If you’ve ever wondered how large-scale fraud’s get discovered, you’re not alone. Sometimes it’s through luck or an internal whistleblower. Sometimes, however, it’s just a hunch and a ton of hard work.
The Luckin scandal was discovered via the latter method, and this is that story. It is a long read, but we wanted to provide the depth of analysis that the story deserves.
In order to ensure we didn’t accidentally change the meaning of some complex parts of the fraud report, some highlights from the anonymous pdf have been copied here directly.
The original document (PDF) is available at the bottom of this article for your own download.
Who Published this Report?
According to people familiar with the matter, the anonymous Luckin report was later identified as coming from Snow Lake Capital, a Chinese hedge fund with offices in Beijing and Hong Kong. It was sent anonymously to a number of known ‘short sellers’, including Muddy Waters Research LLC.
Muddy Waters Research is a US-based research company. The quote on their front page says what they do.
Doing the Work Wall Street Won’t
If the company sounds familiar, you may have heard their name back in 2011 when they broke the bubble on another Chinese company scandal – Sino Forest.
Muddy Waters usually does their own research into company’s they think aren’t telling the truth. If they find something, they compile the evidence, then short the stock and publish their findings.
What is Stock Shorting?
If you are of the opinion that a share price will down in the near future – how can you make money off that knowledge? You want to do the opposite of buying the stock, you want to sell stock at the price you can get today, but only deliver the stock to the buyer at some point in the future, perhaps 1-3 months down the road.
If the price goes down as you suspect, you can now go buy that stock at the lower price, but you’ve already agreed to sell it to someone earlier at the price it was before, which was higher. You make money on the difference.
“Coffee for Closers” – a Cryptic Email
Luckin launched on the Nasdaq Stock Market in May 2019 and quickly became a darling of the market, which pundits betting it would outperform the rest of the market, tapping into demand from Chinese consumers for an alternative to Starbucks.
Then in January, days after the stock price hit a record high, valuing the business at $12bn an email started arriving in the inboxes of a number of traders who specialise in ‘short-selling’. (see above the definition of selling a stock short).
The first thing that becomes apparent when reading through the report is the numbers. There are a lot of numbers, and they are specific. We mentioned that this story broke after a ‘ton of hard work’.
To be clear, we are not referring to just hours of computer time, but over a thousand people, working on the ground in China, spending the equivalent of 1 year and 3 man-months inside the actual shops, counting customers, copying receipts and compiling vast amounts of real data. Below is a snippet from that email.
When Luckin Coffee (sic) went public in May 2019, it was a fundamentally brokenLuckin Coffee: Fraud + Fundamentally Broken Business (by anonymous)
business that was attempting to instill the culture of drinking coffee into Chinese consumers through cut-throat discounts and free giveaway coffee.
The email continued to say they could provide evidence in the form of receipts and even video from Luckin outlets to show how they had reached their numbers.
Amazingly, the author offered to share this information and the report and would allow them to take the credit for it.
Enter Muddy Waters
One of those who received the report was the famous and respected, if not particularly liked by Wall Street, research house, Muddy Waters LLC. Carson Block from the company – the same person who published the report on Sino Forest, published the report on Twitter.
The report sent a shockwave through the industry, forcing Luckin’s auditors to wake up from a delightfully pleasant nap and suddenly discover that several employees had faked revenue and expenses.
Gradually, then Suddenly Bankrupt.
My favourite line from my second favourite Hemmingway book (The Sun Also Rises) when asked “How did you go bankrupt”, the answer was “Two ways, gradually, then suddenly”.
Luckin Coffee was riding high in January with a $12bn valuation, in April they admitted that as much as $310m of their 2019 sales were fabricated and in June they accepted Nasdaq’s decision to delist them. All that happened in just a year, and it’s unclear what will happen to Lu Zhengyao, but I wouldn’t bet on him facing any serious ramifications, although he will unlikely lead another company listed on any major stock exchange.
I thought it would be interesting to include some summary parts of the report below. It explains in detail how the fraud was perpetrated and why there were red flags that existed which should have warned off investors, and should have been easily uncovered by anyone motivated to do due diligence.
Some Did Their Homework
In fact, due diligence, or DD as it’s called, was done by some investment funds, but different conclusions were reached.
One fund’s work comprised spot checks on individual stores, noting crowded shops and the ever-present Luckin blue-and-white coffee cups. They reviewed Independent data that showed a growth in downloads of Luckin’s mobile app and tracked the company’s reported growth in sales.
Baillie Gifford & Co., a UK finance house, sent an analyst to China last year to review a number of companies for potential investment, including Luckin.
The analyst they sent, who speaks Mandarin, met with Luckin’s management, and visited one of its shops in Shenzhen and even took the time to speak with customers. The analyst returned to the UK and the company decided not to invest. I hope that analyst got a pay rise.
The Luckin Report
The document opens with a summary and a number of headings titled “Smoking Gun” and “Red Flag”. Some of them involve complex financial terms, and for the sake of brevity, I’ve kept our reporting to the more general observations here. For the full text, see the attached report at the bottom of this article.
Smoking Gun Evidence:
The number of items per store per day was inflated by at least 69% in 2019 3Q and 88% in 2019 4Q, supported by 11,260 hours of store traffic video. We mobilized 92 full-time and 1,418 part-time staff on the ground to run surveillance and record store traffic for 981 store-days covering 100% of the operating hours. Store selection was based on
distribution by city and location type, the same as Luckin’s total directly-operated store portfolio.
Luckin’s “Items per order” has declined from 1.38 in 2019 2Q to 1.14 in 2019 4Q.
We gathered 25,843 customer receipts and found that Luckin inflated its net selling price per item by at least RMB 1.23 or 12.3% to artificially sustain the business model. In the real case, the store level loss is high at 24.7%-28%.
Excluding free products, the actual selling price was 46% of the listed price, instead of 55% claimed by management.
Luckin’s revenue contribution from “other products” was only about 6% in 2019 3Q, representing nearly 400% inflation, as shown by 25,843 customer receipts and its reported VAT numbers.
Luckin’s management has cashed out on 49% of their stock holdings (or 24% of total shares outstanding) through stock pledges, exposing investors to the risk of margin call induced price plunges.
(Ed. Investors naturally want to see managers hold their shares and not sell them. By ‘pledging’ their stock through mechanisms like margin trading, they effectively borrow money using their shares as the collateral. This leaves the other shareholders owning the risk if the shares become worthless).
‘CAR Inc’ listed on the HK Stock Exchange was another company of Luckin’s Chairman Charles Zhengyao Lu. Both he and the same group of closely-connected private equity investors walked away with USD 1.6 billion from CAR while minority shareholders took heavy losses.
Through the acquisition of Borgward, Luckin’s Chairman Charles Zhengyao Lu transferred RMB 137 million from UCAR (838006 CH) to his related party, Baiyin Wang. UCAR, Borgward, and Baiyin Wang are on the hook to pay BAIC-Foton Motors RMB 5.95 billion over the next 12 months.
Now Baiyin Wang owns a recently founded coffee machine vendor located
next door to Luckin’s Headquarter.
Luckin recently raised USD 865 million through a follow-on offering and a convertible bond offering to develop its “unmanned retail” strategy, which is more likely a convenient way for management to siphon a large amount of cash from the
Luckin’s independent board member, Sean Shao, is/was on the board of some very questionable Chinese companies listed in the US that have incurred significant losses on their public investors.
Luckin’s co-founder & Chief Marketing Officer, Fei Yang, was once sentenced to 18 months’ imprisonment for the crime of illegal business operations when he was the co-founder and general manager of Beijing Koubei Interactive Marketing &
Planning Co.,Ltd. (“iWOM”).
Afterwards, iWOM became a related party with Beijing QWOM Technology Co., Ltd. (“QWOM”), which is now an affiliate of CAR and is doing related party transactions with Luckin.
Accounting firm Ernst & Young Hua Ming LLP in April disclosed that it now had found evidence that some Luckin employees had fabricated revenue and some expenses.
Yet only a few months earlier, the same auditor had issued a private “comfort letter” that indicated it didn’t have any issues with the numbers included in the companies interim financial statements. A spokeswoman for EY declined to comment, citing client confidentiality.
The markets work on trust and a belief that companies only become listed once they have gone through rigorous due diligence. I have personally witnessed, albeit on a lower level stock exchange, what I consider misfeasance from bankers who ignore red flags, which are ‘inconvenient’.
Anyone investing in the markets should be aware that there are many conflicts of interest. Commission structure of bankers is one, and the large fees companies pay to their auditors is another.
While some of these are trying to be addressed by for example, breaking up the auditing companies, I don’t have much faith that they will succeed. The biggest trap is greed on behalf of the investor. Fraudsters rely on investors greed to get phenomenal returns that blind them to the tricks they’re playing with their other hand.
Lu Zhengyao has now pulled this trick twice (CAR and Luckin), seemingly without consequence. The Chinese government needs to act if it is to restore faith from foreign investors into Chinese companies.