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Luckin Coffee: Summary of Fraud and Business Model Issues

Core Content

Luckin Coffee (NASDAQ: LK) was a company that faced significant issues both in terms of financial fraud and a fundamentally flawed business model. This report outlines the fraudulent activities and business challenges that led to its downfall.

Main Points

Financial Fraud

1. Inflated Sales Data

   • In the third and fourth quarters of 2019, Luckin inflated the number of items per store per day by at least 69% and 88%, respectively.
   • This was supported by 11,260 hours of store traffic video recorded by 92 full-time and 1,418 part-time staff over 981 store-days.

2. Inflated Net Selling Price

   • Luckin inflated the net selling price per item by at least RMB 1.23 or 12.3%.
   • In reality, the actual selling price was only 46% of the listed price, while the management claimed it to be 55%.

3. Overstated Advertising Expenses

   • Third-party media tracking revealed that Luckin overstated its 2019 Q3 advertising expenses by over 150%, especially for Focus Media.
   • There is a possibility that these expenses were recycled to inflate revenue and store-level profit.

4. Inflated Revenue from "Other Products"

   • Luckin's revenue contribution from "other products" was only about 6% in 2019 Q3, but it was reported as a 400% inflation.

5. Stock Pledges by Management

   • Luckin's management cashed out 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.

6. Past Fraudulent Behavior

   • Luckin's chairman, Charles Zhengyao Lu, and a group of private equity investors had previously walked away with USD 1.6 billion from CAR Inc while minority shareholders suffered heavy losses.

7. Related Party Transactions

   • Luckin's chairman transferred RMB 137 million from UCAR to his related party, Baiyin Wang.
   • UCAR, Borgward, and Baiyin Wang are responsible for paying BAIC-Foton Motors RMB 5.95 billion over the next 12 months.
   • Baiyin Wang owns a recently founded coffee machine vendor located next to Luckin's headquarters.

8. Recent Fundraising

   • Luckin raised USD 865 million through a follow-on offering and convertible bond offering, which is likely a convenient way for management to siphon cash from the company.

9. Independent Board Member Involvement

   • Sean Shao, an independent board member of Luckin, was on the board of some questionable Chinese companies that have incurred significant losses on their public investors.

10. Co-founder's Legal History

    • Fei Yang, Luckin's co-founder and Chief Marketing Officer, was once sentenced to 18 months in prison for illegal business operations.
    • iWOM, the company he co-founded, became a related party with QWOM, which is now an affiliate of CAR and engages in related party transactions with Luckin.

Business Model Flaws

1. Misaligned Target Market

   • Luckin's proposition to target core functional coffee demand is incorrect.
   • China's caffeine intake is comparable to other Asian countries, with 95% of intake coming from tea.
   • The market for core functional coffee products in China is small and moderately growing.

2. Highly Price-Sensitive Customers

   • Luckin's customers are highly price-sensitive, and retention is driven by generous price promotions.
   • The attempt to reduce discount levels and increase same-store sales is mission impossible.

3. Flawed Unit Economics

   • Luckin's unit economics are flawed and have no chance of profitability.
   • The company's broken business model is bound to collapse.

4. Lack of Core Competence in Non-Coffee Products

   • Luckin's dream to be part of everyone's everyday life, starting with coffee, is unlikely to come true.
   • The company lacks core competence in non-coffee products and has a platform full of opportunist customers without brand loyalty.

5. Labor-Light Store Model

   • Luckin's labor-light store model is only suitable for making "Generation 1.0" tea drinks, which have been in the market for over a decade.
   • Leading fresh tea players have pioneered "Generation 3.0" products five years ago.

6. Franchise Compliance Risk

   • Luckin's franchise business for Luckin Tea is subject to high compliance risk.
   • The company launched its franchise business in September 2019 without having at least two directly-operated stores fully operational for at least one year.

Key Information

• Store Traffic Tracking: The company's reported number of items per store per day was inflated, with actual numbers found to be 263, significantly lower than the reported 444 in 2019 Q3 and 483-506 in 2019 Q4.
• Store Locations: Luckin's 4,507 directly-operated stores were located in 53 cities, with 96% of them in 38 cities.
• Store Types: The store locations were categorized into office, mall, school, residential, transportation, hotel, and others.
• Store Age: Luckin's stores opened in or before May 2019 accounted for 59% of its total store count.
• Foot Traffic Data: The offline tracking results of 981 store-days revealed a national average of 230 orders per store per day, which was used to calculate the inflated item count of 263.
• Surveillance Data: Luckin's stores were covered by 8 internal surveillance cameras, providing no blind angles and allowing for verification of order numbers.
• Company's Strategy: Luckin's "unmanned retail" strategy is likely a means for management to siphon cash from the company.

Conclusion

Luckin Coffee's fraudulent activities and flawed business model significantly undermined its financial health and long-term viability. The company's inflated sales data, overstated advertising expenses, and flawed unit economics indicate a fundamental lack of transparency and sustainability in its operations. The lack of core competence in non-coffee products and the high compliance risk associated with its franchise business further highlight the challenges it faces. These issues collectively suggest that Luckin's business model is not viable and that its financial statements are not reliable.