All the Coffee in China
The story behind Luckin Coffee’s $310m fraud
The world’s attention is fixed on coronavirus. That’s why you might have missed the news that a Chinese start-up admitted to an over $300m fraud. It’s a good time to bury bad news, but not so for Luckin Coffee. The markets took notice and hammered China’s largest coffee shop chain. Its share price has plummeted, from over $50 in mid-January to less than $5 today. That 95% drop wasn’t the end though. Its chairman was forced to default on a $500m loan and shareholders have organised and are suing the company. It is a fall from grace for a darling of the Chinese start-up scene akin to that of WeWork’s. What happened?
Tea reigns in China.
It has been the beverage of choice for thousands of years. From the lowliest peasant to the highest-ranking bureaucrats and rulers, everyone in China drinks tea. Chinese cities are studded with teahouses. Patrons gossip, smoke cigarettes and play board games, often spending hours sitting sipping tea. Starbucks wanted to change that and launched in China in 1999. Beforehand coffee had only been served in hotels and other places foreigners congregated. With the launch of its first outlet, Starbucks tried to change the palette of regular Chinese consumers, unaccustomed to the taste of coffee. Sugary and milk-laden drinks were the way to get people drinking coffee.
But as important was presenting the drink as western, youthful and cosmopolitan. Young, urban professionals, working in China’s booming tech hubs, began to take to the new drink. A nascent coffee culture was appearing. Serving social media-friendly beverages and contrasting with the sedate pace of teahouses, coffee took on a glamour similar to the people it served. Its ambitious image struck a chord with the tech industry where late nights were fuelled by coffee. Enter Luckin.
Founded in October 2017, Luckin Coffee grew from its base in Xiamen quickly. By May 2019 it was already running 2,370 locations, a growth trajectory that fit in with the booming tech start-ups. It managed this by eschewing the type of stores favoured by its competitors. Starbucks was by now the largest coffeehouse chain in China with Costa in second. Their Chinese stores are familiar to anyone who knows the laptop strewn tables and young creatives nursing cups of frappuccinos, iced coffees or macchiatos in any western city. Luckin’s locations were a little different.
If you wander into any of Luckin’s outlets you won’t be able to order a coffee at the counter. A little strange for a business which makes money by selling coffee. Instead, you must place and pay for your order through its app. Customers collect their coffee at kiosks smaller and without the comforts of a Starbucks or Costa. This tech-first approach appealed to Luckin’s target consumer. It also helped keep costs low as the firm expanded.
Customers are served quickly, and the turnaround time is low. This low-cost ethos helped Luckin undercut Starbucks on price and appealed to price-sensitive Chinese consumers who could get tea for cheap. Luckin also offered free and discounted cups of coffee to new customers. This aggressive and targeted discounting could only have been done through an app which tracked customer orders, tastes and signups. Another feature of Luckin’s model that appealed to its chosen demographic was delivery. Customers could get their coffee delivered straight to their offices or studies within half an hour. It was a feature Starbucks eventually copied, though it took them a while to do so.
Luckin grew. It grew fast. But it needed money — and lots of it. Less than a year after it was founded, in July 2018, it secured $200m of funding in an early series round. A year after it had launched, it had 1,300 locations. It was on its way to achieving its goal of eclipsing Starbucks as the largest coffee chain in China. In May 2019, it launched an IPO in the US. It raised $561m to help its ambitious growth strategy and was valued at $4bn. It needed the money as it was burning through cash at around three times the rate it was bringing it in. From its cashless stores and data mining app to its clientele and areas where it opened, Luckin positioned itself like a tech start-up. It produced the growth required to stay in that company too. But much like WeWork, Luckin was a traditional business masquerading as a tech start-up. WeWork was essentially a landlord. Luckin sold coffee. The bubble was ready to burst.
In January 2020 Luckin continued its expansion by launching vending machines that served coffee. They achieved the long-term goal of having more locations than Starbucks. Though the people behind Luckin didn’t know it, it was to be the company’s high point.
That same month, on 31 January, Muddy Waters, an investment firm that backs up its positions with investigative research, tweeted out a report that claimed Luckin was fabricating its sales. By watching thousands of hours of CCTV, examining customer receipts and monitoring app metrics, the report claimed that Luckin had been overreporting revenue since the third quarter of 2019. Founded by Carson Block, Muddy Waters was a firm that investigated Chinese businesses and took a short position if they smelled something fishy. Block had dealt with tech entrepreneurs early in his career and had come away from the experience with a sour taste in his mouth. The lying and obfuscation had motivated him to start his investment firm. Seeing the numbers Luckin released, Block and Muddy Waters thought that not everything at the firm was kosher.
To grow as bigger than Starbucks in less than three years Luckin had to launch a lot of new locations. Over 4,000 of them. Often these were near existing Luckin outlets. They targeted tech quarters and university districts. When a firm opens new stores in such a manner, it is expected that sales per store will fall. The new shops cannibalise some of the existing customer base of the older ones. Despite how aggressive Luckin was expanding, this was not happening. Instead comparable store sales were going up by around two-and-a-half times. Those were unbelievable numbers — and for good reason.
After the Muddy Waters tweet, Luckin took a small hit to its share price. But it wasn’t until early April when things got bad. An internal investigation backed up the allegations. The Chief Operating Officer was fired after over $300m of sales were found to be faked. Luckin’s cofounder, Lu Zhengyao, may have to step down from his other companies as the stink spreads.
Luckin may survive, but it will be tough. Analysis from Seeking Alpha shows that each Luckin store is averaging a turnover of only $350 per day. Even in China, with low labour and other costs, that is hardly enough for a viable business. And it’s hard to believe any numbers coming out of the company right now, so the situation could be a lot worse. One redeeming quality is that China’s coffee culture has a lot of room to grow. The average Chinese person only drinks around 5 cups of coffee per year. Americans drink over 400. The entire Chinese coffee market was worth only $8.2bn in 2019 but is growing at a rate close to 10%. Its economy is reigniting after the coronavirus lockdown. It may just be enough to keep Luckin limping on.
