Think of a coffeehouse chain store that you visit almost every day. You get a cup of coffee right before you start another day at the University/Office. You log into their mobile app, order a cup of coffee, pay online, pick your order from a neighbourhood franchisee store, and rush to your College/Office. Convenient, isn’t it? Moreover, the company intends to take down the big boys, including STARBUCKS. Whoa! Chap’s got some major courage! Now imagine that this company’s shares are up for sale in an IPO (Initial Public Offer). Would you buy it? Who wouldn’t want a coveted company to become a part of their portfolio?

Luckin coffee

That is the brief story of the Chinese Coffee and coffeehouse chain company, Luckin (Ruixing) Coffee. Incorporated in October, 2017, Luckin Coffee opened its first stores in Beijing and Shanghai. One of the biggest growth stories in the Chinese Corporate space, Luckin Coffee grew to become the 2nd biggest Chinese coffee brand, after beating Costa Coffee stores. As per a January, 2019 report, Luckin Coffee planned to open 2,500 new stores to dethrone Seattle-based Starbucks off its leading spot. The company came up with a $645 million IPO in May, 2019 and started trading on Nasdaq at UD$17/share. In January, 2020, the company reported that by opening 4,507 stores in the past 2 years, it had already surpassed Starbucks to become the largest coffee chain brand in China. They also announced their unmanned store strategy and two new technical products – Luckin Coffee Express and Luckin popMINI. No wonder Luckin Coffee soon became the ‘Investors’ Darling’.

Business Model

Luckin Coffee ousted Coffee major Starbucks off its leading spot in China. The company’s stock surged over 160% within the first 2 months of its listing. To unravel the reasons behind this behemoth success story, it is imperative to investigate Luckin’s business model. Following are the major factors that fuelled the company’s jet-pack propulsion:

  1. Convenient store locations: Most of Luckin Coffee stores are located at the most convenient locations, including offices, college campuses and train stations, unlike Starbucks’ lavish, opulent locations, making takeaways very convenient.
  2. Marketing techniques: Luckin positioned itself extremely well with its consumers, through wonderful marketing techniques, including a generous bunch of offers and discounts. In its early stage of business, it offered a free first drink and a 50% off coupon for one cup. They also offered “buy one get one free” coupons for loyal customers. This technique attracted a huge number of Luckin’s early customers.
  3. The Role of Technology: Luckin’s prospectus mentioned the word ‘technology’ over 5 times as often as the word ‘bean’. It was more a tech-startup, than a drinks company. It opened no brick-and-mortar stores in the beginning. Physical stores were only for preparation and fulfilling of orders placed by customers online. Bookings and payments are made online, through a mobile app, and collected offline.
Coffee

Image: The Luckin Mobile Application

The Reek of Fraud

Founded by ace short-seller Carson Block, Muddy Waters Research is a privately held due diligence based investment firm that conducts investigative research on public companies and takes investment positions to reflect upon the research. Thanks to Muddy Waters, shares of Luckin Coffee slumped more than 80% in a single day’s trade.

So how did Muddy Waters bring down the coffee giant? Well, the lucky guys got their hands on an 89-page anonymous report – a financial dynamite, that was powerful enough to bring down an empire. Luckin Coffee’s stocks plunged over 26%, soon after Muddy Waters released a copy of the anonymous report on its official twitter handle. QUESTIONS – Why did Muddy Waters do it? Who prepared the report? What does the report say? Read on.

Muddy Waters is primarily a research and short selling firm. It means that the firm sells shares that do not belong to it. So how does short-selling work? In simpler terms, a short seller borrows shares from another investor and sells it in the market at a high price (say $25). When the share prices decline (to say $20/share), short sellers buy these shares and return them back to the lending investor. The short seller in our example above just made a profit of $5. Interesting, right?

MW soon tweeted the report on its official Twitter handle, stating that it had been short-selling Luckin Coffee’s stock based on their assessment of the report’s credibility.

Image: Muddy Waters’ Tweet, citing reference to the 89-page anonymous report

The Report by ‘Coffee_Anonymous’

So who was behind this ’89-page’ dynamite that brought Luckin Coffee to ruins? No one knows. It might be another short-selling firm, a competitor like Starbucks itself, or some other entity that would benefit massively from Luckin’s failure. ‘Coffee_Anonymous’ hired 92 full time and 1418 part-time staff to collect over 11,260 hours of store-traffic for 981 days. Luckin Coffee could not publish the videos due to privacy reasons, but they substantiated their claims with an enormous volume of facts, figures and images.

The report makes several claims backed by cutting edge evidences:

  1. Data misstatement: Coffee_Anonymous stated that the number of items per store per day (No. of Orders X No. of items per order) was inflated by around 69% and 88% in the third and fourth quarters of 2019, respectively and its ‘items per order’ had also declined. Online app orders were also inflated by intentionally skipping and jumping invoice numbers. Coffee_Anonymous used 25,843 consumer invoices from 10,000 customers to arrive at these results (secured Google drive link provided for auditors/investigators).

Image: Randomly gathered 25,843 invoices (Coffee_Anonymous)

  • False ‘Store Level profit’ claim: Luckin’s management claimed to have achieved a store-level profitability (if each store is assessed as a separate business, every Luckin Coffee outlet is profitable, as per management claims).Inflation of store level prices by around 12.3% was alleged, to cover for the actual store level loss of up to 24.7% – 25%.

Image: No. of items per store per day – Coffee_Anonymous

  • Re-routing of Expenses: The data tracked by CTR Market Research showed that Luckin overstated its advertisement spends by over 150%, especially on Focus Media. In its report, Coffee_Anonymous brings out that the total overstated media spends (RMB 397 million) closely match the store-level overstated profits (RMB 336 million). This implies that Luckin may be re-routing its advertisement spends, (by paying Focus media to buy its products) to conduct the fraud in its revenue and store-level profits.
  • Revenue from other products: Luckin Coffee allegedly inflated its revenue from the sale of other products. However it was found that coffee is charged to VAT@6% in China, while other products are charged@13%. This implies that there must be an increase in the VAT payment made by Luckin. However, Luckin’s regulatory filings make it evident that the tax payments had not increased, implying a fudging with the sale figures.

Image: Luckin’s reported VAT cannot match reported operating data

  • Fraudulent Management Practices: Several flaws in Luckin Coffee’s management were also alleged, including related party transactions by Chairman Charles Zhengyao Lu, co-founder Fei Yang’s imprisonment for illegal past business operations and management cashing out 49% of their holdings.
coffee

Image: From prisoner to Luckin Coffee’s CMO – Fei Yang

  • Flawed business model: Luckin’s very business model is allegedly flawed, since China’s caffeine intake is much less than other Asian Countries. It was alleged that its customers are highly price sensitive and their abundance directly corresponds to its generous practices of doling out discounts. High Compliance risk is amongst other highlighted facts.
coffee

Image: Luckin Coffee intends to changeChina’s low caffeine consumption habits

The Way Forward Premium coffee

The bad news continues to take its toll on Luckin Coffee. While stock prices continue to tumble, the company’s very existence and survival is under threat. However, there’s one striking aspect, which makes us believe that there’s a fair chance that Luckin might still be able to survive the rumble.

Mobile intelligence service Apptopia reports suggest that the Luckin iOS App is currently experiencing a major toll in downloads. The number of app downloads has grown exponentially, as presented in the following graph:

The reason behind the phenomenon is believed to be the Chinese Population’s inclination towards indigenous brands, as against American rivals like Starbucks. A reporter at Chinese News network SupChina reported that loyal customers of the coffeehouse stood unfazed by the scandal, and shall appreciate every second of Luckin while it lasts. Individuals living on limited budgets are unwilling to lose an affordable alternative to Starbucks. People are also rushing to Luckin Stores to redeem prepaid orders and discount vouchers on fears of the company’s prospective bankruptcy.

However, the bigger question persists – Will the company survive the Regulatory and Legal heat, or would it go down in flames? In either case, the Luckin Coffee fraud is a landmark accounting fraud and shall be cited amongst the list of major accounting frauds in the aeons to come.

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