Luckin Coffee: out of luck
Luckin Coffee seemed too good to be true. It was.
The company, China’s answer to Starbucks, stunned investors last week when it announced that an internal investigation had found that Rmb2.2bn ($310.7m) of its sales from the second to fourth quarters last year were nothing but hot air. The company’s shares, listed on the Nasdaq in May 2019, fell 81% as a result.
The news is a blow to Chinese listings in the US, a once-crucial source of deal flow that has already been undermined by the trade war. But it also raises questions about how discerning investors really are when it comes to the latest piping hot deal and how difficult it is for banks to conduct thorough due diligence on Chinese companies.
Luckin managed to capture the attention of global fund managers by ballooning from a coffee chain with a handful of locations in 2017 to one with nearly 2,400 by the time of its IPO in May last year. Among its pre-IPO backers were BlackRock, Singapore’s sovereign wealth fund GIC and China International Capital Corp. All three did not respond to requests for comment from GlobalCapital Asia.
Luckin’s pitch was fundamentally that of a technology start-up: a high cash burn in order to rapidly gain market share, leaving the thorny question of profitability until later. The company’s impressive sales numbers for the nine months to September-end last year — now known to be largely false — justified a further $979.6m fundraising through a combined convertible bond-share sale in January.
But despite the shock of the alleged fraud, which has been blamed on a senior executive and several employees reporting to him, investors should have recognised that its business model was unsustainable from the start. GlobalCapital Asiawarned a year ago that the valuations ‘carried a lot of froth’.
Luckin has thousands of locations but most are small with little more than a pick-up counter — orders are made through its smartphone app. The company’s primary tactics to attract customers are to offer discount coupons and promotions with purchases and provide a delivery service. But how likely was it that customers would continue to be loyal when prices went up?
Investors’ spirits seemed buoyed at the time of the IPO by the potential size of the domestic market. This is common with Chinese growth stories: the huge population means all growth plans are raised exponentially. Investors’ willingness to rely on hope seems to grow at the same rate.
But to say the least, coffee is not a dominant drink in the country and the idea of ‘if everyone had a cup’ is a naïve one that forgets how competitive food and beverage and most other sectors are in China.
Luckin has done well to focus attention on its contrast with Starbucks. But that is not its only competitor, nor really a direct competitor. Starbucks is a well-established name in China and is not only a place to buy a coffee, tea or light food, but is also seen as a place to meet or to get work done.
Luckin declined to comment.
The flow of Chinese companies listing in the US — through IPOs of American Depositary Shares (ADS) — had been suffering before Luckin’s debacle became public. The weight of the US-China trade war has reduced demand from US investors and subsequently the vast majority of Chinese ADS listings this year and toward the end of 2019 have been below $100m, in some cases having their sizes revised down.
But Luckin’s debacle only strengthens the US congressmen who have been calling for mass forced de-listings of Chinese companies from America’s stock exchanges because they can’t be trusted. The mood will not be helped by another incidence of suspected fraud this week, from US-listed Chinese company TAL Education.
There should be no reason to assume any company is involved in fraudulent activity without evidence. But due diligence should start from a position of scepticism, not hope. More than anything the Luckin scandal is a reminder that this is not always the case.
The standard argument for a Chinese company listing in the US is that investors there are much better at understanding and valuing high-growth companies. This is usually true, especially in comparison to the often irrational retail investor base that drives Chinese equity prices.
But those famously smart US investors seemed not to ask tough enough questions in this case. Investors should not be expected to predict fraud. They can be expected to ask whether a discount coffee company should be valued like a tech start-up.
There are concerns that Luckin’s woes will reflect poorly on US-listed Chinese companies as a whole, but the chances are investors will forget about the episode soon enough. A similar situation to Luckin’s fraud occurred in late 2010, when Rino International Corp, a firm based in the city of Dalian in Liaoning province, was accused of cooking its books by a short-seller report. It ended up being delisted from the Nasdaq after admitting wrongdoing.
The following year saw a wave of Chinese companies delisting from US stock exchanges for various reasons. Among them were China Media Express Holdings and Longtop Financial Technologies, both of which had their listing status cancelled following alleged fraud charges.
The incidents put many Chinese IPOs on hold at the time as investors turned cautious. But the market recovered ─ and it will do the same again. Whether investors will start asking tougher questions in the future remains to be seen.