Luckin Coffee Runs Out of Luck

Luckin Coffee, a Chinese coffeehouse chain that has been championed as the potential threat to Starbucks’ success in Asia, recently released damning news to all stakeholders in the company. On April 2, the firm announced that an internal investigation into the intricacies of business operations found that Jian Liu, the Chief Operating Officer of Luckin Coffee, had fabricated 2019 sales figures by roughly 310 million USD.

Founded in Beijing in 2017, Luckin Coffee quickly rose to fame across China, and by May 2019, the company was trading on the NASDAQ (LK). By January 17, 2020, shares of LK had more than doubled, rising from 20.38 USD to 50.02 USD in eight months. Such optimism was fueled by the firm’s rapid expansion in China, a market that Starbucks had appeared to grab a hold of. At the beginning of 2019, Luckin Coffee had 2,380 locations in China, compared to 3,700 Starbucks locations. By the end of 2019, Luckin and Starbucks had both surpassed 4,000 stores, meaning Luckin had been growing at a rapid pace since filing its Initial Public Offering.

It is worth noting that Luckin Coffee’s business model differs slightly from that of Starbucks. For one, Luckin does not offer any cafe seating, which may help to explain why the company was able to open new stores at such a fast pace. Additionally, Luckin only accepts payments from its mobile application, as opposed to the broader options accepted by Starbucks. In essence, Luckin Coffee was established for those who wish to simply walk into a coffee shop, pick up their beverages and depart within a few minutes. This differs drastically from the more casual and relaxed atmosphere of a Starbucks cafe, where customers may end up staying for multiple hours with a coffee and book in hand.

As 2019 progressed, it became clear that such a business model was working in China. For Quarter 3 2019, Luckin Coffee reported revenue of 216 million USD, a sizable increase from Quarter 2 2019, when the firm reported revenue of 35 million USD. Such drastic increases in both sales and popularity prompted many people to call into question the dominance that Starbucks had experienced within the Chinese market for coffee.

However, there remained others who were less optimistic about the business. In January 2020, an anonymous document was released depicting numerous instances of fraud at Luckin Coffee. The report states, “When Luckin Coffee went public in May 2019, it was a fundamentally broken business that was attempting to instill the culture of drinking coffee into Chinese consumers through cut-throat discounts and free giveaway coffee.” Furthermore, “Right after its 645 million USD IPO, the company had evolved into a fraud by fabricating financial and operating numbers starting in [third] quarter 2019.” When asked for a response, Luckin Coffee responded, “The methodology of the Report is flawed, the evidence is unsubstantiated and the allegations are unsupported speculations and malicious interpretations of events.”

Roughly three months after the anonymous report was released, Luckin Coffee announced that it had, in fact, fabricated sales figures in order to inflate the company’s value. Such a confession caused shares of LK to fall over 75 percent in overnight trading. Since April 6, trading of LK has been halted at a price of 4.39 USD, more than 91 percent below its all-time high reached in January of this year.

The dramatic rise and fall of Luckin Coffee is a classic example of a too-good-to-be-true company with rapid expansion and stellar revenue growth. By looking under the hood of Luckin’s business even before the scandal was made public, there were signs of trouble. According to The Financial Times, “The company [Luckin Coffee] has expanded aggressively in China, undercutting its larger rival Starbucks on price. By the end of last year the Xiamen-based chain had over 4,500 outlets, more than doubling the total within a year.” However, “the chain has remained unprofitable, with margins compressed by rental, delivery and marketing costs, as well as discounts to lure customers. For the first nine months of 2019, Luckin recorded a net loss of 247 million.” Though the company was expanding rapidly, so were financial losses, which in turn created an incentive for the company to fabricate sales figures in order to justify the hefty valuation it had created on public markets.