I don't mean to say, "I told you so." But, well, you know ...
The implosion of Luckin Coffee (LK) , the Chinese company that admits made-up sales, comes as no surprise.
In this story from May 20 last year, I encouraged investors who had bought the shares in the company's IPO to sell and collect their gains. I also encouraged anyone else to avoid the stock at all costs.
The shares rose 19.9% at the close of the IPO on May 17, 2019, and shot as high as 52.7% in intraday trade. "But subsequent investors should not buy into the company's growth story. Those that are counting their winnings in Luckin's IPO lottery should collect them," my column states.
My logic was very simple: Luckin Coffee could not possibly open almost seven stores a day across China, every day, as it planned to do. The loss-making company wanted to go from zero stores in November 2017 to the 2,370 outlets it had at the IPO and add another 2,500 stores in 2019.
Starbucks (SBUX) has been in China 20 years. Over that period, it has opened a very aggressive 3,600 stores. Luckin planned to be one-third bigger, in just over two years. It didn't make sense.
What worried me further was that it aimed to do this with an app. "People think we're just coffee, but actually we're more than coffee," Chief Financial Officer Reinout Schakel said at the time. It planned to use coffee as a "connection" and then "cross-sell different types of products."
It is coffee. "More than coffee" means maybe you sell them a strudel too. You're not selling people semiconductors, laptops, houses or jet planes. It's food. A low-margin business. What's more, everybody else can sell coffee and strudel, too.
So, the whole enterprise sounded too good to be true. It had the whiff of bike sharing, which boomed only to implode in China. It also had the well-worn storyline of actually being a tech play, because it had an app that lets you watch people make coffee. And buy coffee. It's still coffee. With an app.
I did not expect the company would be caught out by making up fake sales of fake coffee. But that's what has happened, according to the company. I bet it snowballed when the pressure to open all those stores proved simply too great.
The company's shares sank 75.6% on April 2 after the coffee chain said that an internal investigation showed its chief operating officer and several employees reporting to him had been fabricating sales. The shares have lost further ground and are now down 83.2% since word broke.
Luckin Coffee says it has set up a special committee to investigate issues surrounding its financial statements for the 2019 year. The company said the investigation reveals that some 2.2 billion yuan (US$310 million) in sales had been made up from Q2 through Q4. That's equivalent to around 40% of the annual sales projected by analysts for 2019.
The company has suspended COO Jian Liu and the employees who report to him. Liu had been in that post since May 2018.
The whole enterprise sounded too good to be true. It had the whiff of bike sharing, which boomed only to implode in China.
Short-selling specialist Muddy Waters Research, run by Carson Block, said this Jan. 31 in a tweet that it had taken a short position in Luckin Coffee stock. Muddy Waters said it had received an "unattributed 89-page report" that Luckin is "a fraud," and that the company had been inflating sales in Q3 and Q4 2019.
"We view the work as credible," Muddy Waters said in the post, adding that it was supported by 11,260 hours of video traffic in Luckin Coffee stores.
The Muddy Waters report caused the stock to fall as much as 26.5% in intraday trade, although it closed down 11% that day.
The company denied the Muddy Waters report at the time. "The methodology of the report is flawed, the evidence is unsubstantiated, and the allegations are unsupported speculations and malicious interpretations of events," the company stated. It said it would take "appropriate actions" to defend itself against the allegations.
Hedge fund Citron Research, which has often shorted China stocks, said it had a long position in Luckin and that the Muddy Waters report would "fall short on accuracy." Andrew Left, who runs Citron, told Reuters that the stock would probably eventually trade at US$60 once uncertainty about the coronavirus cleared.
That will be an exceptionally long road back. Trading in the shares has been halted by Nasdaq since April 7, with them now standing at US$4.39. They debuted at US$17 in the IPO last May, and peaked at US$50.
The halt came the day after Goldman Sachs said in a note to clients that the Luckin chairman and the Luckin CEO had together handed over millions of shares after defaulting on a US$518 million margin loan. Goldman said it is acting as "disposal agent" for the Luckin Coffee shares, pledged as collateral for the loan by Chairman Charles Lu Zhengyao and founder and CEO Jenny Qian Zhiya, after a company controlled by Lu's family defaulted on the loan.
Goldman itself as well as Morgan Stanley, Credit Suisse, Haitong, CICC and Barclays are the lenders left holding the bag, according to Reuters. The bulk of them helped underwrite the IPO of the company, with Singapore sovereign wealth fund GIC and the world's largest asset manager, BlackRock, also among Luckin's early backers.
Multiple law firms are now investigating class-action lawsuits on behalf of shareholders posting losses in Luckin shares.
I agree with Reuters Breakingviews columnist Pete Sweeney. "The reality is that Luckin is just a loss-making food and beverage business with an app," Sweeney wrote on April 7.
All too many investors may have been lured in by the sweet talk from the coffee company, its incredibly aggressive growth projections, and its long line of influential backers. The debacle has raised further questions about the wisdom of buying into the shares of U.S.-listed Chinese companies.
It's often stated that many Chinese companies have two sets of books: one for public sharing, and another that show the real numbers. But we assume the companies going public in the United States are among the better ones, ones that have produced a proper set of books. Have they?
Left told the Financial Times that the Luckin Coffee episode "makes you question the whole system, honestly," adding that it "just shows you the lack of controls; you obviously know this wasn't done by just one person."
Left said he is now trawling through his inbox looking for signs of potential fraud at other Chinese companies. The Chinese arm of EY, its auditor, reportedly confirmed the fraud to Luckin Coffee, but only after multiple reports by short-sellers such as Muddy Waters.
Muddy Waters has also issued negative research about TAL Education Group (TAL) . That Beijing-based operator of tuition centers on April 7 admitted an audit showed an employee had "conspired with external vendors" to wrongly inflate sales at one of its business segments. That's its "Light Class" business of live-streaming courses to primary-school students, which it says accounts for around 3% to 4% of its forecast sales.
Muddy Waters and the short-sellers Wolfpack Research have also targeted the video-streaming company iQiyi (IQ) , accusing it of artificially inflating its 2019 sales. The video streamer has denied it, saying the "report contains numerous errors, unsubstantiated statements and misleading conclusions and interpretations" about the company.
The pressure plays into the hands of China hawks like U.S. Senator Marco Rubio. It's likely that we will see further pressure on the ability of Chinese companies to raise money from the public in the United States. But judging on the Luckin Coffee episode, greater scrutiny is warranted.