International

Luckin’s Jolt and Echoes of WeWork’s Governance Debacle

For China’s Luckin Coffee, call it a jolt of the most unpleasant sort.

Internal investigations, fabricated revenues, torched stock price and now the lenders have come calling.

Last week, the company said in a filing with the U.S. Securities and Exchange Commission that it had launched a probe into alleged fraud by the chief operating officer, Jian Liu.

As a result, the filing last week noted, the agency (and, we note, pretty much everyone else) should not rely on statements filed with the SEC stretching back over several quarters.

As the news and the filing became public, shares plummeted more than 80 percent to $4.91.  Then the stock fell another 18.4 percent on Monday to $4.39 after Goldman Sachs said it would seize shares from Luckin Chairman Lu Zhengyao that had secured a $518 million margin loan he had defaulted on, according to the Financial Times. The newspaper said that Goldman plans to convert the shares into American depositary shares, sell them and distribute proceeds to lenders, the FT reported.

Luckin’s problems began in recent days when a panel told the company board that starting in the second quarter of 2019, Jian Liu —  who also served as a company director — and several other employees had engaged in misconduct, allegedly fabricating transactions. The independent investigation came after, as reported by The Wall Street Journal, accounting firm Ernst & Young reported to Luckin’s audit committee that certain transactions had been falsified.

As reported, the company said last week that a significant share of revenues — the equivalent of $310 million —  had been falsified.

The stock’s plummet wound up eliminating the collateral backing the loan and setting the stage for Goldman’s actions.

Digging deeper, though, and as reported by FT, the falsified revenues also come as Muddy Waters, a firm tied to short selling (a Wall Street strategy of betting that borrowed shares will fall and that the holders can buy them back more cheaply, and pocket the difference) found that the company was overstating the business at its locations. The company, in turn, has said that Muddy Waters’ contentions are “misleading and false.”

Some Echoes

The story is just beginning, but already there are some echoes of some other, spectacular flameouts, where nascent businesses, claiming to disrupt an old market through new means, accumulate billions of dollars of enthusiastic capital and then collapse.

As it stands today, Luckin is the largest domestic chain in China, where Starbucks is the other juggernaut.

The company went public last May, raising $380 million in its debut on U.S. markets. And it grew at breakneck speed, notching more than 2,300 locations from the time of the company’s founding in 2017 to its initial public offering (IPO) in May 2019. Luckin has touted technology such as artificial intelligence (AI), which analyzed customer behavior, and to deliver mobile-focused discounts and promotions to spur sales.

By November of last year, Bloomberg reported, revenues were up six-fold to 1.5 billion yuan (the equivalent of $219 million) for the September 2019 quarter. At the same time, the net losses also grew to nearly 532 million yuan from the previous year’s quarter tally of a net loss of roughly 485 million yuan.

Yet amid all this growth, Luckin came to market again in January of this year, raising more than $800 million in convertible notes and American depository shares (ADS).

Growth, red ink, going back several times to market to get capital to keep up growth — we’ve seen this movie before.  In one example, WeWork, which never actually came to market via IPO, had opaque internal controls. Forbes noted back in the fall that there were numerous related party transactions; relatives of CEO and founder Adam Neumann also held executive positions; the firm also transacted with vendors owned by family members of other executives.

The fact remains that levels of oversight are crucial for ensuring that transparency is part of the reporting process, that revenues and expenses are accurately reported, that conflicts of interest can be exposed before they become problematic.

As CNBC said this past week, “Securities and Exchange Commission Chairman Jay Clayton and William Duhnke III, chairman of the Public Company Accounting Oversight Board, have often noted that U.S. regulators are prevented from inspecting audit work and practices of audit firms in China. They have called for more cooperation from China, to no avail.” China, said CNBC, has been among the nations that have been relatively less cooperative with SEC compliance and disclosure mandates.

We don’t know the full story yet — but it’s a fair bet the corporate governance will increasingly be on the radar as misconduct continues to hit investors as promises of hyper-growth and surging earnings fall away to reveal accounting sleights of hand.

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