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Luckin Coffee: Fraud + Fundamentally Broken Business
When Luckin Coffee (NASDAQ: LK) (“Luckin” or the “Company”) went public in May 2019, it was a fundamentally broken business that was attempting to instill the culture of drinking coffee into Chinese consumers through cut-throat discounts and free giveaway coffee. Right after its USD 645 million IPO, the Company had evolved into a fraud by fabricating financial and operating numbers starting in 3 rd quarter 2019. It delivered a set of results that showcased a dramatic business inflection point and sent its stock price up over 160% in a little over 2 months. Not surprisingly, it wasted no time to successfully raise another USD 1.1 billion (including secondary placement) in January 2020. Luckin knows exactly what investors are looking for, how to position itself as a growth stock with a fantastic story, and what key metrics to manipulate to maximize investor confidence. This report consists of two parts: the fraud and the fundamentally broken business, where we separately demonstrate how Luckin faked its numbers and why its business model is inherently flawed.
Part One: The Fraud
Smoking Gun Evidence #1: Number of items per store per day was inflated by at least 69% in 2019 3Q and 88% in 2019 4Q, supported by 11,260 hours of store traffic video. We mobilized 92 full-time and 1,418 part-time staff on the ground to run surveillance and record store traffic for 981 store-days covering 100% of the operating hours. Store selection was based on distribution by city and location type, the same as Luckin’s total directly-operated store portfolio.
Smoking Gun Evidence #2: Luckin’s “Items per order” has declined from 1.38 in 2019 2Q to 1.14 in 2019 4Q.
Smoking Gun Evidence #3: We gathered 25,843 customer receipts and found that Luckin inflated its net selling price per item by at least RMB 1.23 or 12.3% to artificially sustain the business model. In the real case, the store level loss is high at 24.7%-28%. Excluding free products, actual selling price was 46% of listed price, instead of 55% claimed by management.
Smoking Gun Evidence #4: Third party media tracking showed that Luckin overstated its 2019 3Q advertising expenses by over 150%, especially its spending on Focus Media. It’s possible that Luckin recycled its overstated advertising expense back to inflate revenue and store-level profit.
Smoking Gun Evidence #5: Luckin’s revenue contribution from “other products” was only about 6% in 2019 3Q, representing nearly 400% inflation, as shown by 25,843 customer receipts and its reported VAT numbers.
Red Flag #1: Luckin’s management has cashed out on 49% of their stock holdings (or 24% of total shares outstanding) through stock pledges, exposing investors to the risk of margin call induced price plunges.
Red Flag #2: CAR Inc (HKEX: 699 HK) (“CAR”) déjà vu: Luckin’s Chairman Charles Zhengyao Lu and the same group of closely-connected private equity investors walked away with USD 1.6 billion from CAR while minority shareholders took heavy losses.
Red Flag #3: Through acquisition of Borgward, Luckin’s Chairman Charles Zhengyao Lu transferred RMB 137 million from UCAR (838006 CH) to his related party, Baiyin Wang. UCAR, Borgward, and Baiyin Wang are on the hook to pay BAIC-Foton Motors RMB 5.95 billion over the next 12 months. Now Baiyin Wang owns a recently founded coffee machine vendor located next door to Luckin’s Headquarter.
Red Flag #4: Luckin recently raised USD 865 million through a follow-on offering and a convertible bond offering to develop its “unmanned retail” strategy, which is more likely a convenient way for management to siphon large amount of cash from the company.
Red Flag #5: Luckin’s independent board member, Sean Shao, is/was on the board of some very questionable Chinese companies listed in the US that have incurred significant losses on their public investors.
Red Flag #6: Luckin’s co-founder & Chief Marketing Officer, Fei Yang, was once sentenced to 18 months’ imprisonment for crime of illegal business operations when he was the co-founder and general manager of Beijing Koubei Interactive Marketing & Planning Co.,Ltd. (“iWOM”). Afterwards, iWOM became a related party with Beijing QWOM Technology Co., Ltd. (“QWOM”), which is now an affiliate of CAR and is doing related party transactions with Luckin.
Part Two: The Fundamentally Broken Business
Business Model Flaw #1: Luckin’s proposition to target core functional coffee demand is wrong: China’s caffeine intake level of 86mg/day per capita is comparable to other Asian countries already, with 95% of the intake from tea. The market of core functional coffee product in China is small and moderately growing in China.
Business Model Flaw #2: Luckin’s customers are highly price sensitive and retention is driven by generous price promotion; Luckin’s attempt to decrease discount level (i.e. raise effective price) and increase same store sales at the same time is mission impossible.
Business Model Flaw #3: Flawed unit economics that has no chance to see profit: Luckin’s broken business model is bound to collapse.
Business Model Flaw #4: Luckin’s dream “to be part of everyone’s everyday life, starting with coffee” is unlikely to come true, as it lacks core competence in non-coffee products as well. Its “platform” is full of opportunist customers without brand loyalty. Its labor-light store model is only suitable for making “Generation 1.0” tea drinks that have been in the market for more than a decade, while leading fresh tea players have pioneered “Generation 3.0” products five years ago.
Business Model Flaw #5: The franchise business of Luckin Tea is subject to high compliance risk as it’s not registered with relevant authority as required by law, because Luckin Tea launched its franchise business in September 2019 without having at least two directly-operated stores fully operational for at least 1 year.
Part One: The Fraud Starting 3 rd Quarter, 2019
“The stock’s gains have almost all come in the past two months, after the company said it had become profitable at a store level in the quarter through September.”
- Jacky Wong, Wall Street Journal January 9 th , 2020
Smoking Gun Evidence #1: Number of items per store per day inflated by 69% in 2019 3Q and 88% in 2019 4Q, supported by 11,260 hours of store traffic video
Reported number of items per store per day: 444 in 2019 3Q, and 483-506 in 2019 4Q
Source: Luckin 2019 3Q Earnings Release Presentation, page 16
Our offline tracking results of tracking 981 store-days from 2019 4Q showed 263 items per store per day only:
No. of items per store per day
600
495
500
444
400
361 345
292 285
300
244
263 200
109
100
-
1Q18 2Q18 3Q18 4Q18 1Q19 2Q19 3Q19 4Q19E Store
Video
Tracking
from 4Q19 Source: Luckin filings, offline footage tracking
We mobilized 92 full-time and 1,418 part-time staff on the ground to run surveillance and successfully recorded store traffic for 981 store-days covering 100% of the operating hours of 620 stores. Store selection methodology was based on distribution by city and location type, the same as Luckin’s 4,507 directly-operated stores reported to be open at the end of 2019. Luckin’s 4,507 stores were in 53 cities, and we covered 38 cities – in which 96% of Luckin’s stores are located. The location type was decided by analyzing the detailed address of Luckin’s stores: we separated them into office, mall, school, residential, transportation, hotel and others.
We counted the foot traffic of each store and recorded videos from store open to store close, averaging 11.5 hours per day. When we double check the foot traffic count and the videos recorded, we discard an entire day’s data if the video surveillance is missing more than 10 minutes of footage. Our success ratio was only 54%, and thus all the data presented for the successful ones are of 100% integrity.
Below is a side-by-side comparison of the city, location type and store age of: 1) The overall Luckin directly-operated stores portfolio (we located 4,409 of them on Luckin’s APP as of Dec 31, 2019); 2) The 981 store-days that we successfully executed and presented in the data analysis; 3) The 851 store-days that we visited but failed to record an entire day’s video, reasons including execution failure - asked out by Luckin staff, equipment crash etc. or quality control failure, mostly due to more than 10 minutes of footage missing for an entire day. The failed store-days are not included in the data analysis. 4Q2019: 483 – 506, implied by 4Q Guidance Product Revenue Guidance of RMB 2.1 billion to RMB 2.2 billion, divided by Net selling price per item of RMB 11.8 (Assuming Luckin to report 5% sequential growth from 2019 3Q of RMB 11.2) and average store number of 4,094
Luckin Directly-Operated Stores
# City Store No. Store%
Office Mall Others
Visited S
Days No.
tore Days (Successful)
Days%
Office Mall Others
Visited S
Days No.
tore Days (Failed)
Days%
Office Mall Others
1
Shanghai
525 12% 61%
26%
12%
131 13%
64%
18%
18%
145 17%
60%
15%
25%
2
Beijing
432 10% 63%
15%
22%
115 12%
49%
27%
24%
117 14%
52%
23%
25%
3
Guangzhou
271 6% 62%
20%
18%
63 6%
83%
5%
13%
55 6%
80%
7%
13%
4
Shenzhen
234 5% 79%
12%
9%
55 6%
76%
16%
7%
50 6%
80%
12%
8%
5
Hangzhou
230 5% 66%
14%
20%
15 2%
93%
7%
0%
15 2%
87%
0%
13%
6
Nanjing
215 5% 58%
23%
19%
37 4%
68%
27%
5%
36 4%
53%
25%
22%
7
Chengdu
192 4% 58%
23%
19%
43 4%
56%
23%
21%
26 3%
42%
23%
35%
8
Wuhan
180 4% 45%
35%
20%
44 4%
43%
41%
16%
42 5%
45%
40%
14%
9
Chongqing
158 4% 47%
28%
25%
61 6%
56%
31%
13%
29 3%
66%
28%
7%
10 Tianjin
147 3% 64%
26%
10%
47 5%
55%
38%
6%
17 2%
41%
41%
18%
11 Xi"an
133 3% 59%
24%
17%
52 5%
56%
31%
13%
22 3%
45%
41%
14%
12 Changsha
116 3% 47%
30%
22%
12 1%
33%
50%
17%
30 4%
27%
30%
43%
13 Suzhou
115 3% 46%
41%
13%
30 3%
47%
47%
7%
3
0%
0%
67%
33%
14 Wuxi
108 2% 56%
27%
18%
8
1%
63%
0%
38%
14 2%
57%
...
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