Not Luckin Good: How Primary Research Exposes Financial Misconducts

By Isabel Wong

The Nasdaq-listed Luckin Coffee was once regarded as the “Foxconn of the F&B industry”. But as the Chinese coffee chain’s accounting scandal unfolded, Luckin’s shares crashed harder and faster than when it first rose to the unicorn status, falling by more than 81% in one day after it issued a press release admitting a significant amount of sales in 2019 had been fabricated.

The Chinese rival to Starbucks released a SEC filing last week to describe what the special committee has found during its internal financial investigation. COO Jian Liu was found to have fabricated transactions of around 2.2 billion yuan (US$310 million) from the second quarter through the fourth quarter of 2019. Certain costs and expenses were also inflated significantly.

Luckin Coffee became China’s first coffee shop unicorn within a year since its inception back in 2018. (Photo: Luckin Coffee)

Luckin might have surpassed Starbucks as the largest coffee chain in China by number of outlets in just a few short years. But the rapid expansion and the eye-watering IPO valuation of the on-demand, hybrid online-offline coffee chain had kept investors scratching their heads for some time, as many of them expressed an IPO valuation of US$4 billion for a startup coffee chain, in less than two years after the company opened its first outlet in Beijing, was simply too lofty given red flags such as major cash burn and uncertain path to profitability.

Behind The US$5 Billion Share Wipeout

The Luckin saga began when famed short-seller Muddy Waters Research shorted the Luckin stock, citing an anonymous report that questioned the coffee chain’s financials. While Luckin initially called the report’s methodology flawed and denied any wrongdoing, it eventually had to come clean as its auditor Ernst & Young reported accounting problems to Luckin’s board and refused to sign off on the coffee chain’s 2019 annual audit report.

While some argue EY might have come under pressure as the anonymous report publicised by Muddy Waters was drawing attention from investors, analysts also said that the reason why Luckin had to admit its wrongdoing was the recently expanded cooperation accord between China’s Ministry of Finance, the China Securities Regulatory Commission (CSRC), and the Hong Kong Securities and Futures Commission (SFC). Under the new accord, Hong Kong securities regulator is able to gain access to audit papers on foreign-listed Chinese companies.

Meanwhile, the anonymous report on Luckin Coffee demonstrated the depth of primary research that some investors take on to evaluate an opportunity.

Investigation Powered by Primary Research

Every great investment begins with preparation. Primary research often plays a vital role when equity research analysts are trying to develop a proprietary viewpoint on the investment opportunity. It allows for more direct and in-depth exploration and verification of assumptions and risks driving the investment thesis.

Primary research is the type of research method where one goes out and collects first-hand data. The research is not based on any other earlier published sources of information, and the process includes different types of personal interviews, surveys, and ethnographic research. Investment firms will often get expert networks to schedule quick chats with industry participants to get their on-the-ground views on a topic. Expert networks are essential to primary research, as it is a better, more compliant option for working with third party industry experts given their compliance framework, systems and auditing capabilities.

In January 2020, Luckin Coffee announced it would launch smart vending machines that make its signature coffee and sell snacks and beverages. (Photo: Luckin Coffee)

In Luckin’s case, a primary research on its financial performance was what ultimately led the Chinese coffee chain to come clean about its wrongdoing.  The firm behind the anonymous report sent to Muddy Waters had reportedly mobilised 92 full-time staff and 1,418 part-time staff to conduct primary research on activities across 2,213 Luckin stores in 45 cities in China. Sources claimed that multiple expert networks were also involved in the research stage to enable interviews with industry experts including packaging material and ingredient suppliers for coffee and beverage retail businesses in China.

The extensive research was able to give concrete evidence to prove that the numbers Luckin has been reporting do not match the reality. Industry experts said that Luckin’s explosive growth the past few years was driven by heavy discounting and coupons along with prepaid coffees. Experts also commented that the announcement about entering the smart coffee and snack vending machine market made by Luckin earlier this year would not do much in terms of real revenue growth as it simply served the purpose of boosting short-term share price.

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