The Department of “Too Good to be True:” Luckin Craps Out On Investors

Luckin Coffee, the so-called “Starbucks of China,” soaked up investor dollars around this world as analysts and the press breathlessly touted the fairytale upward trajectory of this little technology-driven Chinese coffee start-up vs. the behemoth from the West. With seemingly limitless shops sprouting up like mushrooms after a good rain, it all came crashing down in an accounting scandal and falsified earnings reports in April.

Barron’s headline of May 17, 2019, “Everything You Need to Know About the Starbucks of China”, stated that Luckin Coffee, the high-flying, promising firm tapping China’s potentially massive growth in coffee consumption raised US$579.2 million in an IPO launch on the US Nasdaq exchange which valued the company at over $4 billion.  That IPO, the biggest one from China so far that year, made chief executive Lu Zhengyao a billionaire with his 20% stake, joining Qian Zhia, the founder and chairperson already a billionaire since November 2018 with her 30% stake.

Founded only in 2017, Luckin Coffee was out to challenge Starbucks’ dominance in China’s fresh-brewed coffee market. And it expanded wildly. By October 2018 Luckin already had 1,300 shops; by September 2019, there were 3,680; and on January 8, 2020,  the company announced it had opened 4,507 shops throughout China, well surpassing Starbucks’ 4,123 shops with plans to build thousands more in 2020.

In its filing for a US initial public offering (IPO), a Luckin representative stated, “China’s coffee market is highly underpenetrated. Inconsistent qualities, high prices, and inconvenience have hampered the growth of the freshly brewed coffee market in China. We believe that our model has successfully driven mass-market coffee consumption in China by addressing these main points.”

And any chance Luckin executives, surrogates, and devotees had they dutifully pointed out that they believed the model of Starbucks and its Western approach was outdated and unsuitable to today’s digital China.

Luckin’s model for the new digital China

Instead of the premium, sit-down, so-called “third place” environment carefully and successfully cultivated by Starbucks around the world over the last 25 years, Luckin took a different approach. Targeting white-collar millennials, more than 90% of its stores are quite small located inside office buildings, office parks, or on school campuses — kiosks really — which  the company said in its IPO filing allows it to “stay close to our target customers and expand rapidly with low rental and decoration costs.”  Even the larger shops have limited seating. It’s a “grab-and-go” concept.

Another trend was the eschewing of cash entirely — cashless stores! Customers pay for coffee through Luckin’s proprietary app or through or another online payment method such as WeChat.

“Technology is at the core of our business,” said Luckin in a press release. “Our technology covers every aspect of our business, from customer engagement and storefront operations to supply chain management.”

Another Luckin concept: cheap, cheap, and cheaper. Although Luckin’s prices were officially 25% lower than Starbucks, with aggressive promotions and freebies the effective price went well below that. Heavy discounting, sometimes of buy 1 get 2 free, was common on its app. In the end, it was not rare to see a large latte costing only 10 yuan (US$1.40) after the heavy discount.

Yet another “disruptive” (a word the company uses often in its releases) concept  is coffee delivery. Luckin saw an ocean of unserved customers in China who really didn’t want the third place that Starbucks provided. Instead, these new customers preferred coffee delivered to their offices, homes, and dorm rooms. Luckin promised coffee delivery within 30 minutes.

Luckin’s bulletproof coffee?

Luckin’s financial projections, along with its business model, were touted as bulletproof against the promised upcoming technological onslaught that was going to hit coffee retailing in the ever-growing digital China market. Financial advisors thought Luckin sounded so good that they recommended it as a “buy” to any listening ear attached to deep investment pockets. This allowed Luckin to borrow heavily to build out its dream, especially with over a half-billion dollars in IPO financing and with analyst after analyst tripping over each other to say good things about Luckin, building them up and up.

Headlines like “China’s young affluents — quickly turning from tea to coffee — are set to fuel the [Luckin]rally in 2020.” One called Luckin a “long-term winner” in May 2019 at the IPO and doubled down on that in January 2020, arguing that the company “is a great growth stock to buy both now and in the long term.” Luckin was up 135% in January 2020 from its May 2019 IPO.

“The improvement of the instant delivery network in the same city makes coffee delivery possible within half an hour,” said Gong Yinglong,  at the 2nd Pu’er International Specialty Coffee Expo held in March 2019. The self-titled “technical pioneer of new retail and social e-commerce” gave a blustery speech extolling Luckin’s model as a category-killer in all aspects of coffee retailing. He suggested that the only way for Starbucks to “conquer” Luckin was to buy them out.

“This new retail model is suited for the era of the mobile internet,” said Gong, adding that it’s  “the inevitable direction of the development of the coffee industry”.

Storm clouds gather

But clouds started gathering on Luckin’s horizon. In October 2019, a court case filed by Luckin in Shenzhen against Starbucks was summarily dropped by the company. The company accused Starbucks of forming a monopoly by signing exclusive contracts with suppliers and property owners; Starbucks reportedly referred to the lawsuit a “marketing stunt,” according to a news report on the sina.com website.

After that, a heavier drizzle of bad news set in. On January 31, 2020, Muddy Waters Research, which conducts investigations into public companies often recommending short-selling, released a damaging report on Luckin. The firm, not mincing words, called Luckin a “fraud” and a “fundamentally broken business.” Muddy Waters received an anonymous report alleging that Luckin Coffee had been “fabricating financial and operating numbers” since the third quarter of 2019.

The report then went on to mention several problems. For example, the company is said to have inflated the number of items sold every day by at least 69% in the third quarter and 88% in the fourth quarter of 2019. They cite evidence from more than 11,000 hours of store traffic video.

On February 3, Luckin Coffee called Muddy Waters report “meritless” and argued it was written just to benefit short-sellers financially by swaying Luckin’s stock price, adding that, “The methodology of the report is flawed, the evidence is unsubstantiated, and the allegations are unsupported speculations and malicious interpretations of events.”

Accompanying this report, which went pretty much unheeded by investors at the time, was the backdrop of the coronavirus and its ravaging effects on retail businesses everywhere, bringing stock prices down during the uncertainty.

But still, even with Luckin’s prices well off their January highs, Many investment firms advised further investments in the company. “Buy the dips,” suggested one referring to the lower stock price in early March.

“While Luckin will be hurt in the short-term by the coronavirus… investors can buy Luckin for a cheap price… [and]… may be very happy several years down the road,” said one advisor.

On March 5, Motley Fool investment advertisers recommended simply “Buy Luckin Coffee” with the usual buzzwords and phrases we’ve come to expect to get investors salivating: “most populous country;” ”surpassing Starbucks;” “untapped markets;” and “coming overseas expansion.”

The tsunami hits

Less than a month later, on April 2, Motley Fool advised investors to “Hold Luckin Coffee,” which is investment-advisor-speak for “sell.” This came immediately after it was revealed that an internal investigation at Luckin had found evidence that corroborated much of what the short-seller Muddy Waters had published only a few months earlier and of further “significant fraud perpetrated by its c.o.o. Jian Liu and certain employees last year,” according to a company statement. In mid-April, American investment firm Goldman Sachs said it would seize and sell the Luckin stock holdings of the company’s chairman Lu Zhengyao after he defaulted on a $518 million margin loan.

The stock was halted from trading on April 7, and Luckin Coffee has been in the headlines in all financial news sources amidst reporting on the coronavirus and its effect on global business.

That takes us to today. As of this writing, dozens of different law firms are planning to file lawsuits against Luckin, and they’re all looking for shareholders who’ve suffered losses from owning the stock. 

On May 12,  Luckin fired both the c.e.o. and c.o.o., and six others were put on suspension or leave. Its stock, opened for trading in the US on May 20 for one day, lost another 36%. Its shares have now fallen over 95% in value since January. Nasdaq plants to de-list the stock, which should see its share value plummet to virtually worthless

The demise of Luckin Coffee is now being politicized, with some in the US and China taking sides. Politicians in the US are renewing calls to, as the New York Times says, “stop opaque Chinese companies from raising money in the US.”  Luckin’s implosion due to lack of transparency also feeds into the current US administration’s narrative that China is to blame for the coronavirus and misrepresenting its extent.

And in China, some are taking a nationalist view, supporting Luckin by ordering coffee flocking to its shops for takeout. Many are still supportive of their own home-grown brand, which took on the foreign invader brand Starbucks. The jury is out on that as the Chinese government has shown itself to be quite intolerant of financial fraud.

And Luckin Coffee inexplicably continues its expansion in China opening up to 10 shops per day, according to Bloomberg news.