INTRO Over the past few years, you might’ve heard
about the push to delist chinese companies from the US stock market if they don’t comply
with US auditing rules.
Initially, this might seem like more of a political move rather than an objective move,
but a lot of evidence would actually suggest that this move is indeed warranted.
One of these examples is a Chinese Starbucks copycat called Luckin Coffee.
Just a few years ago, Luckin Coffee was a booming startup within China that had seemingly
unlocked the key to Chinese coffee lovers.
But all of this would come crumbling down when it was revealed that Luckin was faking
hundreds of millions of dollars worth of sales.
When the news broke, Luckin Coffee plummeted over 97% which wiped out basically every dollar
invested into the company.
So, here’s how Luckin Coffee went from trying to dethrone Starbucks to being delisted from
the American stock market.
LU ZHENGYAO Taking a look back, the entire fiasco circles
back to a man named Lu Zhengyao.
Lu started off his career as a government bureaucrat who served in the Hebei province
located just outside of Beijing.
But, it didn’t take him long to switch over to the private industry in the early 1990s
when he saw technology companies blowing up leading up to the dotcom bubble.
Lu decided to jump in on the action by selling various parts within the telecommunications
industry.
Once the dotcom bubble burst, Lu jumped over to the rapidly growing Chinese auto industry
by selling insurance.
And in 2007, he would open his own car rental company called Car Inc.
Lu was able to raise hundreds of millions from foreign investors and use that money
to offer car rental prices that were unheard of.
Car inc was barely making money given that they were renting out these cars for basically
0 profit, but given that they were undercutting all the competition, it didn’t take long
for Car to build up a massive customer base.
By 2013, Car was the largest rental provider in China and their biggest competitor Hertz
would actually give in by purchasing a 20% stake in the company and merging their operations
with Car.
But just 2 years later, Hertz dumped most of their position in Car, so maybe they knew
something about Lu’s business practices.
But at the time, this was simply written off as a financial move as Hertz was losing hundreds
of millions themselves.
In the meantime, Lu was praised for being a masterful businessman who had the midas
touch.
He had succeeded in the telecommunications, insurance, and rental industries, and his
timing was impeccable.
He knew exactly when to get in and exactly when to get out.
So, when Lu started talking about his vision for a Starbucks like coffee shop, investors
were sold.
LUCKIN COFFEE You see, Starbucks had been trying to break
into the Chinese market for nearly two decades at that point, and though they were able to
grow a pretty sizable operation, they struggled to match their success in western countries.
This wasn’t necessarily Starbucks fault though, the problem was that coffee simply
wasn’t that popular in China.
As of 2018, annual per capita coffee consumption came in at 388 cups in the US.
In China, it was just 6 cups or 64 times less.
Starbucks was well aware of this, and they tried to address this disparity by selling
the social aspect of their shops.
But Lu would take the exact opposite approach.
Lu told the media that he and his colleagues had become coffee lovers as they put in long
days trying to grow Car Inc.
He suggested that coffee was the perfect boost that the Chinese needed to get through long
work days.
And he felt that the only reason coffee hadn’t caught on in China was because of its lack
of affordability as opposed to a lack of demand.
Starbucks hadn’t really reduced their prices when they moved over to China with a grande
latte selling for $4.57 or 32 yuan.
In 2017, the average Chinese citizen was only making about 36,000 yuan.
So, buying a grande latte was equivalent to an American spending $31 on a cup of coffee.
Lu suggested that he could fix this issue by embracing a new coffee shop model based
on kiosks and automation.
Unlike Starbucks locations, Luckin locations had very little seating if any.
They completely eliminated the social aspect and simply focused on reducing cost as much
as possible.
Luckin also required that customers place their orders on the Luckin app which eliminated
the need for cashiers and minimized labor costs.
Lu was hoping to eventually switch to smart vending machines that would completely eliminate
the need for employees altogether, but he quickly ran into a brick wall.
The truth was shrinking the stores and reducing labor costs wasn’t even close to making
up for the revenue disparity.
In 2018, operating expenses were nearly triple sales meaning that Luckin spent nearly $3
for every $1 of revenue.
To make things worse, it didn’t take long for Starbucks to retaliate.
FIGHTING STARBUCKS In 2018, Starbucks formed a partnership with
Alibaba.
Alibaba already had an established delivery network which Starbucks could leverage.
This allowed Starbucks to set up their own kiosk type stores called Starbucks Now with
minimal space and employees.
This significantly increased the pressure on Luckin Coffee, but Lu was still confident
that he just had to sustain the losses for long enough to achieve incredible economies
of scale and become profitable.
But to sustain such losses, he needed the help of foreign investors, so Lu hired an
investment banker named Reinout Schakel.
Reinout was appointed as the CFO of Luckin Coffee and he was the only non-Chinese executive
at the company.
Fortunately for Luckin Coffee, Reinout was able to open some big doors in terms of funding.
By the end of 2018, Luckin was able to raise a total of $400 million with one of their
most notable investors being Singapore's Sovereign wealth fund.
With this influx of capital, Lu was able to retaliate against Starbucks partnership with
Alibaba by forming a partnership with Alibaba’s biggest rival Tencent.
Alibaba might’ve been able to circumvent Luckin’s kiosk model, but Alibaba had no
chance at circumventing Tencent’s order flow.
Tencent is the owner of WeChat which is a super app that is capable of doing everything
from social media to mobile payments.
WeChat is ubiquitous in China boasting a total of 1.2 billion active monthly users.
Luckin could easily advertise coupons and discounts and promote Luckin Coffee to basically
the entirety of China through Tencent.
This was a massive deal and got major investors excited.
In April of 2019 for instance, Luckin raised $150 million, $125 million of which came from
BlackRock.
But the best way to raise money was of course through the irrational public markets.
So, Luckin started working with American banks to take Luckin public.
Bank of America was selected to be one of the underwriters of the IPO, but Bank of America
eventually backed out after Luckin executives demanded for a higher valuation than what
Bank of America gave them.
Nonetheless, Luckin was able to complete their IPO in May of 2019 with the help of Morgan
Stanley and Credit Suisse.
Luckin debuted at $17 per share, but it would quickly rocket to $25 per share by the end
of the first trading day which valued the company at $5.88 billion.
By the start of 2020, Luckin was killing it.
They had overtaken Starbucks in terms of locations.
At the time, Starbucks had 3600 locations while Luckin had 4500.
And Luckin’s quarterly sales growth was through the roof.
In late 2019, Luckin reported a quarterly sales growth of 6x.
It seemed like Lu had done it again and investors piled in confident that they were investing
into the next Starbucks.
By January of 2020, Luckin Coffee stock had grown to $50 per share valuing the company
at $11.8 billion.
To many investors even this was a great price to jump in.
After all, Starbucks is worth $137 billion.
So, even if Luckin was able to grow to half the size of Starbucks, that would be a 5x
investment.
And, this likely would’ve been the case if Luckin wasn’t lying.
As Luckin grew a massive investor base, they also built a massive group of skeptics.
TOO GOOD TO BE TRUE To many investors, Luckin’s growth numbers
were simply way too good to be true.
I mean what type of company grows their revenue 6 fold in a single quarter.
One of these skeptics was a man named Carson Block who was the founder of Muddy Waters
Research.
Carson had correctly exposed another fraudulent Chinese company called Sino Forest Corporation
a decade ago, and he sensed that Luckin was in a similar boat.
But he knew that exposing a company as large as Luckin would be a massive undertaking financially.
It would cost an absurd amount of money to monitor thousands of stores and search for
disparities.
So, Carson didn’t even try to expose Luckin, but someone else did.
An anonymous fund manager had been monitoring Luckin Coffee for a while and had already
uncovered massive disparities.
The fund manager had hired 1000 investigators to monitor the foot traffic at Luckin locations
across China.
These investigators also collected 25,000 receipts from customers to estimate the average
cost of each order.
Using this data, the fund was able to estimate the quarterly sales of Luckin throughout the
third and fourth quarters of 2019.
And the disparity between the estimated sales and reported sales wasn’t 5 or 10%.
No, it was 69% in the 3rd quarter and 88% in the fourth quarter.
It was pretty clear that the Luckin was faking sales, but the fund manager didn't want to
release the evidence himself as he feared the backlash he would receive from investors.
So, he asked Carson to release the report, and Carson would follow through.
As soon as the report debuted in February of 2020, Luckin Coffee plunged.
Luckin Coffee of course refused the allegations and many investors refused to believe it.
But, it didn’t take long for the SEC to get involved, and once the SEC got involved,
Luckin really had no choice but to come clean.
They could’ve waited until the SEC exposed them which would probably take quite some
time given how slow the SEC is.
But, when the SEC did finally expose them, there would be no coming back for Luckin as
the SEC’s findings would completely discredit the entire executive team.
So, Luckin’s executives decided to pin the blame on a couple of executives and hopefully
save face.
On April 2, 2020, Luckin admitted that their numbers were overstated.
They tried to claim that the fraud was carried out by two executives named Jenny Qian and
Jian Liu, but that the rest of the company was clean.
Investors didn’t buy that story and Luckin Coffee stock would jump into the abyss.
In May, Nasdaq announced that they would be delisting Luckin Coffee from the stock market
at the end of June.
And unsurprisingly, Luckin Coffee would plummet to less than a $1 per share.
In July, Luckin Coffee confirmed that $300 million worth of sales was fabricated and
Lu would be ousted that same month.
CNBC estimates that throughout the duration of the fraud, Luckin was able to raise a total
of $864 million which basically evaporated after they were exposed.
And most positions ended up looking like this.
THE AFTERMATH As for Lu, he claims that he was never trying
to deceive investors and that he was just trying to grow Luckin as fast as possible.
And I do think he’s partially telling the truth.
It’s not like he was trying to run a pump and dump.
He was actually trying to grow a long term company, but he succumbed to external pressures
and turned to faking it till he made it.
And unfortunately for Lu, he never made it.
It should be noted though that Luckin Coffee never stopped operations and many bag holders
still think Luckin can make a comeback, but only time will tell.
Do you guys think Luckin can make a comeback or do you think that the company should be
shut down for their deception?
Comment that down below.
Also, drop a like if you agree that foreign companies should be held to the same auditing
requirements as American companies.
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