Luckin Coffee: From Brewing Coffee to Cooking the Books

Luckin’s shares fell more than 83% over the last week, wiping out 75% of its market cap

Luckin Coffee, a China-based coffee chain listed in the US stock exchange, has made a remarkable journey since its inception in October 2017. It competes with Starbucks in China and has followed a money-is-no-object approach to capture market share and expand rapidly. Below is a chronological list of events that led to Luckin’s current crisis, which could potentially catapult the loss-making company into bankruptcy in the worst-case scenario.

Between June 2018 and Apil 2019, Luckin raised US$550 million from investors like investment bank China International Capital Corporation (CICC), Singapore’s sovereign wealth fund GIC, and BlackRock, according to Crunchbase. The company was valued at approximately $2.9 million dollars after the last investment in April 2019.

On May 16, 2019 the then-19-month-old startup raised $571.2 million by selling 33 million shares at the company’s Initial Public Offering (IPO) price of $17 a share. The next day, Luckin started trading publicly on Nasdaq under the ticker LK, and opened at $25 a share. The company later reported that after fully exercising the greenshoe option, its total fundraise from the IPO was $645 million.

The company was valued at approximately $4 billion at IPO and had 2,370 stores at the time, according to Luckin’s IPO filing. However, the company had reported a loss of $475 million with a revenue of $125 million in FY2018.

On November 13, 2019 Luckin announced its unaudited financial results for the third quarter (Q3) of 2019. Luckin reported a net loss of $74.4 million and net revenue of $215.7 million for the quarter. At the end of the quarter, the company had 3,680 stores operating in China.

In December 2019, Luckin, which owned just over 4,500 stores, overtook Starbucks to become China’s biggest coffee chain by number of stores. It planned to reach 10,000 stores by 2021.

On January 15, 2020 Luckin announced that it had raised a total of approximately $752 million in a post IPO equity funding round, following that up quickly on January 17 with the issue of more American Depositary Shares (ADS), pushing the company’s net proceeds to $865 million.

Things got interesting when an 89-page-long anonymous report became publicly available on January 31, 2020. The report alleged that Luckin had indulged in fraud and had an “inherently flawed” business model. The author of the report claimed to have store traffic surveillance video that suggests that Luckin inflated its per-diem sales numbers in Q3 and Q4 of 2019. The report also claimed that Luckin inflated its net selling price per item by at least 12.3%, overstated its advertising expenses by at least 150%, and manipulated net revenues from other products in 2019 Q3.

Things took a dark turn for Luckin as its share price began to plunge following the allegations. On February 3, 2020 Luckin responded to the report saying that it contained ‘misleading and false allegations.’ According to the press release, the ‘meritless’ report was published by a short seller looking for profit, and Luckin categorically denied all allegations.

On April 2, 2020 Luckin announced the formation of a “Special Committee” to oversee an internal investigation into Chief Operating Officer (COO) and Director Jian Liu and several employees reporting to him. According to the report, Liu, who had been COO since May 2018, along with employees reporting to him, fabricated transactions from Q2 to Q4 of 2019. The inflated sales for the two quarters amount to approximately $310 million–equivalent to 40% of its annual sales estimate.

The press report asked investors to disregard the company’s financial statements and earnings releases for Q1 through Q3 of 2019. The responsible employees, along with Liu, have been suspended.

Following Luckin’s announcement of investigation into manipulated financial data, Luckin’s shares nosedived. Over the past week, the company’s shares have fallen as much as 83%, wiping out almost 75% of its market cap, which now lies at $1.11 billion.

On April 5, Luckin issued an apology in Chinese on social media platform Weibo. According to the statement, Luckin reserved the right to take legal action against Liu and other Luckin employees involved in the fraud, and the company would not attempt to cover up the incident.

“The company will also deeply reflect and repent, and strengthen our internal controls,” the statement added.

Following the publication of apology, Luckin Chairman Lu Zhengyao said on Weibo that he was “ashamed” and accepted all questions and criticisms.

“I personally blame myself. Regardless of the final findings of the independent committee, I will bear the responsibility that I ought to,” said Mr. Lu in his Weibo post, according to Financial Times.

According to mobile intelligence service Apptopia, Luckin’s iOS app downloads skyrocketed since the declaration of fraud. Social media posts point to one of two reasons behind this phenomenon–either it was a display of Chinese solidarity against American rival Starbucks, or it was a show of support for Luckin’s heavily discounted products, which make coffee more affordable for consumers.

Chinese government newspaper People’s Daily denounced Luckin’s financial fraud for harming investors and the “overseas reputation of Chinese companies.”

There maybe some truth to that claim, as Credit Suisse, one of the underwriters of Luckin’s Nasdaq IPO last year, withdrew its sponsorship for the planned listing of Tencent-backed WeDoctor. Western investment banks may have become warier of risking their reputations on Chinese companies in light of such cases.

On April 6, 2020, one of Luckin Chairman Zhengyao’s family-owned companies defaulted on a $518 million margin loan, according to Goldman Sachs. Following this, Zhengyao, along with Luckin Founder and Chief Executive Officer (CEO) Jenny Zhiya Qian, surrendered their shares in the company. Although the sale will not affect Zhengyao’s voting interest, Qian, who has a 20% stake in Luckin, stands to lose significant voting interests, according to Goldman.

Luckin, whose share value further erodes with every new day, is expected to have a weakened cash position since it is unlikely that pre-paid customers would add to the company’s revenue stream. Options to raise external funding have also significantly reduced due to the fraud case.

Already, law firms in the US are recruiting investors to join a Class Action Suit against Luckin to recover damages under U.S. Federal Securities law.

Much of what will happen next is going to depend on the extent of the financial fraud perpetrated by Liu, and its financial ramifications on Luckin. The company may have to restructure or downsize to deal with the financial burden. More importantly, Luckin will have to take great efforts to regain the trust of investors and other financial institutions and authorities.

Header image courtesy of Shwangtianyuan on Wikimedia Commons.

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