On April 2, Luckin Coffee (LK:NASDAQ) announced that its COO, Liu Jian, is suspected of manipulating sales volumes to the value of CNY 2.2 billion (USD 310 million) from the second to the fourth quarter of 2019, according to the results of its internal investigation.
Driven by this, the stock price of the Chinese coffee chain shrank by over 80% premarket, to USD 4.91.
The company has formed an independent special committee to watch over the internal survey on audit issues. Meanwhile, the committee has proposed several temporary remedies, including suspensions of Liu Jian and other related employees, and terminating the contracts and transactions with all the parties involved in this scandal.
On April 3, The China Securities Regulatory Commission (CSRC) issued a statement (in Chinese), paying close attention and strongly condemn the financial fraud of Luckin Coffee. The commission will investigate the issue involved in accordance with the relevant arrangement of the International Organization of Securities Commissions (IOSCO).
On top of the law and business ethics issue, another serious issue would be: does the cash burning business model of Luckin Coffee work?
EqualOcean previously raised questions over the issue after the coffee chain published its third-quarter 2019 report, and now it seems like we were not alarmist.
The original expectation for the sales revenue of Luckin Coffee in 2019 would have been around CNY 4.98 billion, if we used the CNY 2.1 billion – CNY 2.2 billion projections in the fourth quarter that the board noted during the third quarter's earnings call.
This implies that the revealed misconduct accounts for about 45% of its total revenue from products for the entire year.
Recap the major findings that Muddy Waters Research pointed out in its famous short report on the Chinese coffee chain published at the end of January 2020, that “the average daily total items sold decline from the second quarter of 2019 to the fourth quarter of 2019, and the effective average selling price was inflated in the third quarter of 2019.” The problem underlying the Luckin business model was more or less being confirmed around this time.
Seeing through the emperor’s clothes in this case, we see the current failure of its heavily subsidized strategy, where a considerable part of its huge sales and marketing expenditures was inefficient.
The thousands of new offline stores Luckin Coffee opened in 2019 under its ambitious expansion were the vanguard of a strategy aiming to beat Starbucks in the mainland; in fact, this hardly injected decent growth into its business at all, and these new stores began to look like a liability.
Meanwhile, the situation might be even worse for those older outlets, some of which are very likely to have negative quarter-to-quarter growth over the past year due to poor repurchase rates caused by Luckin’s ineffective marketing campaigns – the lack of real growth in the business being a sign of said weakness, leading to certain of the company’s executives attempting to spin such an audacious fraud.