This article first appeared in The Edge Malaysia Weekly on April 27, 2020 - May 3, 2020

LEGENDARY billionaire investor and Berkshire Hathaway CEO Warren Buffett once said, “Only when the tide goes out do you discover who’s been swimming naked.” The recession that followed the dotcom crash in 2000 and 9/11 terrorist attack in 2001 saw the unravelling of high-flying energy firm Enron, telecom firm WorldCom as well as conglomerate Tyco. As the 2008 recession unfolded in the aftermath of the subprime mortgage crisis, former Nasdaq chairman Bernie Madoff admitted to running a Ponzi scheme by cooking the books of his hedge fund, which delivered consistently high returns in good times and bad. The current coronavirus-induced recession has so far not produced a single high-profile bankruptcy, though one Chinese firm, Luckin Coffee, is now on the brink.

The Xiamen-based coffee chain operator had emerged as yet another icon of the high-growth consumer business in China, with huge sums of early-stage funding that helped position it as a threat to behemoth Starbucks Coffee Co. In May last year, Luckin listed in the US with much fanfare, boasting a stratospheric valuation of more than 30 times its annual sales and losing almost as much money on every cup of coffee it sold as it spent on actually making it. At its peak in January, with a market capitalisation of around US$12.5 billion (RM54.6 billion), Luckin was trading at nearly 50 times its real annual sales. Not even the fastest-growing software firms command such a valuation.

Not surprisingly, within eight months of its Nasdaq listing, Luckin’s luck was running out and its business model was coming undone. On April 2, it disclosed that nearly half of the revenues it had reported in the last three quarters of last year, or RMB2.2 billion (RM1.36 billion), was actually plucked out of thin air rather than derived from selling a lot of coffee. Luckin blamed chief operating officer (COO) and board director Liu Jian for the misconduct, which came to light after an internal investigation by its auditors Ernst & Young found that Liu and several other employees had overstated early revenue figures. The Edge obtained Liu’s email address but he has so far not responded to our queries or addressed the allegations.

Luckin’s stock cratered after the allegations first surfaced in early April, losing nearly 84% of its value. The stock is down nearly 90% from its peak and is currently suspended from trading. That brings me to another famous Buffett quote. “There is seldom just one cockroach in the kitchen,” the billionaire known as the Oracle of Omaha once said of corporate malfeasance. “When you see one cockroach in a corporate cupboard, his relatives are nearby,” he said.

Clearly, the overstating of Luckin’s revenues for three consecutive quarters — the one preceding its listing, the one during which the firm listed and the one immediately following its listing — to the tune of half of its total sales is not the only cockroach at Luckin. How could the COO, a director of the board and a long-time close confidant of the firm’s founder, pull off something like that? Who knew about the elaborate scam? How long had they known?

The company’s lucky streak began with a rip-roaring listing last May. Its stock popped nearly 20% on the first day of trading after Luckin had priced its IPO at US$17 per share, at the top end of its expected range, raising US$561 million. The IPO valued Luckin at about US$4.2 billion and came just one month after a US$150 million round of funding at a US$2.9 billion valuation.

One big red flag for start-ups is when they constantly raise cash. Luckin raised US$2.4 billion in its 19 months as a start-up. It raised cash from asset management powerhouse BlackRock; Chinese private equity firm Centurium Capital, which is headed by David Li, former China CEO of private equity firm Warburg Pincus and an old ally of Luckin’s founder Charles Lu Zhengyao; Legend Capital, the venture capital arm of Chinese PC giant Lenovo; as well as Singapore’s GIC. Indeed, the start-up had achieved a unicorn valuation even before it brewed its first cup of coffee.

In mid-January, an anonymous 89-page report on Luckin Coffee landed on the desks of investors known to short China stocks, including Muddy Waters Research founder Carson Block, famous for his short-selling of Singapore commodities firms Noble Group and Olam International. The report, based on 11,000 hours of store traffic video, alleged that Luckin had inflated sales by 69% in the third quarter and 88% in the fourth quarter of last year. Block immediately made the report public, and Luckin stock fell nearly 30% despite the company’s denials.

The surprising thing about the Luckin saga is that investors were throwing so much cash at a company with a story that was too good to be true — it had an untried, untested business model selling coffee that did not even taste good, at just about half the price of Starbucks, in a country that does not have much of a coffee drinking culture. On average, 1.4 billion Chinese drink just three or four cups of coffee a year. Beijing-based Daxue Consulting in a recent report on coffee in China notes, however, that these days, young white-collar workers in Beijing and Shanghai consume between 100 and 150 cups of coffee annually outside their own home. For a nation deeply influenced by its thousand-year tea-drinking culture, Chinese are increasingly more open to the Western lifestyle.

In comparison, Americans drank an estimated 400 million cups of coffee a day last year. That’s 456 cups of coffee per person.

Starbucks’ influence

The Daxue report notes that China’s coffee market is growing at a breakneck pace. It has more than doubled in the six years since end-2013, or a compound annual growth rate of over 18%. Blame China’s growing love of coffee on Starbucks.

In January 1999, Starbucks opened its first store in the lobby of the China World Trade Center in Beijing. Today, there are more than 4,200 Starbucks stores in 177 cities in the country, employing over 57,000 people. Until Covid-19 forced a lockdown, a new Starbucks was opening in the country every 15 hours. Starbucks plans to have 6,000 stores in 230 Chinese cities by the end of 2022. Last year, the Seattle-based chain chalked up US$2.6 billion in sales in China. That’s an awful lot of coffee for a nation of tea drinkers.

Moreover, there are now many international chains peddling gourmet coffee in China. The UK’s Costa Coffee (now part of Coca-Cola), Canada’s Tim Hortons and US-based Dunkin’ Brands Group, owners of the Dunkin’ Donuts chain, have been growing their footprint across China for years.

Founded in late 2017, Luckin raised US$200 million in July 2018 at a valuation of US$1 billion. At the time of its listing 11 months ago, the company claimed it was operating 2,370 stores across 28 cities in China. By the end of 2019, it had grown its total store base to 4,500 locations across the country, surpassing the number of Starbucks stores. Yet it was selling one-tenth worth of coffee that Starbucks was selling in China. And that’s when you take into account that its revenues were being inflated by about 100%!

From the start, Luckin pitched itself as a local “David” battling a foreign Goliath. Although it did not have the branding or taste of Starbucks coffee, Luckin employed some daring marketing tactics to draw attention. It opened a “Relax” Luckin Coffee outlet inside Beijing’s Forbidden City, the former Chinese imperial palace and home to emperors for nearly five centuries. The site was the same one from which Starbucks was evicted in 2017 amid protests of a “Western invasion”. Reopening a Chinese coffee shop on the same site looked like a huge marketing coup.

Luckin also had the chutzpah to claim that it was “suing” Starbucks in China for its monopolistic behaviour. Luckin never actually filed a suit. The whole thing was just a publicity stunt but it raised awareness for the fledgling brand.

Glorified kiosks

There was little that Luckin had in common with Starbucks. A key part of the latter’s appeal is its cafés’ ambience, including cozy seating, mood lighting and soothing music. Luckin’s appeal to investors was that it did not need as much valuable real estate as its American counterpart. More than two-thirds of its outlets are essentially glorified kiosks.

Luckin touted itself as a tech play. You download an app, order on your smartphone from within WeChat, the dominant super-app in China, approach the kiosk, grab the cup with your name and walk away. Most Luckin stores had no cashiers and, as such, did not take cash or credit cards. Want a cup of coffee? Just order from WeChat and the money is debited to Luckin. It also offered a fast delivery service. You could order from your desk and Luckin would deliver coffee, snacks or juices to your office.

Luckin also competed fiercely on price. Its coffees and snacks are priced at 20% to 50% lower than comparable Starbucks fare in China. Another well-worn marketing tactic has been strategic tie-ups with distribution platforms such as Meituan Dianping and boosting sales with discount coupons. But despite cheaper coffee, more outlets as well as discounting to bring in new customers, Luckin just was not moving the needle much. And, did I tell you Luckin was spending almost 50% of its revenues on advertising and marketing?

Once it was listed on Nasdaq, it needed to show accelerating revenue growth to justify its lofty valuation. As anyone who has seen a retailing scam will tell you, often the best way to mask tepid or falling same-store sales is to aggressively roll out more stores. Yet, the “build-and-they-shall-come” strategy works mostly with a good product. Luckin’s problem was that its coffee just did not taste good.

Just as soon as Luckin shares were listed on Nasdaq, Lu, co-founder Jenny Qian and other insiders such as Lu’s sister Sunying Wong were busy cashing out. Under US Securities and Exchange Commission rules, insiders are restricted from selling their shares between three and 12 months after the IPO. But Lu, Qian and Wong pledged their shares in Luckin to Goldman Sachs and other bankers to obtain US$518 million in loans. Even if there was an adequate cushion, the 84% slide in Luckin’s share price means banks that force-sold the shares recovered little of what they lent out.

On the day of its IPO, Luckin brought several coffee machines to the Nasdaq site in Times Square in New York and gave investment bankers, journalists, investors and analysts who attended the opening party as much coffee as they wanted to drink. It was not the same coffee the firm serves up at its kiosks in China, but premium fare. Buffett has often talked about the “smell test” he does with companies that he is looking at. Luckin’s investors might be wondering if they should have smelled its store coffee before they bought into the company.

Assif Shameen is a technology writer based in North America

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