How Luckin Coffee, the Chinese coffeehouse chain, lost almost 84% of its value since its peak valuation
This post was originally posted on Medium, and can be found here.
It is well known that the US-Chinese relationship has been complex and tension-filled for a while and varies from negative to positive. However, the case around the Chinese company Luckin Coffee Inc. was a central initiator to introduce a new US legislation, which is currently processed and eventually becomes active soon.
As of June 1st 2020, the “Holding Foreign Companies Accountable Act” has passed the US Senate and has been handed to the Democratic-controlled House of Representatives before reaching the president’s desk to be signed into law. This new legislation would force foreign companies to be audited by US accredited firms and that these audits are further monitored by the Public Company Accounting Oversight Board (PCAOB). Consequently,156 Chinese companies that are currently listed on stock markets in the US and not audited by an accredited US institution, including Alibaba, Baidu and JD.COM, are at risk to be delisted if this legislation is signed into law.
But what was the reason this legislation has been developed? The answer is: the inconsistency in revenue reportings of Chinese companies that were listed in the US. The case of Luckin Coffee showed an exact example of this lack of transparency and brought investors a loss only one year after the company’s IPO in May 2019.
Luckin Coffee was founded in 2017, aimed to conquer the Chinese coffee market which was dominated by US coffee empire Starbucks. Within the first two years, the company opened 2,400 locations all over China and strategically improved compared to Starbucks’ existing approach by offering lower prices and accepting only mobile payments. In the same year, the company announced its IPO at New York Stock Exchange. The company raised about US$ 500 million without being profitable in that year but with great predictions for further expansions. Luckin Coffee traded with a valuation of more than 30 times its annual turnover and had its peak in January 2020. At this time, the company had a market capitalization of around US$ 12.5 billion (RMB 85.4 billion) trading at almost 50 times of its actual annual turnover.
After that rapid rise, Luckin Coffee’s fortune changed and within eight months of its Nasdaq-listing, the business model dissolved. On April 2nd 2020, the company announced that almost half of the revenues it generated in the last three quarters of 2019, namely US$ 300 million (RMB 2.2 billion), were made up. Luckin Coffee made the Chief Operating Officer (COO) and Executive Director Liu Jian responsible for the misconduct that came to light after an internal investigation by the auditing company Ernst & Young and immediately laid him off. This investigation revealed that Liu and other employees had overstated the early revenue figures. In mid-January 2020, an anonymous 89-page report about Luckin Coffee landed on the desks of investors known for short selling of Chinese stocks, including Carson Block, founder of Muddy Waters Research. The report is based on an 11,000-hour in-store video claiming Luckin Coffee had inflated its sales in the third quarter by 69%, the fourth quarter by 88%. Block published the report, whereby Luckin Coffee’s stock fell by almost 30% despite the company’s denials.
Before the disclosure and shortly after Luckin Coffee’s shares were listed on Nasdaq, the co-founder Jenny Qian and other insiders such as Liu and his sister Sunying Wong were busy with share payouts. By the rules of the US Securities and Exchange Commission (SEC), it is prohibited for insiders to sell their shares within 12 months after the IPO. But Liu, Qian and Wong pledged their Luckin Coffee shares to Goldman Sachs and others Banks to obtain loans of about US$ 500 million.
Hence and due to the allegations in early April 2020, the company lost almost 84% of its value. The stock had fallen by almost 90% and is currently suspended from trading. The trust given by many investors in the company’s IPO and in the founding team were exploited. The business model, which has never been profitable, turned out to be inapplicable to the coffee drinking behavior of people in China. For US investors, the behavior of the founding team was a clear indicator that the development of Luckin Coffee was a planned action.
This case left many investors with a growing lack of confidence in Chinese stocks and contributed to the creation of the new legislation.
We are observing this trend closely as this legislation could be the end of fast growing Chinese start-ups that seek to raise their capital through an IPO at the US stock exchange. Assessing which companies transparently share actual audited numbers is particularly difficult from outside of China. Therefore having a team or network that can understand investor structure and associated people to a company is essential.
The next months will show how severe the regulatory situation for Chinese US-listed companies will become. In case the US administration follows through with a hard hand, Chinese companies will need to find other financial market places to be listed. Companies such as JD.com and NetEase for example, prior only listed in the US, are now planning their secondary listing on the Hong Kong Stock Exchange as well. This could very well become a trend as uncertainty about Chinese companies’ remaining in the NASDAQ persists. A further possibility would be alternative listings in i.e. Tokyo or London in order to further be able to tap into foreign capital markets.