SINGAPORE (Apr 30): Legendary billionaire investor and Berkshire Hathaway CEO Warren Buffett once said: “Only when the tide goes out do you discover who’s been swimming naked.” The recession that followed the dotcom crash in 2000 and the 9/11 terrorist attack in 2001 saw the unravelling of high-flying energy firm Enron, telco WorldCom as well as conglomerate Tyco. As the 2008 recession unfolded in the aftermath of the subprime mortgage crisis, former Nasdaq chairman Bernie Madoff admitted to running a Ponzi scheme by cooking the books of his hedge fund, which delivered consistently high returns in good times and bad. The current coronavirus-induced recession has so far not produced a single high-profile bankruptcy, though one Chinese firm, Luckin Coffee, is now on the brink.

The Xiamen-based coffee chain operator had emerged as yet another icon of the high growth consumer business in China, with huge sums of early-stage funding that helped position it as a threat to behemoth Starbucks Coffee. In May last year, Luckin listed in the US with much fanfare, boasting a stratospheric valuation of more than 30 times its annual sales and losing almost as much money on every cup of coffee it sold as it spent on actually making it. At its peak in January, with a market capitalisation of around US$12.5 billion ($17.75 billion), Luckin was trading at over 50 times its expected annual sales. Not even the fastest-growing software firms command such a valuation.

Within eight months of its listing, Luckin’s luck was running out and its business model was coming undone. On April 2, it disclosed that nearly half of the revenues it had reported in the last three quarters of last year — or RMB2.2 billion ($440 million) — was fake. Luckin blamed chief operating officer (COO) and board director Liu Jian for the misconduct, which came to light after an internal investigation by its auditors Ernst & Young found that Liu and several other employees had overstated early revenue figures. On April 26, State Administration for Market Regulation, China’s top business regulator, raided Luckin’s headquarters and is likely to continue searching documents and electronic records for weeks. China Securities Regulatory Commission, the agency that regulates listed companies, had earlier denounced Luckin’s “misconduct” and is separately investigating the coffee chain operator.

Luckin’s stock cratered after the allegations first surfaced in early April, losing nearly 84% of its value. The stock has dropped 90% from its peak and is currently suspended from trading. Analysts say Luckin stock is unlikely to ever trade on Nasdaq again, although shareholders may be allowed to trade its shares as “pink sheets” on the over-the-counter market.

Clearly, the overstating of Luckin’s revenues for three consecutive quarters — the one preceding its listing, the one during which the firm listed and the one immediately following its listing — to the tune of half of its total sales is not the only skeleton at Luckin. How could the COO, a director of the board and a longtime close confidant of the firm’s founder pull off something like that? Who knew about the elaborate scam? How long had they known?

The company came into public eye with a rip-roaring listing last May. The stock popped nearly 20% on the first day of trading after Luckin had priced its IPO at US$17 per share, at the top end of its expected range, raising US$561 million. The IPO valued Luckin at about US$4.2 billion and came just one month after a US$150 million round of funding at a US$2.9 billion valuation.

One big red flag for start-ups is when they constantly raise cash. Luckin raised US$2.4 billion in its 18 months as a start-up according to Pitchbook. Asset management powerhouse BlackRock; Chinese private equity firm Centurium Capital, which is headed by David Li, former China CEO of private equity firm Warburg Pincus and an old ally of Luckin’s co-founder and principal financier Charles Lu Zhengyao; Legend Capital, the venture capital arm of Chinese PC giant Lenovo; as well as Singapore’s GIC were among those investors. Indeed, the start-up had achieved a unicorn valuation well before it even brewed its first cup of coffee.

In mid-January, an anonymous 89-page report on Luckin Coffee landed on the desks of investors known to short China stocks, including Muddy Waters Research founder Carson Block, famous for his short-selling of Singapore commodities firms Noble Group and Olam International. The report, based on 11,000 hours of store traffic video, alleged that Luckin had inflated sales by 69% in the third quarter and 88% in the fourth quarter of last year. Luckin stock fell nearly 30% despite the company’s denials.

The surprising thing about the Luckin saga is that investors were throwing too much cash at a company whose storyline was too good to be true. It had an untried, untested business model selling coffee that left a bad taste in the mouth, at a fraction of what Starbucks was charging, in a country that does not have much of a coffee drinking culture. On average, the 1.4 billion Chinese each drink just three or four cups of coffee a year. In comparison, Americans drank an estimated 400 million cups of coffee a day last year. That is 456 cups of coffee per person.

However, for a nation deeply influenced by its thousand-year tea-drinking history, the Chinese are increasingly more open to the Western lifestyle. Beijing-based Daxue Consulting notes in a recent report on coffee in China that these days, young white-collar workers in Beijing and Shanghai consume between 100 and 150 cups of coffee annually outside their own home. The report notes that China’s coffee market is growing at a breakneck pace and it has more than doubled in the six years since end-2013.

Blame China’s growing love of coffee on Starbucks. In January 1999, the Seattle-based giant opened its first store in the lobby of the China World Trade Centre in Beijing. Today, there are more than 4,200 Starbucks stores in 177 cities in the country, employing over 57,000 people. Until Covid-19 forced a lockdown, a new Starbucks was opening in the country every 15 hours. Last year, Starbucks chalked up US$2.6 billion in sales in China. International chains like UK’s Costa Coffee (now part of Coca-Cola), Canada’s Tim Hortons and US-based Dunkin’ Brands Group, owners of the Dunkin’ Donuts chain, have also been growing their footprint across China for years.

At the time of its listing 11 months ago, Luckin said it was operating 2,370 stores across 28 cities in China. By the end of 2019, it had grown its total store base to 4,500 locations across the country, surpassing the number of Starbucks stores. Yet it was selling one-tenth worth of coffee that Starbucks was selling in China. And that is when you take into account that its revenues were being inflated by about 100%!

From the start, Luckin has pitched itself as a local “David” battling a foreign Goliath. Although it did not have the branding or taste of Starbucks coffee, Luckin employed some daring marketing tactics to draw attention. The opening of a “Relax” Luckin Coffee outlet inside Beijing’s Forbidden City, the former Chinese imperial palace and home to emperors for nearly five centuries, was hailed as a marketing coup. The site was the same one from which Starbucks was evicted in 2017 amid protests of a “Western invasion”. Luckin also had the chutzpah to claim that it was “suing” Starbucks for its monopolistic behaviour. Luckin never actually filed a suit. The whole thing was just a publicity stunt but it raised awareness for the fledgling brand.

There was little that Luckin had in common with Starbucks. A key part of the latter’s appeal is its cafés’ ambience, including cozy seating, mood lighting and soothing music. Luckin’s appeal to investors was that it did not need as much valuable real estate as its American counterpart. More than two-thirds of its outlets are essentially glorified kiosks.

Luckin also touted itself as a tech play. You download an app, order on your smartphone from within WeChat — the dominant super-app in China — approach the kiosk, grab the cup with your name and walk away. Most Luckin stores had no cashiers and, as such, did not accept cash or credit cards; the money is debited to Luckin via WeChat. It also offered a fast delivery service. You could order from your desk and Luckin delivers coffee, snacks or juices to your office.

Luckin competed fiercely on price. Its coffees and snacks are priced at 30% to 60% lower than comparable Starbucks fare. Another well-worn marketing tactic has been strategic tie-ups with distribution platforms such as Meituan Dianping and boosting sales with heavily discounted coupons.

But despite cheaper coffee, more outlets as well as discounts to bring in new customers, Luckin just was not moving the needle much. Indeed, it was spending 50% of its revenues on advertising and marketing.

Once it was listed on Nasdaq, it needed to show accelerating revenue growth to justify its lofty valuation. Often the best way to mask tepid or falling same-store sales is to aggressively roll out more stores. Yet, the “build and they shall come” strategy works well only with a good product. Luckin’s problem was that its coffee just did not taste good.

Just as soon as Luckin shares were listed, Lu, co-founder Jenny Qian and other insiders such as Lu’s sister Sunying Wong were busy cashing out. Under US Securities and Exchange Commission (SEC) rules, insiders are forbidden from selling their shares before the end of a lockup period — typically three to 12 months — following the IPO. But Lu, Qian and Wong pledged their Luckin shares to Goldman Sachs and other bankers to obtain US$518 million in loans. Even if there was an adequate cushion, the 84% slide in Luckin’s share price means banks that force-sold the shares recovered little of what they lent out.

The US SEC last week warned investors about the “significant risks” of investing in Chinese firms. “There is substantially greater risk that disclosures will be incomplete or misleading and, in the event of investor harm, substantially less access to recourse, in comparison to US domestic companies,” the SEC said.

Senator Marco Rubio of Florida wants a ban on Chinese listings on Nasdaq and New York Stock Exchange. Clearly, the stakes are getting higher for Chinese companies seeking listing in the US. Unless Beijing is transparent about the Luckin fraud and punishes culprits, China could end up losing access to US capital markets.

Assif Shameen is a technology writer based in North America.

Why Luckin Coffee is now toast

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