Discussions after the Luckin Fraud: Interview with Adam Li, Partner of Panda Capital [1/3]
"Shame on Luckin for the misconduct – while still being bullish on its business logic," Adam Li – Founding Partner of Panda Capital – remarked.
The article is translated by EqualOcean from the Chinese version published on the official WeChat account of iyiou.com, our Chinese website.
On April 2, Luckin Coffee announced its turnover had been inflated by CNY 2.2 billion (USD 309 million) between the second quarter and the fourth quarter of 2019. During the two-month period between the publication of the short-side report by Muddy Waters Research in February to its stock being halted on April 7, its market share fell by nearly 80% from a previous historical high.
The negative influence of Luckin’s incident continues to spread. On the same date that Luckin’s stock was suspended by the US Securities and Exchange Commission (SEC), Muddy Waters Researches and Wolfpack Researches jointly released a short-side report that took aim at iQiyi (IQ:NASDAQ) – a Chinese streaming firm. Meanwhile, TAL Education (TAL:NYSE) disclosed it had been probing a sales fraud. The US-listed Chinese stocks are facing a ‘collective crisis.’
In response to the Luckin incident, a number of articles have already been published by information service providers that walk through the background of the misconduct and discuss the potential impact on the listing of Chinese companies in the US market.
EqualOcean also replayed its financials to investigate Luckin’s store-level operating performance adjusted for the CNY 2.2 billion misconduct, and examined how did it strategies work in 2019. Please click here to explore more.
In the interview with Adam Li, Founding Partner of Panda Capital, we discussed the market reactions to the Luckin incident (which will be addressed in this part), the value of Luckin’s business, the future of the industry landscape (these two topics can be found in Part 2/3), the potential future strategies of Luckin and the impact of the incident on the investment industry (for these two, please take a look at Part 3/3), to dive into the issue from the perspective of an institutional investor.
Where did the problems of Luckin Coffee lie?
Q: Where did the CNY 2.2 billion turnover misconduct come from?
Adam Li: Before we move on, it should be first noted that it is a very negative practice for any company to engage in any kind of financial fraud. The turnover manipulation of Luckin has imposed a serious impact not only on itself, but also on Chinese firms aiming to go public overseas in the future and those who have already listed overseas, downgrading their credibility and goodwill.
Back to Luckin itself. When the incident broke out, I saw most of the voices were crowded at the level of emotional venting rather than rational discussions on the value of its business.
We have tried to analyze how the fake accounts came about. One possibility is that Luckin recognized in advance a portion of revenue that is yet to be eligible for revenue recognition. It may be that it accounts for the unredeemed vouchers in users’ ‘coffee wallet’ as turnover. However, the possibility has been ruled out as it is shown in the company’s prospectus that revenue will only be recognized when the products are handed over to the customer.
We then shifted to another perspective to see if historical financial reports can tell us something. We found that the number of Luckin stores nearly doubled since its IPO in the first quarter of 2019. However, the number of orders per store and the revenue per store that was generated from coffee was growing much slower than the number of stores. The relevant members of Luckin wanted to make the two grow at the same pace in the book, so they inflated the figures. As there were no explanations from the company’s side on where the falsified turnovers came from, for now, let’s just project it as so.
Q: What has been the biggest problem for Luckin up to now?
Adam Li: From a macro point of view, China’s coffee market is growing at 30% annually. The company that can benefit the most from market growth should be the one that can reach out to more customers. Through opening stores aggressively, Luckin now has more than 4,500 stores in mainland China – even surpassing Starbucks. In fact, it has the potential to benefit more than Starbucks from this rapidly growing market. From this perspective, Luckin’s strategy of aggressively expanding its number of stores is right to some extent.
The cost structure of Starbucks and Luckin is not really that different. Taking Starbucks as a benchmark, coffee is a category that has enough room for a gross margin, and after deducting a series of operating costs, a certain level of margin can still be maintained. Plus, coffee machines and other equipment that can standardize the production. Therefore, coffee has certain advantages over other product categories.
However, after all, as Luckin is doing retail business, there many regular patterns in the industry that any players cannot avoid, and thus, Luckin is also not able to directly take a shortcut.
Based on our continuous tracking of Luckin, our understanding is that it has been moving too fast. On the one hand, perhaps the company has been too eager to surpass Starbucks to become the top coffee chain in China, and its store layer has expanded too fast. On the other hand, Luckin has been too anxious to get into the secondary market – where the fault tolerance is much lower than the primary one – for financing. And correspondingly, the company adopted strategies that tend to be radical (in order to fulfill market expectations), which may cause its growth, in the end, to lose health.
You can explore more insights from our interview with Adam Li regarding the real value of Luckin Coffee (in Part 2/3), the leeway of the company and the impact of the incident on Chinese companies to list in the US and on the PE/VC investment market (in Part 3/3).