The Big Sell | Luckin is not dead

Out of all the Icarus stories in China tech, Luckin Coffee’s is one of the most spectacular. Founded in 2017, in under two years the delivery-focused company was the country’s second-biggest coffee chain, raising half a billion dollars in a US IPO. By the end of 2019, it had more stores in China than Starbucks—and had the larger chain beat on prices.

It didn’t last. In April 2020, Luckin Coffee admitted to fabricating $310 million in sales, the most spectacular fraud admission we had seen in a while in China tech. As shares of the company plunged by as much as 75% in a single day of trading, the Chinese internet wrote it off with a snarky epitaph: “Hey Wall Street, thanks for the free coffee!” By May 22, 2020 shares hit $1.39, from a January high of $50.02.

The disgraced company faced multiple class action lawsuits from shareholders and was delisted from Nasdaq on June 29, 2020. Chairman Lu Zhengyao defaulted on a $518 million loan. In February this year, the company filed for bankruptcy.

But Luckin is still very much alive: despite some closures, its stores are still a ubiquitous presence in Chinese office districts, and this summer it even launched a new range of fruit drinks. On the over the counter markets—the largely unregulated home for stocks that can’t make into a traditional exchange, its stock has recovered to around $9 per share. It’s even reporting higher revenue despite cutting stores.

Is Luckin a comeback story?

It’s hard to say. 

With high-profile marketing campaigns and steep discounts, Luckin changed habits for millions of Chinese consumers. It helped get office workers hooked on reasonably priced coffee, and it still dwarfs its closest competitors in size. But with hipper, low-priced beverage chains nipping at its heels, it’s not clear if Luckin will be the beneficiary of the coffee culture it built.

Luckin seeks profit

Luckin went into bankruptcy with a huge asset: a vast network of busy stores. With its meteoric rise ended, the company has promised to stop burning cash for growth, and raised prices in an effort to turn a profit with the business it has. Bankruptcy administrators Alvarez & Marsal have told the court they are “optimistic” the firm will survive and resume growth.

Price increase & less coupons: For consumers, the most obvious change is increased prices and fewer coupons. Luckin told Chinese media in May that store heads could apply to raise prices up to RMB 3 for each drink, amounting to a RMB 1 or RMB 2 rise considering discounts. Meanwhile, the company stopped giving free drink coupons to first-time buyers. Its current coupons offer around 50% discount, compared with the more aggressive 80% or 90% discounts at the peak of its marketing campaign before the scandal.

Wang Jia, a 38-year-old avid coffee drinker from Shanghai, told TechNode she still orders regularly from Luckin, but receives fewer coupons compared with one year ago.

TechNode staff in Beijing and Shanghai were able to order a black coffee with delivery for RMB 14 ($2.17), discounted from a notional standard price of RMB 26. In China, the most basic drink is an Americano, usually priced at RMB 20.  

Fewer stores: To cut costs, Luckin also closed down about 609 of its self-operated stores, bringing the total from 4,507 to 3,898 at the end of November 2020. The chain is no longer bigger than Starbucks, but it remains a clear second. No other coffee chain has 1,000 stores.

“Luckin has made a decision to turn away from an expansion-at-all-costs approach and prune its network of coffee chains. From outward appearances and occasional company updates, this decision has reduced the number of under-performing stores.” Michael Norris, research and strategy head at institute AgencyChina. 

Existing stores are operated thinly to manage staffing costs. A 40-square-meter Luckin store TechNode visited in downtown Shanghai depends on only one staff member to handle more than 700 orders per day, an employee told TechNode.

Franchise model: Luckin, which previously insisted on running its own stores, launched a franchise model in January. The company does not collect franchise fees from its partners, but becoming a Luckin franchisee requires an upfront investment of between RMB 35,000 to RMB 37,000 for storefront decoration, equipment, and a deposit. Luckin then takes up to 40% of the store’s profits once it reaches an agreed earnings threshold, depending on the size of the store.

Double down on existing users: Instead of spending heavily to acquire new users, Luckin focuses on getting value from regular customers, encouraging repurchasing by funneling them to a private user pool on social network tools such as WeChat Work. After scanning a QR code in a Luckin store at the request of a staff member, TechNode joined a WeChat group where the company sends discounts and coupons to nearly 100 customers. The tactic, commonly known as “private traffic,” is a popular marketing tool in China for increased user intimacy with brands and improved consumer retention rate.

Is it working?

Since delisting, Luckin has not published financial reports, so it’s hard to say whether the company is making headway on profits. In April, Luckin said it will publish corrected 2019 and 2020 earnings “as soon as possible.” But some figures have come out through the bankruptcy process.

When last seen, the company’s bottom line was in the red: in Luckin’s last financial statement, it claimed a loss attributable to shareholders of $324 million for the nine months ending September 2019. Of course, without the fake sales it would probably have looked worse.

Luckin appointed Alvarez & Marsal (A&M), a Cayman Islands-based consultancy which oversaw the liquidation of Lehman Brothers, to oversee its restructuring. The coffee chain owes millions to investors who bought into its January 2020 bond offering. The liquidators most recently released revenue information for 2020, reporting increased revenue despite a steep cut in store numbers. 

Luckin scored revenue growth in 2020, A&M said. The auditor estimated the net revenue for 2020 to be between RMB 3.8 billion and RMB 4.2 billion, compared with RMB 3.0 billion net revenue for 2019. That’s a 27% to 40% year-on-year increase. Nothing significant compared with three-digit growth before, but healthy enough for a tumultuous year. 

“It’s a reach to make predictions about the company’s current operating status based on last year’s data because there have been lots of developments in the market since then. But consumers and the market reckon that the company’s operations are getting better. The beverage industry is highly profitable. Avoiding large-scale store closures during the most difficult times in last year’s pandemic is obvious evidence that the company is doing well,” Mark Zhang, analyst from Tiger Brokers told TechNode (our translation).

Some of its stores managed to break even for the first time in August 2020, and in September 2020, 60% of Luckin’s self-operated stores were profitable on the store level, the liquidators reported. The company claimed $710.3 million in cash and cash equivalents as of Nov. 30, 2020.

New business focuses start to pay off

• As of Nov. 30, 2020, Luckin has 894 franchised “partnership stores.”. This line of business was loss-making as of June 2020, but by November, 70% had reached the profit threshold required to share profits with the company. These thresholds vary between stores.
• A&M claim that “increased number of our transacting customers, purchasing  frequency per customer, higher effective selling prices of freshly-brewed products and our increased efforts in enriching our product portfolio” drove higher returns.

The company still faces debt trouble

• $467 million from 0.75% convertible senior notes are due 2025. One group of investors that holds 84% of said bonds has sued Luckin in the Cayman islands.
• Luckin entered into a restructuring agreement with a group controlling 59% of aggregate principal of the shares on March 16, which will give them back 91%-96% of the value.
• Ordinary shareholders also have claims based on the fact that the company misrepresented its financials. In a statement, the company said it is negotiating non-disclosure agreements with these plaintiffs.
• Luckin paid a $180 million penalty to settle accounting fraud charges brought by the US Securities and Exchange Commission.

Raising money: The company received new investments from Centurium Capital and Joy Capital on April 15. Centurium Capital put in $240 million and Joy Capital invested an additional $10 million in senior convertible shares. Both of the funders were early-stage investors of the company and sat on the original board of Luckin. 

“The company’s original investors, a motley crew with ties to Lu Zhengyao, haven’t given up on the concept. Query, however, whether they believe in the company’s strategy and competitive position or whether they are clinging onto the prospect of a lucrative exit,” Norris said. Norris previously criticized the company’s reliance on the personal networks of its founder in a 2019 TechNode article.

Vending machines: In January 2020, Luckin announced $865 million in post-IPO fundraising to fund growth and “unmanned” vending machine strategy. Due the the turmoil caused by its fraud admission, the firm suspended all expansion of the vending machines business in May 2020.

• Luckin started recruiting partners for its coffee vending machine program, Luckin Express, in March this year. As of December 2020, the company operated 150 vending machines for the program, which is loss making, according to the A&M report.
• The company has nothing about snack vending initiative Luckin Pop Mini, so local media supposes they have dropped the latter.
• A short report that rocked Luckin’s shares in January 2020 focused on vending machines, alleging that the company overpaid for the machines in a related party transaction.

Fool me once…? 

Luckin admitted to bad corporate governance and simply inventing sales figures out of whole cloth. Has it changed enough to be trusted?

• Luckin’s board of directors has undergone a slew of changes since its fraud admission, including the ousting of Charles Lu and Sean Shao in July, and reinstating of Sean Shao at Centurium Capital’s request in September.
• Transparency about the company’s financial status remains limited, with auditors being replaced twice. Auditor EY was replaced by Marcum Bernstein & Pinchuk LLP in December 2020. The latter was subsequently replaced by Centurion ZD in April 2021. Marcum says it “believes that it has not gathered sufficient independent third-party data or conducted sufficient audit procedures to complete the audit.”
• Only two out of the eight directors on the board had no personal ties with the company as of June 2020. The majority of directors must be independent to list on Nasdaq, where Luckin shares were traded before being delisted last year.

The Luckin legacy

Luckin is alive, and so is the model it started. But the world is different now—in part because of Luckin’s success. Coffee shops and beverage chains mushroomed in China over the past year. 

“Previously, Luckin was fighting to take shares from Starbucks. Now, Luckin is trying to complete the same objective, while grappling with Luckin-imitator coffee chains, such as Manner Coffee. It’s unclear whether the company has what it takes to fight a two-front war for coffee-drinkers’ wallets,” said AgencyChina’s Norris.

Local rivals like Manner Coffee (in Chinese) and Coffee Box have become new investor darlings in the coffee segment. Manner, which operates more than 100 mostly Shanghai-based stores, eschews discounts and deliveries, offering app-based pick up at a consistent price (RMB 15 for an Americano, with few to no discounts). Coffee Box, which started as a delivery service for Starbucks and Costa before setting up its own brand in 2014, shut down almost all of its brick-and-mortar stores to focus on online channels after setting up a joint venture in June last year with China’s largest gas station chain Sinopec. The joint venture plans to sell coffee in Sinopec’s Yijie convenience stores as “Yijie Coffee,” and targets 3,000 locations in gas stations and beyond by 2023.

Milk tea and fruity drinks chains also pose a challenge as the boundary between the coffee and tea fads is blurring. That means coffee chains also face competition from IPO candidates like Naixue’s Tea and Heytea, both of which now serve coffee. HeyTea operates more than 700 stores as of December, up from 390 one year ago, while Naixue’s Tea has nearly 500 stores as of 2020.

And, of course, Luckin faces international competitors. Starbucks is becoming more localized and online through a partnership with Alibaba. Fast food chains KFC and McDonald are increasing their coffee forays. Canadian coffee chain Tim Hortons is expanding its China operations after an investment from Tencent in February. 

“There are too many beverage brands to choose from in big cities like Shanghai. Instead of constantly purchasing from one single brand, I buy from several brands, and will choose whichever brands that are most accessible or most affordable at the time,” said Wang Jia.

UPDATE: An interview has been rephrased to remove the implication that Seesaw is a Luckin imitator.

Additional contributions by Julia Lu and Louis Hinnant