Reasons for Luckin Coffee's Pre-Market Trading Suspension What Happened with Luckin Coffee's Trading Halt

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FrontStreet Coffee - Luckin Coffee Trading Suspension

On April 2, 2020, Luckin Coffee (Nasdaq:LK), listed in the United States, issued an announcement revealing that during an audit, the company's COO and others were found to have fabricated data, involving approximately 2.2 billion RMB. Upon this news, Luckin's stock plummeted by 85% in pre-market trading and closed down 75.57%, evaporating 35.2 billion RMB in market value in a single day. Over two consecutive days, the stock fell by 90%.

Some have commented that previously, one could buy Luckin coffee at 82% discount, and now one can buy Luckin stock at 82% discount. Rising like lightning and falling like lightning, this represents Luckin's biggest crisis to date. However, its impact extends far beyond Luckin itself.

Luckin's Biggest Crisis

Why did Luckin expose itself? The main reason is that the cover could no longer be contained.

As early as January 31, 2020, international short-selling firm Muddy Waters released a report exposing Luckin's inflated revenue. According to reports, this 89-page document involved the work of 92 full-time investigators and 1,400 part-time investigators, who collected over 25,000 receipts and more than 10,000 hours of store surveillance footage. The report concluded that Luckin's third and fourth quarter 2019 sales figures were inflated by 69% and 88% respectively.

For those familiar with capital markets, Muddy Waters Research is no stranger. Over the years, Muddy Waters has shorted multiple Chinese concept stocks, including New Oriental, Huishan Dairy, Anta Sports, and TAL Education Group (parent company of Xueersi).

Currently, Muddy Waters' short-selling success rate appears impressive. According to statistics from 21st Century Business Herald, of the 18 companies they shorted, 9 are still trading normally, 1 has been suspended, and 8 have been delisted (including those acquired or returning to A-shares). Interestingly, Muddy Waters' founder Carson Block has a legal background, and the name "Muddy Waters" originates from the Chinese idiom "浑水摸鱼" (muddying the waters to catch fish).

The Threefold Impact of the Luckin Incident

The problems facing Luckin are likely not as simple as disclosed. Looking forward, there will be at least three major impacts.

First, based on current information, Luckin's disclosure primarily involves the company's Chief Operating Officer (COO) and Director Liu Jian, along with several employees reporting to him. Can a COO's authority be sufficient to engage in such high-risk actions? What was his motivation? Without much specialized knowledge, even ordinary people can reasonably question these aspects.

It's hard to believe that a single COO could conceal such activities for so long. It can be expected that class-action lawsuits will be unavoidable.

Second, with the downfall of one Luckin, Chinese concept stocks listed in the United States have collectively suffered collateral damage. On the day Luckin's stock plummeted, many Chinese concept stocks already experienced declines. For those already listed, stock prices were affected; for those not yet listed, under the shadow of "fraud," listing plans have been temporarily shelved.

Beyond fraud, Luckin's practices such as pledging stocks at high levels are not unique and are relatively common among Chinese concept stock companies. A friend lamented to me that if Luckin triggers class-action lawsuits, other Chinese concept stock companies with similar operations will likely not escape involvement.

Examining the Luckin Model

Behind Luckin's rapid rise and fall story lies a multi-layered game of technology, capital, and finance. From founding to IPO, Luckin took only a year and a half and was once considered a miracle. However, Luckin Coffee's miraculous rise, while appearing special, when deconstructed, essentially follows a strategy of winning through speed and telling a compelling China story.

In September 2018, Luckin Coffee became China's first coffee shop valued at $1 billion. At that time, co-founder Guo Jinyi stated in an interview with the Financial Times that Luckin was currently more focused on rapid expansion rather than profits.

In 2018, Luckin planned to have 2,000 stores by year-end. At that time, Starbucks had approximately 3,300 stores in China, opening about 50 new stores per month. Subsequently, Luckin's store count surpassed Starbucks. Currently, Luckin has over 4,500 stores and continues to expand. In comparison, UK's Costa Coffee or Peet's Coffee are incomparable in terms of store expansion.

After going public, Luckin's expansion pace did not stop. As early as mid-2019, Luckin Coffee founder and CEO Qian Zhiya stated that by 2021, Luckin's store count would reach 10,000. From founding to IPO, Luckin's timeline was merely a year and a half—a true blitzkrieg. As the Chinese saying goes: "In martial arts, only speed is unbreakable."

Without this fraud scandal, how much longer could Luckin's wind-like speed have continued?

Fraud is not the only issue worth reflection. Behind the Luckin Coffee incident, there are many thought-provoking questions. The broader context of Luckin's rise is also the rising tide of global capital markets in recent years. When China's growth story dons a new technological cloak, it can create brilliant Chinese imagination in Western capital markets.

The recent sharp decline in US stocks has drawn considerable attention, but in fact, US stocks have been trending upward for over a decade. This nearly the longest bull market in US history has also brought considerable imagination to the primary market. Luckin's story, while appearing in new internet clothing, is actually quite old-fashioned—it's about China's enormous market capacity—this is the same motivation as when foreign enterprises entered China seeking "one billion consumers."

In the new era, with the help of some internet model halo plus capital backing, success seems so easy, but those who ultimately pay the cost are naturally the secondary market investors. However, are they the only ones paying the bill? Any major event has impacts beyond itself—this is what economists call externality.

China-US financial ties, under trade war and pandemic, have already shown signs of decoupling. Now, because of one Luckin, the image and valuation of Chinese companies will collectively bear the losses.

On April 2, 2020, Luckin submitted a report to the US Securities and Exchange Commission (SEC). The report stated that after investigation by Luckin's board of directors' special committee (presumably after the SEC questioned Luckin following Muddy Waters' doubts and required Luckin to conduct a self-investigation), it was found that company COO and Director Liu Jian, along with several employees reporting to him, engaged in misconduct, including fabricating certain transactions and falsifying 2.2 billion RMB in sales amounts from the first to fourth quarters of 2019.

Upon this news, the stock price crashed in pre-market trading, once dropping by 85%. Within 40 minutes of market open, it triggered 5 circuit breakers and plummeted by 75.57%, with market value evaporating by over 30 billion RMB. Currently, Luckin Coffee has announced trading suspension.

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