Luckin fraud admission leaves more questions than answers

Well, here we are. A little over a year after I wrote about Luckin’s fast-and-loose corporate governance and the all-too-cosy nexus between management and venture capital, Luckin has admitted that it used significant sales fraud to prop up its frothy valuation.

But you, dear reader, are more street-smart than that. You know that if there’s anything to be learned about Luckin Coffee, it’s that there’s always more than meets the eye. And as Luckin’s most vocal critic, there’s still a lot I want to know following the company’s recent fess-up.

How much fraud are we talking about, really?

First up, a cross between a cryptic crossword and a reading comprehension test. Luckin’s fraud announcement reads:

The information identified at this preliminary stage of the Internal Investigation indicates that the aggregate sales amount associated with the fabricated transactions from the second quarter of 2019 to the fourth quarter of 2019 amount to around RMB 2.2 billion. Certain costs and expenses were also substantially inflated by fabricated transactions during this period.

In essence, Luckin’s ballparked the revenue-side fraud. RMB 2.2 billion is around USD$310 million, which works out to about half the sales Luckin expected from Q2, Q3, and Q4 2019.

But did you notice the line about “substantial” inflation of “certain costs and expenses”? A lot of commentators didn’t.

This still-unquantified question is critical—if you remember the anonymous short report distributed by short-seller Muddy Waters, it laid out evidence that Luckin’s misdemeanors may extend well beyond double-counted cappuccinos. Specifically, the report claims the company inflated advertising expenses and procured coffee machines at prices above market rates from a business partner of Chairman Lu Zhengyao, both as ways for Luckin’s unscrupulous management team to siphon funds from the company.

Given the report’s current track record and management’s pattern of using fast-growing companies to enrich themselves, investors must ask themselves how big an iceberg is sitting below that $310 million in sales fraud.

How far does the rot go?

You can probably tell that I’m thoroughly unconvinced by the company’s attempt to pin the fraud on its COO and his underlings.

That’s because COO Liu Jian hasn’t got a clear motive. He has very little financial interest in Luckin’s share market performance—in fact, according to Luckin’s pre-IPO prospectus, he’s got a grand total of zero equity in the company. Zilch. Nada. Bupkis. Yes, he’s got a handful of stock options, but just barely enough to incentivize you to come to work early and leave late—nothing close to worth committing fraud and ending your career over.

Chairman Lu Zhengyao and CEO Qian Zhiya, on the other hand, have more skin in the game than a sumo wrestler. Luckin’s initial prospectus reported that Chairman Lu Zhengyao owned 30.53%, an investment fund owned by Lu’s sister (yes, you read that right) owned 12.4%, and CEO Qian Zhiya owned 19.6%.

These shareholders, not Liu, had the most to gain from Luckin’s doctored financial results.

It was Luckin’s better-than-expected Q3 results that precipitated a 160% increase in Luckin’s stock price between November 2019 and January 2020. January, of course, was when the company went back to public markets for an additional capital raise. The prospectus used for that capital raise revealed the Lu Zhengyao, Lu’s sister, and Qian Zhiya have cashed out varying proportions of their shares through stock pledges. In layman’s terms, that’s when you use shares as a security for a loan. By using part of his handsomely-valued Luckin shares as collateral to take out loans, Lu Zhengyao has made away with in excess of $500 million. That amount would have been much, much smaller if Luckin’s numbers were accurately reported.

All this makes it hard to believe that COO Liu Jian would commit fraud without the actual or constructive knowledge Chairman Lu Zhengyao, CEO Qian Zhiya and CFO Reinout Hendrik Schakel. My present hypothesis is that Liu, as a long time errand boy for Chairman Lu Zhengyao, has taken the fall to buy time for Luckin’s management to work out their next move following a quarter rocked by an extended Chinese New Year and COVID-19.

Luckin’s less-than-an-A4-sheet-of-paper response to a damning short report, and its attempt to pin the fraud on an implausible culprit, evidence complete disrespect toward the investment community’s collective intelligence. If you’re in any way involved with Luckin Coffee (and God help you if you are), you shouldn’t be satisfied until the whole board has been replaced, alongside the company’s worse-than-useless auditors.    

Where does Luckin go from here?

Even if Luckin’s numbers were real, the company would still face serious business challenges.

Let’s consider it as a Harvard Business School-style case study:

You’re the incoming CEO of a grab-and-go coffee kiosk business in China. You’ve expanded to 4,500 stores very quickly, but your sales are a mere pimple on those of your established competitor. In January 2020, a bull market and hype around your coffee network has allowed you to raise $800 million in debt and equity to continue fueling your expansion. What do you do?

As I’ve argued before, there’s a semblance of a business case behind Luckin’s freebies and discounts. The largest cost in the China’s coffee and café scene is rent. By running grab-and-go (rather than sip-and-stay) stores, Luckin saves on that expense line item. It pockets some of the savings and reinvests some of the proceeds to entice repurchase and refer new customers, and drives a strong loyalty program for frequent customers with above-average purchase frequency.

Nice in theory. But where that business case falls apart at the seams is its reliance on blitzscaling over physical assets. “Blitzscaling” is Silicon Valley code for the science, art, or witchcraft of rapidly building a company to capture large markets. It usually relies on years of losses underwritten by investors. Wannabe blitzscalers need to operate in large markets, have massive or zero-marginal cost distribution, enjoy high gross margins, and take advantage of network effects—easy enough for a social network or a platform company, but disconnected from reality in the case of people making cups of coffee. That’s been proven in Luckin’s case, where a shaky value proposition outside China’s metropolises and rapid store expansion have made a hot mess of its balance sheet.

Can it come back from the brink?

The recent rush in consumers looking to cash in their Luckin coupons makes it appear like the company’s close to folding. That’s not strictly true. Luckin’s still got enough cash on hand to make a proper go of selling coffee, juice, and beverages. However, Luckin’s ambition and expenditure need to downsize from “Venti” to “Short.” 

If there’s any shred of commercial sense at the company, they’ll take a butcher’s knife to the store network, closing underperforming locations as boldly as they opened them. This would slim down Luckin’s cost profile to something much more manageable.

The turnaround wouldn’t stop there. Luckin’s business lines would need a re-think. The plan to deploy vending machines across the country should be scrapped. Yes, vending machines offer distribution at a lower cost than grab-and-go kiosks, but limit what type of beverages Luckin can sell. High-margin beverages like coffee, milk tea, and juice should be front-and-center and are best sold from kiosks. It can partner up to introduce snacks, meals, and non-beverage products into its offer, rather than going it alone. Most importantly, Luckin will have to put in the hard yards of finding, nurturing, and expanding pools of grab-and-go coffee customers in China. That necessitates pumping the brakes on carpet-bombing coupons and discounts, and a focus on cultivating real loyalty in office precincts.

Make no mistake, this would be a Herculean effort—a turnaround predicated on business smarts and an acute sense of priorities. But Luckin also needs urgently to reclaim investor confidence.

The investment community now knows Chairman Lu Zhengyao and CEO Qian Zhiya profited by pledging their shares for loans. Even with one fraud culprit named and shamed, it’s going to be hard for the Chairman and CEO to claim squeaky-clean corporate governance while they’re at the helm. If they’re serious about Luckin cracking China’s coffee market, they should announce a transition and stagger their exits. Without significant change at the top, Luckin remains a frothy latte with a double-shot of unjust enrichment.