×

Investor confidence tumbles amid Luckin Coffee’s fraud scandal

April 21, 2020
Editor(s): Jiamin Fang
Writer(s): Richard Yuan, Nuoya Liu

Luckin Coffee is a Chinese coffee company founded in Beijing in 2017. This new coffeehouse chain entrant opened its first few trial shops in January 2018 and continued to invest aggressively in rapid market expansion by spending almost three times as much as it earned to feed the growth. By October that year, Luckin coffee has beaten Costa Coffee, a multinational coffee franchiser, in the number of stores, rendering itself the second-largest coffee brand in China. With an ambitious goal of taking over Starbucks’ leading position, 4507 stores were opened in the past two years till early 2020, accompanied by the announcement of two new technical products – Luckin Coffee EXPRESS and Luckin Pop MINI – targeting the self-service market. Different from traditional coffee franchises (e.g. Starbucks), the brand has a strong focus on technology with physical locations only allowing for making coffees and fulfilling pick-up-only online orders with little customer service. This operation principle is targeted at the fast-paced lives of Chinese students and working classes, capturing a new generation of customers through its convenience and competitive prices. Following the initial success, it has gained exposure in the US stock market and started to trade on Nasdaq at $17 a share, which later reached a first-day closing price of $25.96.

On 2 April 2020, Luckin Coffee announced that an internal investigation had revealed that approximately 50% of the profit for the last three-quarters of 2019 were fictitious sales. This amount was estimated as being around 2.2 billion Yuan. The company’s shares suffered a major decline of around 75.6% in value.

Three days after the disclosure of the fabricated sales, investors sold off 447 million Luckin Shares on the market and trading was suspended on Nasdaq. Some blame was placed on the founder and Chairman Lu Zhengyao. Many have brought up that his focus on rapid expansion and engagement in reckless expansion by taking on risky heavy debt have led to this current situation. According to Goldman Sachs, the chairman defaulted on a loan worth $518 million USD, with lenders preparing to sell about 76.4 million shares to secure the loan. However, a majority of the responsibilities were claimed to be held by the former Chief Operating Officer, Jian Liu, who was suspended, along with several people reporting to him. Moreover, an investigation has been established to examine the activities of Jian Liu in order to provide more information regarding the 2.2 billion financial fabrication. Nevertheless, many remain doubtful about how the board could fail to take notice of such a massive amount.

Inevitably, Luckin is going through a hard time amid the scandal. Its acquisition of a $2.5 billion fund from Centurium Capital, a three-year-old Chinese private equity firm that has a sizeable investment in Luckin, was put on hold. Banks who have extended loans to Luckin are also now under considerable pressure to buy the stock on margin. They could suffer a loss of up to $100 million as a result of a structured loan to one of the company’s executives. The legal ramifications for Luckin are also striking the company hard, especially amid the downturn for the beverage industry caused by the coronavirus outbreak. Up till present, many suits against the company have been filed by law firms, each making allegations of its own. Further, dozens more are planning to file lawsuits, either on behalf of investors or other shareholders affected by the scandal.

Other than the immediate legal and financial consequences for Luckin Coffee, the fraud is likely to have some long-term spillover effects on all other Chinese companies, especially the 15 that are currently intending to raise $10-125 million in the US. On one hand, equity financing becomes more difficult as investors, who have witnessed or even suffered financial losses from Luckin’s financial misconduct, will undeniably suspect similar behavior from other Chinese corporations. Journalists from major financial reviews have also examined past confirmed Chinese frauds and directly warned market participants to watch out for any unusual cash balances, as Chinese companies are reportedly good at hiding their profits there. As a result, the authenticity of any high growth figures or new business models put forward by Chinese companies will elicit doubt from investors, making new listings with desirable valuations more challenging. On the other hand, debt issuance may also become out-of-reach for many companies, as the higher rates of return required by potential lenders – due to the greater perceived risks – may no longer be affordable.

In addition to the deterioration of investor trust, regulatory pressures are also building up to limit the success of Chinese companies overseas. It is likely that greater scrutiny of accounting documents will be required and tighter oversight of China-based auditing firms will be put in place to prevent the occurrence of future scandals. Partly owing to the ongoing tension between the two countries, there have also been increasing calls for restrictions on the listing of Chinese companies in the US market (IPOs), as well as greater stress on IPO advisors, banks, and other professionals to perform their roles with due diligence.

Despite the damage Luckin has made to the international reputation of Chinese companies, it surprisingly received extensive support from its domestic customers. This is in part, due to the consumers’ nationalism against Starbucks, which is magnified by their ongoing resentment toward the US since the onset of the trade war. In fact, many are proud that their home-born coffee chain could rival its American competitor, and claimed that they would still regard Luckin as a “national champion as long as it corrects its mistake”. The other factor contributing to the sales boost after the scandal is the heavy discounting and coupons Luckin introduced to drive its exponential growth in the past few years. Pre-paid customers, after hearing about the company’s sales fabrication, became concerned that the coupons would soon lose their values after the company goes bankrupt. As a result, sales experienced a temporary hike as customers rushed in to redeem their coupons. Additionally, Luckin’s low pricing – a cup of coffee at Luckin’s could be sold at 5 to 10 Yuan cheaper than at Starbucks – also attracted a loyal fan base that is likely to help the company in this difficult time.

References

Caplinger, D. (2020, 2020-04-08).  “What’s with all the lawsuits against Luckin Coffee”. Retrieved from https://www.fool.com/investing/2020/04/08/whats-with-all-the-lawsuits-against-luckin-coffee.aspx

Crichton, D. (2020, 2020-04-07). “Luckin Coffee’s alleged fraud has some silver linings (and even more bad news too)”. Retrieved from https://techcrunch.com/2020/04/06/luckin-coffees-alleged-fraud-has-some-silver-linings-and-even-more-bad-news-too/

Crichton, D. (2020, 2020-4-3). “Luckin Coffee’s board initiates investigation into $300M potential fraud”. Retrieved from https://techcrunch.com/2020/04/02/luckin-coffees-board-initiates-investigation-into-300m-potential-fraud/

Garcia, T. (2020, 2020-4-3). “Luckin Coffee shares plummets 75% after financial misconduct investigation launched”. Retrieved from https://www.marketwatch.com/story/luckin-coffee-shares-plummet-72-after-financial-misconduct-investigation-launched-2020-04-02?fbclid=IwAR2AEgeY3vEkGTluca1H1MgHcPEdndBV3U2MQNtlyNiPtyi_HWSaNhYLUv0

Li, J. (2020, 2020-04-06). “Luckin Coffee, China’s Starbucks rival, is getting a nationalist boost amid a huge fraud scandal”. Retrieved from https://qz.com/1833297/fans-rally-to-aid-chinas-luckin-coffee-after-fraud-scandal/

Moon, L & Bay, C. (2020, 2020-4-7). “Luckin Coffee lenders seek to sell over 76 million shares after chairman defaults on loan”. Retrieved from https://www.scmp.com/business/companies/article/3078691/luckin-coffee-lenders-seek-sell-over-76-million-shares-after

Stevenson, N. (2020, 2020-4-16). “Luckin Coffee scandal highlights murky standard of China Inc”. Retrieved from https://asia.nikkei.com/Opinion/Luckin-Coffee-scandal-highlights-murky-standards-of-China-Inc

Wang, Y. (2020, 2020-4-10). “China Stocks Face Increased Scrutiny After TAL Education and TAL Education And Luckin Coffee Reveal Inflated Sales”. Retrieved from https://www.forbes.com/sites/ywang/2020/04/10/china-stocks-face-increased-scrutiny-after-tal-education-and-luckin-coffee-reveal-inflated-sales/#5aa950bd51b2

Xinyue, S. et al. (2020, 2020-04-20). “In depth: investors sip the bitter taste of the luckin coffee scandal”. Retrieved from https://www.caixinglobal.com/2020-04-20/in-depth-investors-sip-the-bitter-taste-of-the-luckin-coffee-scandal-101544557.html

Yang, J & Griller, H. (2020, 2020-4-17). “Luckin Coffee’s accounting scandal thwarts Backer’s $2.5 Billion Fund”. Retrieved from https://www.wsj.com/articles/luckin-coffees-accounting-scandal-thwarts-backers-2-5-billion-fund-11587109890

The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ, our Partners and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.