Episode 65 of Tech Buzz China is a special one — a reading of the seventh issue of Extra Buzz, our new biweekly newsletter written by co-host Rui Ma. Listen (and read along) to follow Rui’s thoughts on the biggest story in China tech last week: the alleged fraud of China’s on-demand coffee company, Luckin Coffee 瑞幸咖啡. At its core, we at Tech Buzz believe Luckin is a story of information asymmetry, with voices on either side of the Pacific at times seeming to be telling different stories altogether. Rui explains why investors and other observers who did the proper digging would never have been bullish, or mistaken Luckin for Starbucks.
Dear Tech Buzz Extra Buzzers,
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We talk about public companies all the time, but given the topic, I will reiterate this disclaimer: the following content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Here we go!
How Luckin’s Luck Ran Out
The biggest story in China tech in the last week was the alleged fraud of China’s on-demand coffee company, Luckin Coffee 瑞幸咖啡. I use the word alleged because the investigation is ongoing, although the company has already filed a 6-K with the SEC saying that the preliminary investigations have already uncovered “fabricated transactions” from the second quarter of 2019 to the fourth quarter of 2019 of around $300mm. I mean, the now-known-to-be-unreliable Q2 and Q3 reported results added up together was just $340mm, so there you go, that’s the scale of the fraud we are talking about. And to whom may we owe this heroic effort? The now-suspended COO and his 4 minions. The stock fell about 75% the day of announcement, and as of writing, it’s only inched lower. From over $10Bn just three months ago, when it was trading at $51 right after its concurrent convertible and follow on offering, to $6.5Bn the day before the announcement, Luckin is now hovering at just a tenth of its 52-week high, right around $1Bn in market capitalization.
I absolutely regret not covering this company more on Tech Buzz, but the choice was a conscious one — the company was just so uninteresting. When we first discussed in December 2018, a few months before its IPO and just thirteen months after its founding in November 2017, we called it the “Uber of coffee.” It made sense — the company was founded by a team who had previously launched a car rental and ride-hailing business, now listed on the Hong Kong Stock Exchange, and in either case, it was very obvious this was no Starbucks, even though that’s how it billed itself. Sure, it used an app to do everything, which meant that it was digital from the get go, but the vast majority of its stores were kiosk-like and delivery only, not a cafe but a pickup station. Optimistically, we thought that they were trying to build a new type of F&B business — one that’s digital-first and primarily delivery, which would have made it, in startup speak, a kind of cloud kitchen business. I still think our idea was a sound one. It was, after all, a business that Travis Kalanick, ex-CEO of Uber, was also getting into at the time. And from listening to Tech Buzz you probably know of the many instances where Chinese entrepreneurs have taken a story from the West and localized it for China, like e-cigarettes, esports livestreaming, etc. So I didn’t think of “copying Travis” as too much of a stretch. Plus, even at that early stage Luckin was already expanding into light snacks, so it all seemed reasonable.
The problem was, Luckin didn’t do any of these reasonable things. It just continued to expand mindlessly and supercharge the “we are the Starbucks killer” story. For good reason, too, because at least overseas investors bought into it. More on that later. That allowed it to price at the top of its IPO range, $17 a share, and even upsize its IPO to raise $561mm last May. Cash in hand, it went into franchising tea stores, as well as automated vending machines. It successfully used all of these distractions to raise a further near-billion dollars in a concurrent follow-on and convertible note offering in January 2020, both of which were exercised in full, including over-allotments. What capital markets mastery. But also so boring. So uninnovative. The only time I thought about talking about it again was when, shortly after its convertible offering, renowned short seller Muddy Water posted an 89-page report from an Anonymous source alleging that Luckin was a “fraud and fundamentally broken business.” Theatrically, another short seller Citron Research came to Luckin’s defense. Citron said that it had also reviewed the same Anonymous report, but had done its own research, and had come to a different conclusion. Unfortunately, the research it did, was far less intensive than Anonymous.
So what exactly happened? I’m not an investigative reporter so I can only tell you what I’m reading from those who claim to have done the primary research. And a picture does emerge. But more importantly, I really think Luckin is a story of information asymmetry. While there were skeptics and cheerleaders on both sides of the ocean, a lot of times they didn’t seem to be telling the same story. And if you listened more to the voices on the ground, it may not have led you to assume fraud, but it might have led you to do a bit more digging, a bit more questioning. I mean, why were so many people hating on the company? Do they not like cheap coffee?
The Anonymous Report
Let’s first start with Anonymous. Anonymous’ report was 89 pages and enlisted 92 full time, 1,418 part-time staff on the ground who recorded over 11,000 hours of video, the equivalent of 981 store-days, covering 620 stores in 38 different cities. Got that? This was one epic report.. But who was behind it? Well, the most comprehensive series of articles that came out of this whole Luckin mess has been from 燃财经 Rancaijing, a one year old new media run by an ex-Caijing & Phoenix reporter. According to them, the fund who paid for all the diligence that went into the Anonymous report is Snow Lake Capital, a $2Bn Asian hedge fund founded in 2009. A primarily long fund, Snow Lake has since denied this, so we may never know which fund went to the great trouble of exposing Luckin in this dramatic fashion. Anyway, if we believe the detailed Rancaijing reporting, the flow of events seems to be this: when Luckin was going public in May of 2019, a lot of investors were already very skeptical. Remember, it did have the distinction of not-even-18-months to NASDAQ IPO at the time. Anonymous was one of them, and apparently hired some people to do customer counts very early on. No idea what they found, but it apparently their views turned sufficiently negative that they then hired an expert network called Third Bridge to conduct some initial interviews. One of these experts says his interview took place last August. Obviously, these expert interviews further confirmed their suspicions that the business was unsound, so two domestic Chinese consulting firms, Huisheng and Meritco, were retained to do further investigations. These two companies, who both do commercial due diligence for PE and VC, were the ones who finished the massive Luckin order-counting project.
I don’t know about you, but I was pretty curious at this time how this was accomplished, though I had some ideas, having some idea of labor costs in China. Sure enough, the report was built on the blood and tears of Chinese university students. Only half kidding. In China, it’s high school that’s tough, and college that’s a breeze — in comparison, anyway. In fact, if you’re not preparing for graduate studies, you really do have quite a bit of free time. So many college kids work part-time on the side. Of course, consulting internships are coveted, so these consulting firms tried to pass these gigs off as “consulting internships” on a “coffee project”. That probably got some folks in the door, but really only those with no choice or nothing better to do would want to sit there all day counting Luckin orders. So yeah, the 1,418 part-time staff? Turns out it was a bunch of college kids and anyone else who needed spare change and who could follow directions.
Rancaijing actually posted what they claim to be an example of the original hiring notice and WeChat screen grabs of the interns’ job instructions. The “interns” were paid 200-300 RMB ($30-45) per day, depending on which city they were in. But it was hard to hire because the job was so mind-numbingly boring. They literally had to sit there for hours (except bathroom breaks) and record down how many orders each store was generating, from opening till close. They were given scripts in case people asked — like, pretty please my internet is down at home and I really need to write my dissertation. They had to sign in after geo-locating themselves and taking a selfie with the storefront, report their order counts hourly, and sign out with a selfie too. If they were at one of the many Luckin pick-up kiosks with no seats … well good luck, they were just going to have to stand the whole day. And oh yeah, the interns also had to install or carry hidden cameras. Where do you think all the video footage came from? All that was then reviewed and verified too. In fact, all videos with more than 10 minutes missing footage were discarded, which is pretty strict. Overall, only 54% of the videos met this criteria, and so that means, according to Anonymous AKA Snow Lake, all the data “are of 100% integrity.”
I’d Like a Short Coffee Please
Chinese tech media is often very effusive about new “business model innovations.” But not so with Luckin, at least not for a long time. If you Google “Luckin Ofo” — that’s ofo the near-bankruptcy bikesharing company — you’ll see a lot of results, as early as January 2019, four months before Luckin’s IPO. But, almost all of these came from Asia-based investors, Asian media, or digests of Asian media. And that’s because users in China, fresh from losing their deposits to ofo, literally asked this question. “Is Luckin the next ofo?” The entire bikesharing industry, if you’ll remember, offered heavily subsidized rides to gain market share. Exactly what Luckin was doing.
Western media, on the other hand, pretty much regurgitated Luckin’s Starbucks story. The typical headline reads something like this. May 2019, MarketWatch. “Luckin Coffee Inc., a China-based company that has quickly become a key competitor to Starbucks Corp. in that country.” Even this week, TechCrunch wrote, ”… the company’s disclosure and its positioning in the competitive Chinese coffee market, where the company displaced Starbucks as the retail and delivery leader in just a few short years.” Search “Luckin Starbucks” in Chinese (瑞幸星巴克) and what you’ll get on the first page instead are articles like Luckin: Starbucks Not the Benchmark, Defeat Starbucks: are you sure you understand Luckin?. The lone “He defeated Starbucks” link is from a Taiwanese media. Everyone else is pretty clear — Luckin and Starbucks are completely not comparable.
I’m pretty confident that if you’re a long time Tech Buzz listener, you wouldn’t have that idea either. Like I said, I might have guessed their eventual direction wrong, but no one could possibly have mistaken Luckin for Starbucks. That was just corporate story-telling. But as I said in a recent video interview, Luckin was one of the companies where the difference in how customers understood the product and how investors saw it was bewilderingly different. And if you’re investing in a consumer product, wouldn’t you care what customers thought?
And here is what Chinese customers thought. One word: bargain. Or when it comes to the first cup of Luckin — free. Invite a friend, they also drink free. You could do this via the Luckin app or their WeChat mini program. After that, you will get bombarded with coupons via SMS, at least 50% off, and sometimes 82% off. Now using free as a way to attract the customer’s initial purchase isn’t all that weird — but even in subsidy-heavy Chinese consumer internet, which is very, very promotions driven, see Pinduoduo for another great example — Luckin was considered excessive. There is this one video that’s become more viral since the fraud investigation was announced, and it’s facetiously titled, “Luckin Coffee, the Light of our Nation.” I focus on this because the moniker “Light of our nation” has now become the new nickname for Luckin, and it is not always being used ironically, like it is in this article. Since the news broke, there are even some thick-skinned store managers who have put this as a sign at their pickup counter in an effort to connect nationalistic sentiment to drinking coffee. But despite trying to tap into peoples’ patriotism and experiencing an uptick in orders as cusomers realized that they might lose their pre-purchased coffee vouchers — so Luckin is just like ofo after all — it’s really still the low prices that are getting people in the door.
But let’s go back to the video for a moment, because it provides a nice window into what the average but informed non-insider Chinese person was thinking at the time. You see, the video’s creator is a popular trashing talking Gen Z blogger who “works in risk management” for his day job and uses his knowledge of finance and business to regularly expose what he thinks are scams. The villains he targets are mostly Chinese, such as Justin Sun of TRON, one of his favorite punching bags, but he’d written a series of articles on Luckin beginning with their IPO. In May 2019, he authored his first viral article against the company — “Luckin is the most Kickass Chinese business.” Hint: the title is meant to be sarcastic. His whole point was — Luckin is a terrible business that makes no sense whatsoever — its main highlight was that it was incredibly good at “burning cash.” They’re basically a “nonprofit” that’s taking American investor money to buy Chinese people cheap coffee. Why would you do this unless you are a “kindhearted nonprofit”? He would refine this story later, especially post the Muddy Waters report, and imply that this kind of scam was so crude that Chinese investors were longer falling for it, and that the only way it could survive was to go to the US markets, where people hadn’t seen this kind of brazen nonsense and hadn’t developed immunity yet.
His viewpoint was popular. Like I said, it went viral. It also shows you the huge disconnect, almost from the very beginning between Luckin’s narrative in the West and how it was perceived or understood in China. Yes, Luckin went public 18 months after being founded, but it didn’t actually soft open its stores until December 2017 and its official grand opening was actually May 8, 2018. So it really went public only 12 months after its official opening, and even the more neutral commentary in Chinese media at the time noted that it should be more vigilant of competition from convenience stores, not Starbucks.
Crying over Spilled Coffee
Now, Luckin has always been well covered in Chinese media — it’s a good story. But how its business model was faring was honestly of limited interest to most Chinese consumers. Unless you used an overseas brokerage account, you wouldn’t be able to invest in it. Your best way of taking advantage of this overflowing of capital was just to take advantage of its cheap coffee. When the fraud investigation was announced, that remained the way most people viewed the situation. The overwhelming reaction was — what does this have to do with me?
The business community reaction, however, was one of universal outrage. Luckin was the proverbial “pellet of rat shit” which while small, easily ruins an entire pot of porridge, as a popular Chinese adage goes. Not that this alleged fraud is small, but the fear is that as a singular instance, it would one-handedly destroy the credibility of every other Chinese business — of course the ADRs listed overseas, but maybe beyond that as well. It would raise the cost of doing business. Remember in the early 2010s when multiple Chinese ADRs were found guilty of fraud and pretty much trust in all Chinese equities was wiped out overnight? Not just public investors overseas, but also private investors domestically were affected too. And now it’s even worse, because there are geopolitical tensions that seem to degrade every single week.
Most of the Chinese people I talked to in the business world despise Luckin and think the Chairman and executive team need to face jail time. Especially internet executives, for whom this hit close to home. Absolutely no one believes that the COO, with his measly 40,000 options, orchestrated this fraud, especially when it was obvious that he was only brought in because the CMO (and formerly named co-founder) was revealed by Chinese media to have been to jail before. But A-share retail investors were not as bothered. And not for a lack of A-share acts of fraud (just ask any A-share investor about their favorite scallop breeder).
That’s because, they told me, a company like Luckin would’ve never been able to go public domestically — its unprofitability means that it wouldn’t have been allowed to list on the domestic exchanges, and even for the experimental STAR exchange, which is NASDAQ-like and allows for loss-making firms to list, who’s to say it would’ve passed the application process? It was specifically designed with companies with real strategic IP, not coffee sellers. Not to mention, they said, prosecuted offenders in China get real jail time and their sentencing is relatively quick. So sure, there’s fraud, but there are serious deterrents. The government is very protective of the health of the stock market — some would even say they manipulate it — and so in their opinion? Except for a few names, ADRs are riskier than A-shares, and Luckin merely confirms their suspicions.
I think they should have more sympathy. Luckin had a bunch of red flags, yes, but without serious work like Snow Lake did, it wouldn’t have led you to the conclusion that it was a “fraud,” merely that it was a very bad business. For example, there are those who point to the lack of “good VCs” and saying the deal was “all done by insiders.” Erhai Liu, and David Hui Li, Luckin’s early investors, were previously senior investors at Legend Holdings and Warburg Pincus China and they can hardly be said to be inexperienced investors. And sure, pretty much everyone involved — the founders, executive team, investors, and even bankers — were the same group of people who were behind the success of Chairman Lu’s other children — Shenzhou and its affiliates. But business partners who work well together and make money together tend to stick together. That isn’t necessarily fishy. What is fishy is what this group accomplished at Shenzhou a few years back. Snow Lake points out that they were behind a $1.6Bn dumping of stock there, at public shareholders’ expense. Now that is a problem. But still not enough to say it’s a fraud. Even the case of Yang Fei, the ex-con CMO, who was quickly erased, nor its problematic Independent Director, Sean Shao, who was always getting mixed up with questionable companies, don’t prove it’s a fraud. Without deep diligence, I don’t think that tells you anything, except to start digging.
Who’s Left Holding the Bag of Coffee Beans
Will Luckin get punished? Most of the securities lawyers being interviewed by Chinese media say yes. Very few companies admit wrongdoing after denying it so vehemently, and when they do so, the odds are not in their favor. It also isn’t a good look that the executive team had pledged its shares and effectively cashed out on 49% of their holdings and some of those shares have now been surrendered now that the loan has defaulted. Lawyers speculate that there will be monetary compensation, and maybe jail time. And versus ten years ago at least, there’s a lot more cooperation between the SEC and CSRC. From what I could find, under rules in place since a few years back, in case of investigation, auditors must first provide the underlying audit documents to the CSRC, who will then deliver them to the SEC. If they do not, then an automatic six-month bar may be imposed, meaning that they cannot act as auditor for any issuer. That’s why Luckin had to “expose itself,” as the Chinese press guessed, because while the last two quarters’ earnings were unaudited, the upcoming one would have to get the auditors’ signoff. And E&Y Hua Ming LLP simply wasn’t willing to do that.
So what’s to take away from all of this? Are we back in the times of Sino Forest, when it seemed like every Chinese company was cheating in some way? That was in 2011, if you’ll remember, also a multi-billion dollar fraud and Muddy Waters’ most famous win. Well, I certainly hope not. At least the cost of doing fraud seems to be more expensive these days. But Luckin shows us that when there are folks, willingly or unwillingly — let’s give at least some of them the benefit of the doubt — able to spend millions of dollars willing to dress up a pig it’s easy to make a mistake. Yeah, yeah, many of us called it a pig, but only a few really got it really right, which was that it wasn’t even a pig. More like a hologram of a pig. And the only way all this will get better — less fraud, better companies — is if everyone, including China-based consumers and investors, understand that fraud is bad. And not just in an abstract “it increases the cost of doing business” way, but in a, we-are-all-connected and we-are-all-going-to-hurt-from-this way. This wasn’t just a crime against Luckin’s shareholders, but also against its tens of thousands of employees. Certainly some of them, if not all, will lose their jobs. And Luckin suppliers, if Luckin becomes insolvent, will also lose money, no doubt. So too the Chinese retail investors who invested using overseas brokerages, a fast-growing crowd. And there are others still, shareholders in Shenzhou, which dropped 70% the day of, and even underwriter CICC, who came out in strong support of the company post Muddy Waters allegations, dropped 4% on the news.
Left bookrunner Credit Suisse has already been dropped by WeDoctor from its Hong Kong IPO because of concerns over their involvement in Luckin. Underwriters and auditors are definitely responsible, but their fellow colleagues and shareholders may also pay a price.
Let me be clear, I have no sympathy for the Luckin management itself, who waited three days to issue any statement regarding the scandal — a weak apology, if you ask me. Of course it should apologize. At the very least, to its employees, customers and shareholders. As for you, I hope you escaped the Luckin fiasco unscathed. I know it’s made me more aware of the importance of making decisions not based on excitement and buzz, but on full-context, first-hand, believability-weighted information. That last one might just be the most important. Not every brand is so obvious about its flaws. Luckin was practically screaming it.
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