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Luckin Coffee: Fraud and Fundamentally Broken Business

Executive Summary

Luckin Coffee (NASDAQ: LK) was a fundamentally flawed business when it went public in May 2019. It relied heavily on aggressive discounts and free coffee giveaways to introduce coffee culture to Chinese consumers. However, shortly after its USD 645 million IPO, Luckin began fabricating financial and operational data, leading to a stock price surge of over 160% within two months. In January 2020, it raised another USD 1.1 billion, including a secondary offering. This report highlights both the fraudulent activities and the structural issues in Luckin's business model.

Part One: The Fraud

Smoking Gun Evidence

1. Inflated Number of Items per Store per Day

   • In 2019 3Q, the number of items per store per day was inflated by at least 69%, and in 2019 4Q by 88%.
   • This was supported by 11,260 hours of store traffic video.
   • The reported numbers were 444 in 2019 3Q and 483-506 in 2019 4Q.
   • Actual tracking showed only 263 items per store per day.

2. Decline in "Items per Order"

   • "Items per order" dropped from 1.38 in 2019 2Q to 1.14 in 2019 4Q, indicating a shift in customer behavior and potential data manipulation.

3. Inflated Net Selling Price per Item

   • Luckin inflated its net selling price per item by at least RMB 1.23 or 12.3%.
   • Real store-level losses were between 24.7% and 28%, and the actual selling price was 46% of the listed price, not the 55% claimed by management.

4. Overstated Advertising Expenses

   • Third-party media tracking showed Luckin overstated its 2019 3Q advertising expenses by over 150%, especially with Focus Media.
   • This may have been used to inflate revenue and store-level profits.

5. Inflated Revenue from "Other Products"

   • Luckin's revenue contribution from "other products" was only about 6% in 2019 3Q, but it was reported as 400% inflated, based on 25,843 customer receipts and VAT numbers.

Red Flags

1. Management Stock Pledges

   • Luckin's management cashed out 49% of their stock holdings (or 24% of total shares) through stock pledges, exposing investors to margin call risks.

2. CAR Inc Similarities

   • Luckin's Chairman, Charles Zhengyao Lu, and his associated private equity investors previously profited USD 1.6 billion from CAR, while minority shareholders suffered heavy losses.

3. Related Party Transactions

   • Luckin's Chairman transferred RMB 137 million from UCAR to Baiyin Wang through the acquisition of Borgward.
   • UCAR, Borgward, and Baiyin Wang are liable for paying BAIC-Foton Motors RMB 5.95 billion over the next 12 months.
   • Baiyin Wang now owns a nearby coffee machine vendor.

4. Unmanned Retail Strategy

   • Luckin raised USD 865 million for its "unmanned retail" strategy, likely to siphon cash from the company.

5. Independent Board Member Ties

   • Sean Shao, an independent board member, was associated with other Chinese companies listed in the US that have caused losses for public investors.

6. Co-Founder Legal History

   • Fei Yang, Luckin's co-founder and CMO, was previously imprisoned for illegal business operations and is now linked to related party transactions with Luckin.

Part Two: The Fundamentally Broken Business

Business Model Flaws

1. Misaligned Target Market

   • Luckin's focus on core functional coffee demand is misplaced, as China's caffeine intake is largely from tea, and the coffee market is small and modestly growing.

2. High Price Sensitivity and Poor Retention

   • Customers are highly price-sensitive, and retention is driven by discounts.
   • Attempting to reduce discounts while increasing same-store sales is not feasible.

3. Flawed Unit Economics

   • Luckin's business model is not profitable and is expected to collapse due to poor economics.

4. Lack of Core Competence

   • Luckin lacks core competence in non-coffee products and has a platform of opportunistic customers with no brand loyalty.
   • Its labor-light store model is only suitable for "Generation 1.0" tea drinks, while leading fresh tea players have moved to "Generation 3.0" products.

5. Franchise Compliance Risks

   • Luckin Tea's franchise business was launched without the required two fully operational stores, leading to high compliance risks.

Data Analysis

• Store Traffic and Order Count

  • Luckin's offline tracking of 981 store-days revealed an average of 230 orders per store per day.
  • With an average of 1.14 items per order, this results in 263 items per store per day, significantly lower than the reported figures.

• Store Distribution

  • Luckin's 4,507 directly-operated stores were spread across 53 cities, with 96% located in 38 cities.
  • Store locations were categorized into office, mall, school, residential, transportation, hotel, and others.

• Success and Failure of Store Visits

  • Of the 981 store-days tracked, 54% were successful, with the rest failing due to missing footage or execution issues.

• Surveillance Coverage

  • Each store has 8 internal surveillance cameras, ensuring no blind spots.
  • Investors and auditors can sample these videos to verify reported order numbers.

Conclusion

Luckin Coffee's success in the stock market was largely due to fabricated financial data and an unsustainable business model. The company's aggressive discounting and reliance on free giveaways have led to a lack of profitability and customer loyalty. The fraudulent activities, combined with the flawed business model, pose significant risks to investors and indicate a lack of long-term viability.