Investors wake up and smell the Luckin Coffee

[HONG KONG] Investors in Luckin Coffee, China's upstart rival to Starbucks, should have seen this coming.

Luckin shares plunged as much as 81 per cent in US trading Thursday after the country's largest coffee chain said employees fabricated much of its sales last year. Car Inc, which shares a chairman with Luckin, tumbled as much as 72 per cent in Hong Kong on Friday morning before trading was halted.

Scepticism swirled around the sustainability of Luckin's business model well before its Nasdaq initial public offering last May. Luckin's success relied heavily on generous discounts funded by investor money, as I wrote in December 2018. The company spent 152 yuan (S$30.75) for every 100 yuan it made selling coffee, my colleague Tim Culpan noted in May. In February, after short seller Muddy Waters Capital said it had received an 89-page anonymous report alleging that Luckin fabricated financial and operating numbers, we again noted its reliance on near-permanent discounts.

Investors in the chain include US fund manager BlackRock and crop trading giant Louis Dreyfus, as well as a slew of venture capital firms. Early backers included Centurium Capital, a private equity fund founded by the former China head of Warburg Pincus.

Luckin's turbo-charged growth and technology sheen were central to the investor buzz it created. Having opened its first store in Beijing only three years ago, the company had 4,500 domestic locations by the end of last year, outstripping Starbucks' 4,300 Chinese stores.

The company described itself as a coffee "network" in its IPO (initial public offering) document and prided itself on an app that offers a "100 per cent cashier-less environment". That slapped a new-economy aura on a largely humdrum and routine business - not unlike the office-sharing company WeWork, another hot unicorn that subsequently fell from grace.

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Luckin said chief operating officer Liu Jian and employees reporting to him engaged in misconduct and it is investigating. The aggregate sales amount associated with the fabricated transactions totaled about 2.2 billion yuan. Certain costs and expenses were also substantially inflated, according to the filing. Mr Liu and others have been suspended and investors shouldn't rely on previous financial statements for the nine months ended Sept 30, the company said. Luckin reported net revenue of 2.9 billion yuan for the nine months through September.

It's a moment of truth and a wake-up call for investors who pile into Chinese startups that show meteoric growth rates. That's a message that few appear to have taken to heart after the spectacular boom and bust of bike-sharing companies such as Ofo. WeWork's failed attempt to list taught US investors that you can't burn cash forever. Luckin could deliver a similar lesson for China.

Luckin's management will need a long time to re-establish investor trust, if it can do so at all. The market for Chinese IPOs in the US is also sure to suffer. After all, it's far from the first time that an overseas-listed Chinese company has been embroiled in allegations of accounting manipulation. Luckin at least can be thankful that it raised US$778 million selling shares and convertible bonds earlier this year, giving it some leeway to ride out the storm. For investors, the moral is an old one: If something looks too good to be true, it probably is.

BLOOMBERG