Luckin: Downfall of the coffee king

• Once seen as a main competitor to Starbucks in China, now trapped in fraud allegations
• NASDAQ issues delisting notice

Luckin Coffee was once considered a strong and direct competitor to Starbucks backed by its rapid growth in its home country China, challenging Starbucks long held dominant position to become China’s favourite coffee chain. Founded in 2017, it expanded its business in China within a short span of under 3 years; from its first store in 2017 to 290 stores in March 2018 and to 3,680 stores in September 2019. By the end of year 2019, Luckin Coffee surpassed Starbucks to become the largest coffee network in China in terms of number of stores. Starbucks opened more than 4,200 stores since entering China in the year 1999 while Luckin’s store count reached over ~4,500 in December 2019. Moreover, the number of cumulative transacting customers for the latter reached over 40 million by the end of the year 2019.

This coffee king was among investor’s favourites and was backed by big names like BlackRock and GIC even before its initial public offer in May 2019. With its different approach of doing business by targeting young white-collar millennials of China, the company expanded very fast with more than 90% of small “Pick-Up” stores located near office buildings and college campuses. Luckin also believed in heavy promotional discounts to attract customers with lower prices than its competitors with an aim to boost its top line. Its revenue grew multi-fold within few quarters, from just US$ 2 million in Q1 2018 to US$219.7 million in Q3 2019. The company also claimed later in the year 2019 that they have achieved store level profitability. Perhaps, that’s the reason, that this technology driven company which claims to use big data analytics and AI to target customers and efficiently optimize the customer experience, touched the market cap of more than $ 12 billion when its share price hit record high of US$ 51.38 before closing at U$ 50.02 on 17^th January 2020.

However, during the latter half of the same month, the company was in spotlight amidst negative reasons, when an anonymous report alleged accounting fraud by the company to inflate its sales numbers. The report (which was floated by Muddy Waters) claimed that Luckin had inflated its number of items per store by at least 69 percent in Q3 and 88 percent in Q4 of year 2019. The report’s evidence was supported by more than 11,200 hours of videotaping. The report also stated that Luckin’s store level loss was around 24.7% - 28% and selling price was 46% of listed price of product, not the 55% as claimed by management and that too excluding free products. Further, Luckin exaggerated its Q3 advertising expenses by 150% so that overstated funds can be used to inflate revenue and store level profit. Following are the main allegations by that anonymous report:

• The number of items per store per day was inflated in 3Q 2019 and 4Q 2019
• Items per order had declined from 2Q 2019 to 4Q 2019 and the effective selling price was inflated in 3Q 2019
• Overstatement of advertising expenses might have indirectly pushed for overstated advertising expenses to inflate revenue in 3Q 2019
• Net revenues from other products were inflated in 3Q 2019

The company released its statements denying all allegation on 3^rd February 2020 but internally started investigating if any fabrication in accounts had been made. Investors of Luckin had a nightmare on 2^nd April 2020, when the company issued a press release admitting that COO Jian Liu and certain other employees had fabricated sales from Q2 to Q4 of year 2019 amount to around RMB 2.2 billion ($310 million). Further, certain costs and expenses were also substantially inflated by fabricated transactions during the same period. This bad news crashed Luckin’s share price by more than 80% on the same day and five days later led to a trading suspension by NASDAQ.

As it turns out, Luckin was never profitable, not even at EBITDA level. With limited operating history, it made a remarkable debut on Wall Street and impetrated a huge US$3 billion valuation within less than two years of being founded. In 3Q 2019, it posted a whopping YoY revenue growth of more than 500% and store growth of 210% with around 166% comparable store sales growth. These unusual numbers might have led to suspicion further leading to an investigation.

Though Luckin has sacked its CEO and COO with other several employees and formed an internal independent special committee to investigate the full matter, it received a delisting notice from NASDAQ on 19^th May 2019 citing two reason for delisting - 1. “public interest concerns as raised by the fabricated transactions disclosed by the company” and 2. “the company’s past failure to publicly disclose material information, citing a business model through which the previously disclosed fabricated transactions were executed.” Later while NASDAQ lifted suspension on trading, it brought even more bad luck to Luckin as its share price tanked even more and closed at US$2.81 on the same day trimming its market capitalization to just $ 700 million.

Luckin’s dramatic fall has raised fresh concerns about corporate governance and especially towards Chinese companies within the investor community. Nasdaq has now introduced new rules that would tighten the conditions for some Chinese companies to float on its stock exchange via initial public offerings. Alongside corporate governance issues, there may be other reasons like the increased trade tensions between the US and China which could have weighed on the exchange to put tighter norms for Chinese players getting listed in the US. Practically, Luckin’s scandal is a wake-up call to investors about how much they should trust financial reporting by companies. In recent years, many companies in the US, Asia and other economies which have listed are either loss making or barely profitable. Since these companies are valued primarily on revenue growth or other key operating metrics (store count and comparable store sale growth in Luckin’s case for example), there are possibilities to mislead the figures without affecting the rest of financials. Particularly for Luckin, although its business is hit by the Covid-19 induced worldwide shutdown along with its offices in China being raided by authorities for investigations, many of its stores are still operating and it is still opening new outlets. The existence of China’s coffee king is now under threat after this fraud scandal wherein only time will tell whether the company will be able to weather the storm.