INSIGHTS | Luckin—out of luck

The Olympics may have been delayed, but we got to see a gold medal dive anyway: Luckin Coffee dropped 75% in a single day’s trading as news emerged that nearly half its sales were fictional. The company claims to be investigating a scheme to falsify sales data perpetrated by the company COO, among others.

The company looks set to go out as it came in, in a wash of free coffee. Customers are flocking to its stores to cash in coupons. On the Chinese internet, commentators have already written a likely epitaph—”Hey Wall Street, thanks for the free coffee!”

Bottom line: Luckin is the most spectacular case of fraud we’ve seen in a while—and not all that surprising, coming from a company that has long had warning signs. It’s probably a cautionary tale about something—but you can take your pick of morals. 

Meteoric rise:

• October 2017: Luckin Coffee is founded in Beijing by former Car Inc COO Qian Zhiya and former CMO Yang Fei.
• June 11, 2018: The company raises a $200 million Series A from Joy Capital, the Government of Singapore Investment Corporation (GIC), Legend Capital and Centurium Capital. Joy, Legend and Centurium all have connections to Car Inc.
• Dec. 12, 2018: Luckin raises $200 million in a Series B, led by GIC and China International Capital. This round gave them a $2.2 billion valuation.
• March 12, 2019: Reuters reports that Luckin Chairman Lu Zhengyao has sought to trade a role in the IPO in return for a $200 million personal loan.
• April 3, 2019: Luckin registered RMB 45 million ($6.7 million) worth of movable assets as collateral to a Beijing-based firm, in an early sign of a cash crunch.
• April 18, 2019: The company raises $150 million in a Series B+ from BlackRock and an unnamed investor. The round put them at a $2.9 billion valuation.
• April 22, 2019: Luckin files for an IPO with the US SEC. To be listed on the Nasdaq under the symbol “LK,” the company set a placeholder amount of $100 million to be raised in the filing. Rumors from February put the IPO at $300 million.
• May 16, 2019: Luckin exceeds expectations to raise $561 million in IPO.
• Sept. 3, 2019: Luckin spins off tea business as “Fawn Tea.”
• November 2019: Luckin store count passes Starbucks at about 4,200 stores, making it China’s most common coffee chain.
• Jan. 21: Luckin announces $865 million in post-IPO fundraising to fund growth and “unmanned” vending machine strategy.
• Feb. 1: Luckin shares plunge 19% as short-seller Muddy Waters publicizes allegations of inflated sales figures and self-dealing made by an anonymous third party. Luckin denies these allegations.
• April 2: Luckin admits that it fabricated RMB 2.2 billion in sales in 2019, causing its shares to plunge 75.6%.

Growth at a high cost: Luckin was built on a simple idea: you can buy growth. The company’s celebrity CMO—and ex-con—Yang Fei even wrote a book about it, as reported by TechNode contributor Michael Norris. Everything it did cost big money: opening 4,500 stores in slightly over two years, and then handing out free coffees to bring customers in and to keep them loyal. 

In its early stages, the spending was backed up by an argument that China was on the verge of becoming a major coffee-drinking nation. But as it progressed, the quest for growth led Luckin into more and more whimsical bets: 

• Luckin pushed into fancy teas in 2019, a field so crowded that Luckin isn’t even the only player whose logo is a deer. 
• I’m honestly not sure what happened to the company’s vow to push into overseas markets.
• Most recently, Luckin raised most of a billion dollars to fund a push into vending machines—which is rather less crowded, since competitors like BingoBox have already flopped.

When did it turn to fraud? We don’t know for sure when Luckin started making up numbers, but we can see why. The company spent hundreds of millions of its investors’ dollars to buy growth, and as it went back for more, it had to show that it was on a road to profit. It is, however, very possible that fraud went beyond what the company has already admitted.

• According to the company’s Thursday statement, falsified sales began with the company’s Q2 results—its first as a public company. 
• The fake sales allowed it to claim—in the now-disavowed Q2 report—that year-on-year sales grew 698%; in Q3, it boasted that net losses had fallen from about 200% to only 30% of revenue. 
• In as-yet unconfirmed allegations, the Muddy Waters-linked report that accurately predicted false sales also claimed that the company inflated the costs in its vending machine push in order to cover up a need to raise funds for ongoing operations, and to transfer money to related parties in self-dealing transactions.

Why did they own up? Norris speculates that Luckin’s admission of fraud was forced by its own board. The company’s Q4 and annual results have been slow to emerge. Whether they are past the filing deadline is unclear, but Norris suggests that independent directors refused to sign off on the results, forcing the company to investigate.

It may be that the scheme wasn’t really meant to last: Pre-IPO, Norris argued that the company might not be intended to achieve profits; suggesting that, like a car with sawdust in the transmission, it was built only to make it to market and let sellers walk away with cash.

Expiration dates: It’s a commonplace in Chinese commentary that the company is a sort of national Robin Hood—taking money from Wall Street investors and spending it on free coffee for Chinese people. Chinese users have scrambled to Luckin to place orders, some to show their support for the company, but more for fear their coupons will expire. 

• Luckin stores were full of buyers on Friday, while its app and WeChat mini-program crashed due to a traffic spike, local media reported.
• The situation echoes the last days of ofo share bikes, when 10 million users applied for refunds as the company collapsed in 2018.

Is it a drinking lesson…: Luckin’s closest peers are fast-growing fancy tea sellers Heytea and Naixue. Like Luckin, they’re spending big to grow fast with a hot beverage. But maybe they can make a Luckin-like model work with a little more patience. After all, Norris told TechNode, even after you discount half Luckin’s sales it’s still sold a lot of coffee.

…pseudo-tech,…:  Maybe the lesson is to beware companies dressed up as tech startups. Luckin is competing with Starbucks—but it’s presented itself as a tech firm to imply Google-like prospects. Looking at its investor relations material, Luckin’s company overview mentions technology four times in three paragraphs, and coffee just twice.  

The last year has been tough on workhorses in unicorn’s clothing. WeWork’s spectacular flame-out is the most famous example, but Indian hotel giant Oyo and Chinese rental platform Danke share the essential features of high costs and decidedly finite revenue. Neither reached Luckin’s heights of fraud, but both illustrate that asset-heavy pseudo-tech firms tempt executives to cut corners. 

Some companies, to be sure, are going to see bets like these pay off. But it’s clearly long past time for investors to ask hard questions about profit, as well as growth.

…information asymmetry,…: For some US commentators, the moral of Luckin is that you can’t trust overseas-listed Chinese stock. As Josh Rogin writes in the Washington Post:  

According to the U.S.-China Economic and Security Review Commission’s 2017 report, China’s opaque financial system makes it impossible to verify Chinese companies’ financial disclosures and auditing reports. Through fraud schemes alone, Chinese issuers have stolen billions from U.S. investors with no fear of punishment inside China.

But China’s securities regulator claims that new laws, effective from March 1, give it the power to police overseas-listed stocks. Luckin executives probably won’t lose any sleep over enforcement, as their scheme likely wound up before this key date, but China’s US-listed blue chips would be well advised to push for real enforcement to protect their own reputations.

…or just dumb money? We can’t get over the suspicion that the real reason Luckin got away with its fuzzy numbers is that a lot of people were willing (or desperate) to buy into the next big thing in China tech. A few years ago, China tech was a dark horse, and betting on it was an easy way to make money. These days, you have to be pretty fast to spot something before everyone knows it—and that means you have to be a lot smarter to make money.