April 3, 2020

Breakingviews: Luckin spills hot bezzle over credulous investors

by Breakingviews.

Luckin Coffee has sprayed its investors with something messy and brown, and it’s not coffee. The Chinese rival to Starbucks, once valued at $13 billion, said on Thursday that over 40% of last year’s revenue may be fictitious. Economist John Kenneth Galbraith popularized the idea that fraud expands with good times and emerges in bad. In this case, it didn’t even take a downturn to expose Luckin’s problems. Just wait until the tide goes out.

The company’s pitch was alluring. The average person in China only drinks a few coffees per year, but the desire is growing rapidly. Orders done through app and delivery meant it could build out thousands of small shops in less desirable locations to saturate the nascent market. But consistent hefty losses – about $250 million in the first three quarters of last year – meant drinks were being subsidized, and reviews critiquing the coffee’s quality brought up questions of whether the brand had sticking power.

Galbraith would recognize why investors piled in despite the warnings of critics including short-selling firm Muddy Waters Research. Human tendencies haven’t much changed since he was writing well over half a century ago. When times are good, people are trusting and money is easy to find. During a downturn, suspicion grows, money is watched carefully and trust must be earned. As a result fraud is exposed and reduced.

In Luckin’s case, the 2.2 billion yuan ($310 million) of suspect sales seem to have been exposed not by a slowdown but by the company’s annual audit. That’s encouraging in a way, because audits have been a persistently weak spot in foreign-listed Chinese companies, which investors have mostly ignored. The U.S. Securities and Exchange Commission’s accounting oversight arm warned in February that after a decade of trying, it still can’t access critical audit records in China.

The synchronized economic downturn worldwide – S&P Global Ratings predicted 0.4% growth earlier this week, which would be the worst showing in nearly 40 years – will presumably expose much more fraud. China, with its big, long-lasting booms followed by severe economic stress, would be a good place to start. Examples such as Longtop Financial Technologies, Sino-Forest, Kangmei Pharmaceutical and others back the idea that it has been a fertile field for fraud. But just as Covid-19 is now global, the exposed bezzle will be too.

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