Luckin’s Fraud And Chinese Stocks: Invest Carefully (NASDAQ:LK)

Introduction

I’ll admit it from the start: I was a shareholder of Luckin Coffee (LK). Was, because I sold my shares from the moment the news of the fraud was announced. It was just a tiny position in my portfolio. I sometimes buy a few shares of a company to track it, so I had bought 5 shares of Luckin. On April 1, as some sort of bad prank, the company revealed that the COO and employees reporting to him made up sales. With just 5 shares, I won’t cry for my losses, of course. If you still have shares, I would sell them as soon as possible. This fraud doesn’t mean you should avoid all Chinese stocks, though, but you should be careful.

What has happened?

Luckin revealed fraud from its COO and people reporting to him on April 1, as if it were a bad prank. It submitted an SEC filing in which the fraud was made public. Luckin had appointed a special committee to investigate ‘certain issues’ that were reported to the board after the audit of the FY 2019 results. And then it states:

The Special Committee today brought to the attention of the Board information indicating that, beginning in the second quarter of 2019, Mr. Jian Liu, the chief operating officer and a director of the Company, and several employees reporting to him, had engaged in certain misconduct, including fabricating certain transactions. The Special Committee recommended certain interim remedial measures, including the suspension of Mr. Jian Liu and such employees implicated in the misconduct and the suspension and termination of contracts and dealings with the parties involved in the identified fabricated transactions.

That’s already a shocker, of course. But ‘fabricating certain transactions’ is still vague. But then comes this:

The information identified at this preliminary stage of the Internal Investigation indicates that the aggregate sales amount associated with the fabricated transactions from the second quarter of 2019 to the fourth quarter of 2019 amount to around RMB2.2 billion. Certain costs and expenses were also substantially inflated by fabricated transactions during this period. The above figure has not been independently verified by the Special Committee, its advisors or the Company’s independent auditor, and is subject to change as the Internal Investigation proceeds.

RMB2.2B, that’s about $310M of sales that were completely fake. That’s almost half of the sales the company had reported. That’s simply mind-blowing.

The stock has been frozen on the Nasdaq at $4.39 since April 7. Nasdaq has said that it first wants answers to certain questions before it would consider to allow trading in Luckin again. My opinion is that the stock will be delisted, and shareholders will have to go to the OTC market to get rid of their shares.

Lesson 1: Listen to shorters

When Muddy Waters announced that it shorted Luckin after it had received a report that claimed that Luckin’s numbers were seriously inflated, I first put it aside. I am as human as anyone else, so my first reaction was: ‘No way!’ The reason is confirmation bias: you and I initially only listen to information that confirms our own opinions. Besides that, shorters often talk their own book and try to talk down a business.

I have developed a habit of mostly ignoring them. I used to read every short report, but the reports often confused me. They are so well-written, and it’s not a simple task to debunk them. I remember when Citron Research published one of his short reports on Shopify (SHOP) when it was around $100, I almost sold my position. By studying very hard, I could poke holes in Citron’s thesis eventually, but it took me days. Fortunately, I kept my shares.

This debacle has changed my position from ignoring to qualifying. What I mean is that I should read the main points of the shorters, and if they look substantial, I should dive deeper. I suspect that I will still skip doing more research if I don’t own the stock or if I only have a tiny position. But if I have a more sizeable position (as was the case with Shopify), I will still try to debunk the thesis and if that is not possible, maybe trim or sell my position.

If I had read the report that Muddy Waters issued, I would probably immediately have seen the red flags, although, in hindsight, that’s easy to say. It was 89 pages long and extremely thorough. 92 full-timers and a staggering number of 1,418 part-time staff recorded over 11,000 hours of video in 620 Luckin stores in 38 cities. That’s almost 1,000 store days, which means that this is one of the most substantiated reports that I have ever seen in the stock market. This is not your average shorter who wants to insinuate a few things without giving facts. There are rumors that the Hong Kong-based hedge fund Snow Lake Capital, with $2B of AUM, could be the one that covered the costs for this investigation.

Lesson 2: Liars keep lying

Do you really believe that the COO, who had just 40,000 options, together with 4 collaborators would set up this complete scam without the CEO and the other top managers knowing everything? Don’t forget that Jian Liu, the COO, was only brought in when it was revealed by Chinese media that Luckin’s CMO and co-founder Yang Fei had faced 18 months of jail five years before co-founding Luckin for whitewashing negative reviews about his clients when he headed a marketing firm. While everybody should get a second chance, this was clearly a red flag.

3) “Sacrificing Jian Liu, the COO, by putting all the blame on him and 4 subordinates, is shameless and cowardly behavior. And above all, I don’t believe it.” please rephrase this, as this is a bit too harsh (although arguably defensible).

Sacrificing Jian Liu, the COO, by putting all the blame on him and 4 subordinates, is questionable behavior, and I don’t believe only these 5 people knew about this. If you inflate numbers like that, the CEO and CFO must know about it. We’re not talking about an accounting mistake of a few thousand dollars here, but about $310M, almost half of the sales. And suppose the CEO and other executives didn’t know about the fraud, is that a management team you’d want and trust? But I think Jian Liu takes one for the team.

Lesson 3: If it’s too good to be true…

You know the saying: if it is too good to be true, it probably isn’t. I hadn’t researched the company thoroughly, which I would have done before I would make it a Potential Multibagger. The reason I had bought those five shares was because of the outstanding results Luckin posted. But this shows why you should always research a company before buying shares.

The story around Luckin has always been different in the West than in China. In the West, Luckin was praised as a Chinese version of Starbucks (SBUX) in China. The euphoria could be seen on the first day of trading. Luckin’s share price jumped 48%.

(Luckin’s IPO)

In China, Luckin didn’t have such a good reputation, and it was often compared to ofo, the almost-bankrupt bike-sharing company in which a lot of Chinese investors lost a lot of money. The fact that Luckin’s management explicitly stated that Luckin Coffee was not the next ofo should have been seen as a big red flag too, in hindsight. Because, what was ofo’s market strategy? Cheap, cheaper, cheapest. What was/is Luckin’s? Cheap, cheaper, cheapest.

Everybody, including Chinese consumers, love bargains, but often, it’s not a sustainable model if you overdo it. Luckin pushed it too far by offering the first coffee for free, and then couponing like there’s no tomorrow, at least 50% off and often a lot more.

After the fraud was made public, Luckin Coffee’s mobile app in China exploded in popularity and ranked as the second most downloaded app in China. Some saw this as a sign of patriotism, but the explanation is much simpler: people were afraid that they wouldn’t be able to drink their free or heavily discounted coffees.

Lesson 4: this is not the same as a decade ago

First, why do more than 150 Chinese companies list in America? There are three main reasons, and all have to do with the rules around stocks in China.

It’s not a coincidence that the majority of the Chinese companies listed in the US are tech companies because the first and most important reason for Chinese companies to list in the US is that until March of this year, a company had to be profitable before it could be listed on the Chinese stock market. A lot of tech companies are not profitable from the start and look for money to scale and then the American market is an ideal solution.

The second reason is that the company’s founders can still have control if they list in the US. In China, there are no dual-class stocks, every share represents one vote. Founder-CEOs issue stocks with multiple votes per share and that’s legal in the US but not in China.

The third reason is that foreigners are not allowed to invest in Chinese stocks directly. Therefore, only Chinese investors and institutional investors can buy Chinese stocks. If Chinese companies want exposure to international investors, they are better off in the US.

About a decade ago, as many investors will remember or have seen in the documentary The China Hustle, quite a lot of fraudulent Chinese companies were pumped and dumped by American investment banks. A lot of investors still have scars and don’t trust any Chinese stock, which is understandable.

But the regulatory context has changed a lot over the last decade. The fact that Luckin now comes with this news itself is a good sign. After the fraudulent Chinese stocks of a decade ago, the SEC and the CSRC (the China Securities Regulatory Commission) work together tighter than they used to do. The companies’ auditors must hand over the signed audit documents to the CSRC, and that hands it over to the SEC. If auditors fail to do this, they are suspended for six months.

That’s why Luckin had to come out with the news itself. The previous quarters were unaudited, but this one had to be signed by E&Y, Luckin’s auditor. Probably E&Y refused. So, investors are better protected than they used to be.

Lesson 5: know your management

This lesson is very important in investing in general: investing often comes down to the people. You can have the greatest idea ever, but if you can’t execute and communicate your idea, your company will fail. That’s why management is so important, especially the CEO. I mainly hold stocks of Chinese companies that have CEOs who are fluent in English, because I want to be able to judge them as I do with other CEOs.

Richard Liu of JD.com (JD) is fluent in English, and he’s a founder-CEO. I’ve read the book The JD.com Story by Li Zhigang, and I think I have more or less insight into how Richard Liu is as a businessman: a real entrepreneur who is heady, is not afraid to take calculated risks, is very good for his employees, is a perfectionist and so on. That’s very important information if you want to become a long-term shareholder.

(Source)

I have listened to a lot of interviews with Jack Ma and Daniel Zhang, the former founder-CEO and chairman of Alibaba (BABA) and the current CEO. Ma was a teacher of English before he founded Alibaba and speaks English fluently and so does Daniel Zhang. I have also listened to Vincent Qiu talking about his company Baozun (BZUN) in reasonably good English.

For Luckin, there were a lot of management red flags. I cite a few (there are more) from the anonymous report:

Red Flag #2:Luckin’s Chairman Charles Zhengyao Lu 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.(…)Red Flag #5: 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. Red Flag #6: Luckin’s co-founder & Chief Marketing Officer, Fei Yang, was once sentenced to 18 months’ imprisonment for crime of illegal business operations.

If you want to invest in a company, American or Chinese, these are always red flags. You should look if management has a pristine past. If not, avoid the stock.

But you should even go further and see if you can get behind the management team. It’s a lot more difficult to listen to Chinese executives who are not fluent in English and don’t give interviews in English if you are a Western investor. That makes the investment so much riskier. But if I research a company, see nothing fishy and I like what the CEO tells, I wouldn’t know why I wouldn’t invest in Chinese stocks.

Conclusion

Western investors investing in Chinese companies are better protected than a decade ago. The fact that Luckin had to come out with this news itself proves this. But if you invest in companies, you should always look at the quality of the management. Luckin’s management doesn’t live up to quality standards. If you still hold shares, I think it would be wise to sell them (once it trades again, on the Nasdaq or OTC) if you are a long-term investor.

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Disclosure: I am/we are long BZUN, JD, BABA, SBUX, SHOP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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