Luckin Coffee’s Troubles May Just Be Getting Started After Revealing Financial Investigation

Luckin Coffee, a fast-growing coffee chain aiming to overtake Starbucks in China, could be forced to restructure or downsize after the company revealed that its staff were fabricating sales in 2019.

Shares of the Nasdaq-listed firm collapsed 76% after the board announced in a Thursday stock exchange filing that it had formed a special committee to investigate Chief Operating Officer Liu Jian and several employees who reported to him. They’re accused of financial misconduct, including fabricating sales involving a total of 2.2 billion yuan ($310 million), from the second quarter of last year to the fourth quarter.

Analysts say the stunning disclosure marks the beginning of an uncertain future for Luckin. Founded in 2017 by former executives from Chinese car rental firm CAR Inc and pulled off a $561 million U.S. IPO in less than two years, but the cash-burning company often used aggressive discounts—such as buy one cup and get two for free—and cheap deliveries to attract customers.

It operated 4,500 stores by the end of 2019, and once planned to reach as many as 10,000 locations next year. Starbucks, by comparison, operated 4,200 stores after first entering China in 1999. But the coronavirus pandemic is slowing Luckin down, recently forcing the company to close all its stores in the central city of Wuhan, where the virus is thought to have first originated.

“The misconduct is the immediate problem, but the underlying issue is Luckin’s business model,” Brock Silvers, managing director of Hong Kong-based Adamas Asset Management, writes in an e-mailed note. “The blitzkrieg rollout was haphazardly executed (perhaps exacerbated by the viral contagion), and the resulting lack of productivity was the likely impetus behind the false reporting.”

A Luckin spokesperson did not respond to phone calls and text messages seeking comment. The company said in the filing that certain costs and expenses were also substantially inflated by fabricated transactions. It added that previous financial statements–including statements and earnings releases for the nine months ended September 30–and guidance for the fourth quarter should no longer be relied upon. Previously, Luckin reported better-than-expected revenues of $209 million and narrowing losses of $74.4 million for the third quarter ended September 30, 2019.

Silvers said Luckin’s cash position should be “significantly weakened,” because customers are unlikely to add to its pre-paid cards and the company’s external financing options are now “severely reduced.” “Luckin could shrink to a smaller and more productive independent entity or it could simply divest better outlets to a more successful chain and shutter the remainder,” he says.

Oliver Rui, a professor of finance at the China Europe International Business School in Shanghai, said the company’s institutional investors could sue, and Luckin could face a dramatic amount of claims that well surpass its total assets. A series of class-action lawsuits are already on the way, with law firm Pomerantz LLP announcing on Wednesday a lawsuit on behalf of shareholders in United States District Court for the Southern District of New York.

“Their final outcome could be really miserable,” Rui says. “ They could go bankrupt.”

Luckin’s troubles first emerged in January, when Muddy Waters tweeted that it would short the stock after receiving an anonymous but credible report alleging that Luckin inflated sales and was a fraud. The company, which denied all the allegations, reportedly raised earlier a combined $778 million from an additional share sale and a convertible bond offering. Luckin announced in the same month that it planned to expand into vending machines to sell snacks and coffee beverages, as it sought a larger slice of China’s nascent coffee market.

This aggressive expansion is overseen by Qian Zhiya, a former COO at CAR Inc that launched the low-priced coffee chain in 2017 after raising over $150 million from investors including Lu Zhengyao, the chief executive of CAR Inc’s ride-hailing firm UCar. Lu, who later became Luckin’s chairman with a 30.5% stake, became a billionaire when the company filed for an IPO amid rapid growth. Qian, who has a 20% stake, saw her own fortune crossing the $1 billion benchmark when Luckin shares surged last November.

The company’s ongoing accounting probe will have wider impact for other U.S.-listed Chinese firms, or Chinese companies that plan to list in the U.S, says CEIBS’s Rui. Aside from a foreseeable stricter regulatory environment and closer scrutiny, there is also likely to be fallout for the financial service institutions that worked with Luckin.

“It is all linked,” he says. “They just issued bonds, so there will be questions about how accounting is done. Aside from penalties for the firm, there can be penalties for these institutions too.”