tencent (Guming) and Hillhouse (Mixue), one would think that amidst the whole Liberation day turmoil, the IPO would be halted and then shifted to a latter date, when the clouds clear - at the very least, to obtain a better valuation.

However, Chagee pushed for the IPO regardless, in a seemingly rushed demeanor, willing to take a huge discount to comparable peers and accepting a meager valuation. One could argue that Mixue IPOed at a modest valuation as well - midteens P/E (similar to Chagee) - before obtaining the huge rerating to 35-40x we see today. However, when Mixue IPOed, there were no peers trading at said lofty valuations i.e. every single peer was trading at sort of the midteens range. On the other hand, Chagee had the privilege of a re-rated Guming and Mixue as public-trading benchmarks.

Putting it all together, it seems incredibly weird to just leave money on the table and green light the IPO, especially with a clean balance sheet and no imminent need of a cash infusion. One hypothesis is that perhaps after obtaining approval from the Chinese regulators for an overseas listing, reneging on the listing may lead to complications i.e. requiring to obtain an approval again which is not a guarantee.

Bubble tea companies reliant on blitzscaling a franchise model have been rejected from A-share listing on the domestic Chinese stock exchanges, especially after the stock collapses of Sichuan Baicha Baido and Nayuki. In other words, regulators onshore view such businesses as inherently risky and are actively protecting their capital markets from such, which is perhaps a signal worth taking note of.

As discussed in the previous post, Chagee’s business began to moderate in H2 24, with SSSG turning negative and the average sale per store declining from the surge in FY23.

Could it be that the founders anticipated a continued decline in operations and thus, did not have the luxury of time w.r.t their capital raising endeavor?

As a segue way from that, it is worth highlighting that Chagee grew its franchise network more than 10x between FY22 and FY24.

How could a business grow its franchise operations so quickly whilst maintaining quality control of its franchisees?

The counter argument to that is that in an incredibly competitive market, some near-term sacrifice on that front is necessary to achieve critical mass whereby the firm entrenches itself in the playing field through scale and leverage over its supply chain - this is basically the playbook of many up and coming F&B operators in China, and not exactly a unique story.

After the scandal at Luckin Coffee, the firm grew quite its franchise network aggressively, whilst not as quick as Chagee, but still at a pretty rapid pace → ~1.9k to ~8k within 2 years.

Secondly, the domestic Chinese market is incrediblyyy competitive.

The pictures above were from a friend in Chong Qing i.e. a Tier-2 /new Tier-1 city. He reports a lack of buzz in the local Chagee he visited (figure 1).

Hotelier spatial model be damned. Chagee copied Starbucks’ logo - with the story of being the Starbucks of milk tea - but Sexy Tea (figure 2) has a similarish logo, has been in operations slightly longer (~2013), and anecdotally, its teas are good and stores frequently packed.

For what it’s worth, Sexy Tea is planning to IPO as well, in the US, somewhere H2 25. A problem with having more fresh milk tea companies IPOing is that, it creates capital alternatives for those looking to play the growing sector, which may reduce valuations across the board (no more scarcity premium). It is even more problematic on a comps basis if Sexy Tea turns out to be a much better operator than the former, true to its name at the very least.

For what it’s worth, the streets of China are paved with fresh milk tea stores and whilst its relatively clear why Mixue has been able to outcompete for years - lindy effect* and a scaled low-cost operator with huge economic efficiencies translating to >20% EBITDA margins - it’s unclear whether Chagee’s premiumization gameplan is enough to survive this competitive market.

lindy effect - posits that the future lifespan of something (like an idea, technology, or business) is proportional to its current age

Chagee has opened its first US store in Los Angeles. Maybe this might diminish its orphaned status a little bit as US investors become more acquainted with the brand. Still, majority of its store network remains in China and the operations thereof remain supremely important.

I’ll be keeping a close watch on the Q1 25 report.