Luckin’s short edit full text: Fraud and basic crash of business

On February 1st, the well-known investigative agency Murat research received a short report from an anonymous person, an 89-page report directed at Luckin Coffee (LK. US) is fabricating the company’s financial and operational data. After receiving the report, Hunshui concluded that the allegations against Luckin were genuine and said on social media that it had been shorted. Luckin Coffee’s short-term decline after the news was announced. By Friday’s close, Luckin Coffee had narrowed to nearly 11 percent at $32.49.

In order to facilitate investors to understand the details, Zhitong Finance compiled the full text of the short report as follows, the views in the text do not represent the financial views of Zhitong. The translator has limited capacity, there are omissions please readers Haihan.

Luckin Coffee: Fraud s/Basic Crash edging of Business

Profile

When Luckin Coffee (LK. When US (“Luckin” or “Company”) goes on sale in May 2019, it’s a complete failure of trying to instill a coffee-drinking culture in Chinese consumers through brutal discounts and free coffee. After its $645 million initial public offering, the company has turned into a scam by fabricating financial and operational data from the third quarter of 2019. The company’s shares have risen more than 160 per cent in more than two months after a series of results showed a dramatic inflection point in its business. Not surprisingly, it managed to raise $1.1 billion (including secondary placements) in January 2020. Luckin knows exactly what investors are looking for, how they position themselves as a growth stock with a great story, and what key indicators are manipulated to maximize investor confidence. The report consists of two parts: fraud and a basic collapse of the business, which shows how Luckin falsified data and why its business model is inherently flawed.

Part 1: Fraud

Iron Evidence I: The 11,260 hours of store traffic surveillance video shows that sales per store were at least 69% and 88% per day, respectively, in the third quarter of 2019 and the fourth quarter of 2019. We mobilized 92 full-time and 1,418 part-time employees to monitor and record store traffic on 981 store days, covering 100% of our opening hours. The choice of stores is based on the distribution of city and location types, which is the same as luckin’s completely direct portfolio of stores.

Iron Evidence 2: Luckin’s “number of items per order” fell from 1.38 in the second quarter of 2019 to 1.14 in the fourth quarter of 2019.

We collected 25,843 customer receipts and found that Luckin artificially maintained the business model by increasing the net selling price of each item by at least $1.23 or 12.3 per cent. In practice, store-level losses were as high as 24.7%-28%. Excluding free products, the actual sales price is 46% of the listing price, rather than 55% claimed by management.

Third-party media tracking shows that Luckin overstated advertising spending by more than 150 percent in the third quarter of 2019, especially on Focus Media. Luckin is likely to re-use its inflated advertising spending to increase revenue and store profits.

Iron Evidence V: Luckin’s revenue contribution to “other products” was only about 6% in the third quarter of 2019, an exflated figure of nearly 400 percent based on 25,843 customer receipts and vat on their reported VALUE added tax.

Red One: Luckin’s management cashed in 49 per cent of its share holdings (or 24 per cent of the total number of shares outstanding) through a share pledge, putting investors at risk of a share price collapse as a result of a margin chase.

Red Flags II: Shenzhou Car Rental (00699) Trap: Luckin Group Chairman Lu Zhengyao and a group of close private equity investors cashed out $1.6 billion from Shenzhou Car Rental, with minority shareholders losing a lot.

Red Signs 3: By acquiring Baovo Motor, Lu Zhengyao transferred Rmb137m to his associate (friend and classmate) Wang Baiying. Baovo, Shenzhou and Wang Baiin will pay 5.95 billion yuan to Beijing Automotive Group Co., Ltd. over the next 12 months. Currently, Mr. Wang has a new coffee machine supplier next door to Luckin’s headquarters.

Danger Signal IV: Luckin recently raised $865 million through the issuance and issuance of convertible bonds to develop its “unretailed” strategy, which is more likely a convenient way for management to suck up large amounts of cash from the company.

Red Flag V: Sean Shao, Luckin’s independent director, was a director of some highly dubious Chinese companies listed in the U.S., whose public investors have suffered heavy losses.

Danger Signal 6: Luckin’s co-founder and chief marketing officer, Yang Fei, was the co-founder and general manager of Beijing Word-of-Mouth Interactive Marketing Planning Co., Ltd. (iWOM), and was sentenced to 18 months in prison for illegal operation. Word-of-mouth has since become a related party with Beijing Hydroive Yiwei Technology Co., Ltd. (QWOM). HydroIve is now a branch of Shenzhou Car Rentals and is in the process of trading with Luckin’s related parties.

Part II: Basic crash of business

Business model flaw one: Luckin’s claim to core functional coffee demand is wrong. Chinese’s daily caffeine intake of 86mg is similar to that in other Asian countries, with 95% of the caffeine intake coming from tea. China’s core functional coffee market is small, with only modest growth.

Business model flaw two: Luckin’s customers are highly price sensitive, while retention rates are driven by price promotions. It is impossible for a company to try to lower the discount level (i.e., increase the effective price) while increasing sales at the same store.

Business model defect three: the unit economic benefits of unprofitable, Luckin’s business model is bound to collapse.

Business model flaw four: Luckin’s dream of “starting with coffee and becoming a part of everyone’s daily life” is unlikely to come true because the company lacks other competitive non-coffee products. Most of the products that buy Luckin are opportunists with no brand loyalty. Its lightweight storage model is only available for the manufacture of “1.0 generation” tea drinks that have been on the market for more than a decade, while leading fresh tea producers pioneered the “3.0 generation” product five years ago.

Business Model Defect sin: The franchise business of Fawchad Tea has a high compliance risk and is not registered with the relevant authorities as required by law, as It did not meet the requirement to operate at least two direct stores for at least one year when it started operating the franchise business in September 2019.

Part 1: Fraud . . . Starting in Q3 2019

The rally was almost all achieved in the past two months after the company said it had made a profit in its store business in the quarter to the end of September. “

Jacky Wong, Wall Street Journal

January 9, 2020

Iron Evidence I: The 11,260 hours of store traffic surveillance video shows that daily merchandise sales per store were at least 69% and 88% in the third quarter of 2019 and the fourth quarter of 2019, respectively.

Daily merchandise sales per store: 444 units in the third quarter of 2019 and 483-506 in the fourth quarter of 2019.

4Q2019: 483 – 506, according to the 4Q guidelines, product revenue is guided by $2.1 billion to $2.2 billion, divided by the net selling price of $11.8 per product (assuming Luckin achieves a 5% month-on-quarter growth, or 11.2 yuan, from the third quarter of 2019) and an average number of stores of 4,094.

Luckin's short edit full text: Fraud and basic crash of business

The results of our 981 store days, which we tracked offline from the fourth quarter of 2019, show that only 263 items were tracked per store per day.

Luckin's short edit full text: Fraud and basic crash of business

We mobilized 92 full-time and 1,418 part-time staff on site to monitor the site and successfully recorded 981 store-day traffic, covering 100% of the opening hours of 620 stores. The store selection method is based on the distribution of city and location types, as is the case with Luckin’s 4,507 direct stores, which are expected to open by the end of 2019. Luckin’s 4,507 stores are located in 53 cities, covering 38 cities, 96% of which are located. By analyzing the detailed address of the Luckin store, you can determine the location type of the store: we divide the store into offices, shopping malls, schools, residences, transportation, hotels, etc.

We counted the traffic at each store and recorded videos from door to door, averaging 11.5 hours a day. When we check traffic and recorded video again, if video surveillance loses more than 10 minutes of footage, we discard the data for the whole day. Our success rate is only 54%, so all success data are 100% complete.

Below are comparison data on location types and store age in some cities, the main information is: 1, Luckin’s overall direct store portfolio (as of December 31, 2019, we found a total of 4409 stores on LuckinAPP); 3, we visited 851 stores, but didn’t record a full day’s video for reasons including execution failures – being kicked out by Luckin employees, equipment crashing, etc., or quality control failures, mainly due to a full day of continuous footage of more than 10 minutes. Data for failed store days were not used in data analysis.

Luckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of business

Here’s the average number of orders per store nationwide, based on the results of our 981 store day-to-day tracking, to 230, multiplied by an average of 1.14 items per order, and we get 263 items sold per store per day. We have given a higher estimate of the number of items per order assumed, as detailed below.

Luckin's short edit full text: Fraud and basic crash of business

Here’s the full results of our 981 store days. We have 11,260 hours of recorded storage of traffic data to support this. Since luckin has eight internal surveillance cameras in each store, and there are no dead ends, investors/auditors can ask Luckin to provide surveillance video and random lying to check the reported order number.

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In the 981 store days we track, our employees are usually sitting in the store, directly observing the movement of the checkcounter and counting the number of customers who took Luckin’s products while recording the video. If the order is delivered by a takeaway delivery person, we calculate the number of Luckin paper bags and know that each person can pick up multiple orders at a time (one order can contain multiple packages, so we may exceed the quantity of the order). The total number of customers and the number of paper bags taken by the distribution staff is a good representation of the total number of orders per store per day. Multiply the order quantity by the number of items per order 1.14 and you get the key metric to validate – the daily volume of merchandise per store.

Luckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of business

Our tracking begins in the fourth quarter of 2019. To compare our tracking period with Luckin’s third-quarter results, we used LuckinAPP’s DAU (Daily Active Users) as the number of agents for daily orders per store for the same period. DAU is from Quest Mobile; although Luckin only reports the number of quarterly stores, we get the number of weekly stores from an article published by Luckin’s weChat official account (it publishes a weekly list of new stores).

During our tracking period from q42 to January 2020, LuckinAPP averaged 0.59K per store, while LuckinAPP’s average DAU per store in q3 2019 and Q4 2019 was 11% and 0% lower than our tracking period, respectively. Our tracking results are likely to underestimate Luckin’s daily sales per store in the third quarter of 2019 and the fourth quarter of 2019.

Luckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of business

The history of opening stores extracted from Luckin’s official account matches the number of end-of-quarter stores reported by Luckin.

Luckin's short edit full text: Fraud and basic crash of business

Luckin increased his online order by an average of 72%.

Since all orders are placed online and paid, offline pick-up, so the current order, will generate a three-digit pick-up number and a two-dimensional code, convenient in-store pick-up. Some people may notice that three-digit pickup numbers are continuous every day in each store and are shared by pickup and delivery orders, and use them as a barometer to track the store’s daily order volume by placing orders at the store’s opening and closing times.

Luckin's short edit full text: Fraud and basic crash of business

You cannot use this method if Luckin Coffee deliberately skips numbers during the day to distort tracking results. This is evidence that the director of operations was notified on November 23, 2019 to take note of the random number of increases in the number of meal codes.

Luckin's short edit full text: Fraud and basic crash of business

We also have more than 10 video evidence recording the process of taking up meal code jumps in real time. While we can’t post these videos for privacy reasons, we encourage investors to do their own research: stay in the store for 0.5-1 hours and count the number of orders received by customers or delivery personnel.

At the beginning and end of placing an order and checking the difference between the quantity of online pick-up and the quantity of the order, we found that the probability of a check-up hop was high.

Luckin doesn’t have to skip the pick-up code to commit fraud — they can falsify more orders in their financial records. However, this may be a clever approach: corporate management may think that more and more investors and data companies are starting to track their food codes as part of the due diligence process, so “picking up the size” is an easy way to mislead investors.

To understand the scale of the inflated online orders, we randomly selected 151 offline tracking stores to track their online orders. We placed an order at the beginning and end of store opening hours to obtain the number of online orders for the day. We found that the number of online orders in the same store on the same day was inflated from 34 to 232, equivalent to an average of 106 orders per day or 72% of the average line order count.

Luckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of business

Iron Evidence 2: Luckin’s “number of items per order” fell from 1.38 in the second quarter of 2019 to 1.14 in the fourth quarter of 2019.

Starting in the fourth quarter of 2019, we collected 25,843 receipts from 10,119 customers in 2,213 stores in 45 cities. The 25843 receipts show that the pick-up and delivery volumes for each order were 1.08 and 1.75, or 1.14 (99% trusted). This marked a continued decline in the number of items per order, from 1.74 in the first quarter of 2018 to 1.14 in the first quarter of 2019.

Luckin's short edit full text: Fraud and basic crash of business

The number of items per order in Luckin is on the decline

Luckin's short edit full text: Fraud and basic crash of business

This trend can be attributed to a decline in delivery order contributions, as people naturally tend to buy more items to meet the requirements for free shipping. ‘By visiting our stores, we found that most customers who come to the door buy only one fresh-grind drink because in most cases coupons are used only for one item in the order, ‘ says Luckin. According to the company’s introduction and management communications, the proportion of orders delivered did decline from 61.7% in the first quarter of 2018 to 12.8% in the third quarter of 2019 and further to about 10% in early January.

Luckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of business

We collected receipts from more than 10,000 customers in 2,213 stores in 45 cities, distributed by percentage of luckin population by city grade and store type (see benchmark below). Statistically, we need up to 5,000 receipts to achieve a 95% confidence interval and a 2% error rate on ASP and items for each order. We increased it fivefold and collected 25,843 receipts to ensure the quality of the data. Our confidence level is 99% and the error is 1%.

Luckin's short edit full text: Fraud and basic crash of business

In addition, the items for each order are independent of the store type or city level, as shown below. Therefore, by simulating a perfect match with the population distribution, the effect on the result is zero. Please note that for delivery orders, customers cannot select a delivery store, so the distribution by type of store applies only to pick-up orders.

Luckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of business

Each receipt contains sufficient information (samples attached below for reference), including the time and place of purchase, whether the purchase order or delivery order, which coupon is used, the listed price and the actual price paid, etc.

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We collected 25,843 customer receipts and found that Luckin artificially maintained the business model by increasing the net selling price of each item by at least $1.23 or 12.3 per cent. In practice, store-level losses were as high as 24.7%-28%. Excluding free products, the actual sales price is 46% of the listing price, rather than 55% claimed by management.

Luckin reported a net price of Rmb11.2 per item in the third quarter of 2019. On a earnings call on November 13, 2019, Luckin’s Chief Financial Officer and Chief Operating Officer, Reinout Schakel, guided a higher price for the fourth quarter of 2019. However, our 25,843 receipts show a net price of Rmb9.97, which means that the inflation rate is RMB12.3 per cent (99 per cent confidence level and 1 per cent statistical error) compared to the quarterly report, which means that 99 per cent of our fixed prices are between Rmb9.87 and Rmb10.07, with a 1 per cent error.

Luckin's short edit full text: Fraud and basic crash of business

Excluding free products, freshly ground drinks and other products sold for 10.94 yuan and 9.16 yuan, respectively, compared with the reported inflation rate of 12.3% and 32%, respectively. Excluding free products, the actual sales price is 46% of the listing price, rather than 55% claimed by management.

Luckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of business

To clarify, we keep our ASP definition consistent with Luckin’s own reporting metrics – net effective selling price, net VAT, net coupon. Specifically to its “coffee wallet”, we assume that all coffee wallet purchases are calculated at 67% of the listed price i.e. 1) we do not count any cups sold at “zero” prices; We still calculate the net effective price of 67% of the listed price. As a result, we are more likely to overestimate ASPs than to underestimate them. The difference in net sales price will not exceed 1% as exactly as Luckin’s store sales.

Luckin's short edit full text: Fraud and basic crash of business

On the earnings conference call, Luckin’s chief financial officer, Reinout Schakel, dodged questions about boosting promotions. However, our receipts show that they have even started offering free drink vouchers to existing users from the fourth quarter of 2019, compared with free drinkvouchers to new and inviting users. It is assumed that the proportion of free items in the documents submitted by each company is declining.

Luckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of business

Luckin’s chief financial officer, Reinout Schakel, said they continue to increase the number of people already paying the price they want to pay. Our receipts show the exact opposite, even in mature markets, where there are more mature customers, the effective price is stuck at RMB10, excluding free products. There is no positive correlation between the net selling price of each item and the month of operation.

Luckin's short edit full text: Fraud and basic crash of business

Reinout Schakel, Luckin’s chief financial officer, noted at a recent Citibank meeting in January that more than 63 percent of customers pay Rmb15-16 per cup of coffee. In the company’s report for the third quarter of 2019, they noted that 63% of the products sold for more than 50% of the retail price. However, these are too good to be true, and contradict our receipt findings.

Our receipts show that only 28.7% of the goods were sold at more than 50% of the list price. In fact, most items sell for between 28% and 38% of the list price. Luckin’s core customers are still very price sensitive. Only 39.2 per cent of customers paid more than Rmb12, and 18.9 per cent paid more than Rmb15 per cup of coffee.

Luckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of business

Why is ASP important? If investors remember Luckin’s sensitivity to store profitability in his speech, they will find as ASP a key factor in store profitability. They point out that with 400 items a day in each store, each item sells for Rmb16 and the profit margin can be as high as 28.4 per cent. In management’s analysis, earnings per share, which is closer to the actual situation, are below the floor of $12, somehow ignored, which represents a more difficult earnings outlook.

In practice, 263 pieces per store per day, the net price of 9.97 yuan, according to management statements, the loss of the store level of 28.0%. Note that all figures are provided by management. ‘We gave the company some credit, achieved economies of scale by delivering free coffee, and reduced costs in the figures reported in the second quarter of 2019, with store-level losses still as high as 24.7 percent,’ he said. At current prices, they can only make a profit at the store level by selling 800 items per store per day, otherwise they will have to raise the effective price to a minimum of Rmb13. That’s why they need to make up ASP numbers to maintain their business model.

Luckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of business

Third-party media tracking shows that Luckin overstated advertising spending by more than 150 percent in the third quarter of 2019, especially on Focus Media.

Luckin disclosed its advertising spending in the quarter ended March 31, 2019 in its prospectus. After an IPO, its advertising costs can be calculated by taking a quarterly basis in which new customers get a cost.”

Luckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of business

In a conference call for the second quarter of 2019, the Company disclosed for the first time that Focus Media accounted for 140 million yuan of total advertising expenditure in the second quarter of 2019 (they explained only 154.5 million yuan, or 64% of the total advertising expenditure of 242 million yuan).

According to CTR Market Research Tracker, Luckin overstated advertising spending by more than 150 percent in the third quarter of 2019: in the third quarter of 2019, CTR implied that Focus Media spent 46 million yuan, or only 12 percent of Luckin’s advertising spending, well below previous quarters. Assuming Luckin spends the same amount on non-spotlight media advertising in the third quarter of 2019, Luckin has overstated its advertising spending by 158 percent.

According to CTR Market Research Tracker, Luckin overstated advertising spending by more than 150 percent in the third quarter of 2019: in the third quarter of 2019, CTR implied that Focus Media spent 46 million yuan, or only 12 percent of Luckin’s advertising spending, well below previous quarters. Assuming Luckin spends the same amount on non-spotlight media advertising in the third quarter of 2019, Luckin has overstated its advertising spending by 158 percent.

CTR Market Research tracks the actual advertising broadcast ingress different brands in a variety of media channels, including all three major media focus media channels: LCD network (office elevator), poster/digital framework network (residential elevator), and cinema network – accounting for 82%, 17% and 1% of Focus Media’s total revenue in the first half of 2019, based on Focus Media’s interim report for 2019.

Here’s the monthly tracking results of CTR’s spending on Luckin’s advertising channels on Focus Media Channel. Luckin’s spending was at its lowest level in September-November 2019, but rebounded in December 2019.

Luckin's short edit full text: Fraud and basic crash of business

The dollar amount in CTR raw data is the media list price, which may be much higher than the actual advertising spend. To calculate the conversion rate between list price and ad spending, we calculated the conversion rate of the total number of media broadcasts broadcast by CTR TrackIng Focus Media (002027.CH) reporting revenue. According to data for the first quarter of 2019 to the third quarter, Focus Media’s actual revenue is about 8% of the price of CTR tracking media lists.

Luckin's short edit full text: Fraud and basic crash of business

According to the accounting policies listed in Focus Media’s financial report, Focus Media’s advertising revenue is recognized “when the ad airs” and, as the CTR tracks, when luckin should book advertising costs.

CTR also publishes the largest advertiser reports on its website based on tracking results. For example, in May 2019 (Link), CTR identified Luckin as the largest advertiser of all the media channels it tracks, including the three most-used channels for traditional outdoor, television, radio and focus media. Notably, 83 percent of Luckin’s tracking advertising budget for the month was spent on LCD display networks, 12 percent on poster/digital frame networks, and 5 percent on cinema networks.

Luckin's short edit full text: Fraud and basic crash of business

However, Luckin’s ranking in LCD and poster/digital box advertising slipped rapidly in June and July 2019, even dropping out of the top 10 from August 2019.

For investor spending purposes, we list the spending rankings, year-on-year increases, and month-on-month growth that Luckin reported in the CTR report.

Luckin's short edit full text: Fraud and basic crash of business

So where did all the money go?

Similar clues can be found in the overstated store profits and advertising costs.

Luckin said it was “profitable at store level” in the third quarter of 2019. Combined with solid iron evidence, Luckin actually hides the loss at the store level below the store level, rather than actually exceeding the break-even point at the store level.

The real case of Luckin’s store-level results is sales of 263 items per store per day, compared with RMB9.97 for ASP. Comparing real-world and reported cases, luckin Group overstated store operating profit by $397 million in the third quarter of 2019. Coincidentally, luckin reported a difference of 336 million yuan in advertising spending and the actual spending of Focus Media, which is tracked by CCTV, which is no different from the overstated operating profit spree of stores. In addition, starting in the third quarter of 2019, these two misstatements became apparent. Luckin is likely to re-use its inflated advertising spending to defraud revenue and store profits.

Luckin's short edit full text: Fraud and basic crash of business

Iron Evidence V: Luckin’s revenue contribution from “other products” was only 6% in the third quarter of 2019, representing nearly 400% inflation, based on 25,843 customer receipts and reported VAT figures.

Luckin’s ambition is by no means to start a coffee company. Its mission is “Everyone’s daily life, starting with coffee!” This has made “other products”, i.e. non-freshly brewed beverages such as light meals, fruit juices, nuts, mugs, etc., an important product – according to the results, its revenue contribution increased from 7% in the second quarter of 2018 to 23% in the third quarter of 2019, and the project contribution increased from 6% to 22%.

Luckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of business

However, in the 981 store days we tracked, only 2% of orders were found to be non-current. The 25843 receipts further showed that 4.9 per cent and 17.5 per cent of orders received were “other products”, accounting for 6.2 per cent, or nearly 400 per cent. Once again, people naturally tend to buy more “other products” to meet the requirements of free shipping. But if the order rate in the second quarter of 2018 fell sharply from 62% to nearly 10% now, why did the “percentage of revenue from other products” rise from 7% to 23% over the same period?

Luckin's short edit full text: Fraud and basic crash of businessLuckin's short edit full text: Fraud and basic crash of business

Luckin’s latest F-1 form also supports our finding that the VAT rate for the sale of goods and services is different according to the State Administration of Taxation of the People’s Republic of China. For the provision of services, such as the sale of brewed products or delivery, the VAT rate is 6%. For goods sold, such as packaged food and beverages, i.e. “other products,” in Luckin’s case, the VAT rate since April 2019 is 13% (or 16%) of the previous 16%. This is further confirmed by the VAT invoice we received after the luckin purchase (see sample below). Based on Luckin’s income classification, we can calculate a mixed VAT rate and compare it with company reports.

Weighted average net income contribution by product category, we find that the value added tax rate calculated is fully consistent with the report for Q4 2018, full year 2018 and Q1 2019 prior to listing (see figure below).

However, in the February-3 quarter of 2019, the gap suddenly widened, with the reported VAT rate at 6.5 per cent, compared with 7.6 per cent in real terms. On the other hand, in line with the reported 6.5 per cent VAT, the revenue contribution of other products would actually be 7 per cent, which is very close to 6.2 per cent of the 25,843 invoices, compared with 22%-23 per cent reported by the company.

In this case, “other products” contributed 6% to 7% of real income in the third quarter of 2019, or Luckin was tax-conscious.

Luckin's short edit full text: Fraud and basic crash of business

In order to confirm that the VAT rate for other products is 13%, we purchased some products in Luckin and requested VAT records. It clearly shows 13% VAT for nuts, muffins, juices, etc., and 6% of freshbrewed beverages and delivery fees. Anyone who wants this information can request a VAT record through Luckin’s app after purchase.

Red one: Luckin’s management has cashed in 49 per cent of its share holdings (or 24 per cent of all outstanding shares) through a share pledge, putting investors at risk of a share price collapse as a result of a margin chase. Luckin’s management stressed that they had never sold any of the company’s shares; The number of mortgaged shares is almost half of their total, worth $2.5 billion at current prices.

Equity pledge financing is a common way for management to obtain financing without selling equity directly, which is often seen by investors as a negative signal. At the same time, however, it is also seen as a key red flag in the company’s due diligence, as a large number of stock pledges can create a negative cycle that could cause share prices to plummet.

Management can use their securities as collateral to obtain loans from banks and brokerage firms. When the value of the pledged stock falls, lenders ask borrowers for more cash or collateral. If they can’t come up with the money, lenders can sell shares to get their debts back, further driving down share prices and triggering more demand for collateral. In Hong Kong, China, and mainland China, there have been countless cases of equity-busting (see article below).

Luckin's short edit full text: Fraud and basic crash of business

In Luckin’s case, its management mortgaged nearly half of its shares as collateral for loans (61 million ADS), or 24 percent of Luckin’s total, surpassing even Luckin’s total shares in the May 2019 IPO and January 2020 placement (51 million ADS). According to the prospectus issued by luckin Group on January 8, 2020, lu Zhengyao, chairman of the company, Qian Zhiya, the chief executive, and Sunying Wong, the sister of chairman Lu Zhengyao, have pledged to hold 30 per cent, 47 per cent and 100 per cent of the company, respectively.

Luckin’s prospectus does not disclose sunying Wong as Lu Zhengyao’s sister, but the relationship was disclosed in the 2018 annual report of UCAR (Shenzhou Auto, 838006 CH, a new three-board listed company related to Chairman Lu). Luckin’s management cashed in nearly half of the shares through a stock pledge, while the rest of the investors were at great risk of a stock crash. Details of the equity pledge are shown in the table below (see the accurate information of the prospectus at the end of this section).

Red Signs II: Shenzhou Car Rental (00699): Lu Zhengyao and the same group of close-knit private equity investors took $1.6 billion from Shenzhou Car Rental (00699), while minority shareholders suffered heavy losses.

Prior to Luckin, Lu Zhengyao founded a Chinese car rental company, Shenzhou Car Rental, in 2007. Shenzhou Car Rental applied for a listing on NASDAQ in 2012, but failed. In 2014, the introduction of Hertz Car Rental (HRI. US) successfully listed on the Hong Kong Stock Exchange after a strategic investment. Lenovo accounted for 29%, Huaping 18%, Hertz 16% and Lu Zhengyao 15%.

Shenzhou Car Rental (00699) has had a short “honeymoon period” with the capital market after listing. In May 2015, before Mr Lu began cashing out, the company’s share price soared from HK$8.50 at the time of the IPO to HK$20.0. Instead of selling directly on the market, he sold all of his Uber technology stock, a subsidiary of Shenzhou Auto (838006 CH). As can be seen from the name, Shenzhou Auto (838006.CH) is another company controlled by Lu Zhengyao: in 2016, Lu Zhengyao and his co-investors held nearly 50% of the shares of Shenzhou Auto, which still accounts for 40%. Mr Lu cashed out HK$3.4 bn at HK$2 a share. In addition, other investors in Shenzhou car rental before the listing, such as Hertz, Lenovo and Huaping, also sold a large number of shares during the same period. From June 2015 to March 2016, Lu Zhengyao and other investors preparing to go public sold 42 percent of Shenzhou’s shares in just nine months, cashing in $1.6 billion.

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Given the large-scale stock sell-off in the industry, it is not surprising that Shenzhou Car Rental’s share price has plummeted from a peak of HK$20/share in June 2015 to less than HK$8/share since June 2016. Keep in mind that Shenzhou Car Rental’s IPO in September 2014 was HK$8.50 per share, which meant that all public investors took on the losses.

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Since its listing in September, the profitability of Shenzhou Car Rental has shown a good growth trend in the first few quarters (adjusted net profit for 2015 and 59 percent). Since the second quarter of 2016, its financial results have started to decline: adjusted net profit fell 8% in 2016 and 25% in 2017. Public investors were left to take responsibility when Mr Lu and other investors preparing to go public took $1.6bn (not to mention $700m worth of remaining shares).

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In January 2017, GeoInvesting released a short report on car rentals in Shenzhou, highlighting its “surge related party transactions”, “problematic depreciation methods” and “dark business prospects” with Shenzhou Auto (838006.CH). The latest share price of Shenzhou Car Rentals is HK$5.30 per share, down 37 per cent from the IPO price and 70 per cent from its 2015 all-time high.

The share price of Shenzhou Car Rental rose from HK$8.50 to HK$20 in the first nine months after the IPO, and Luckin’s share price has seen similar volatility. Luckin insiders are just like Shenzhou car hire. David Hui Li and Erhai Liu, founding partners in Centurium Capital and Joy Capital, Luckin’s main private equity investors, are actually the heads of Huaping and Lenovo’s investment in Shenzhou car hire a few years ago, so they are “old friends” of Lu Zhengyao. Pre-IPO investors in Shenzhou Car Rental began cashing out through a secondary offering on May 28, 2015, eight months after the IPO and two months after the lock-up period expired. By contrast, Centurium Capital cashed out $232 million on January 8, 2020, through Luckin’s convertible bonds and equity offerings, just eight months after Luckin’s IPO and two months after the lockout period expired.

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Among Luckin shareholders, we see once again the familiar “Golden Triangle” Lu Zhengyao, Li Hui and Liu Yihai, who together own 46% of Luckin’s shares and are currently worth $5.8 billion. “Golden Triangle” has cashed in Shenzhou car rental (00699) 1.1 billion U.S. dollars, the future will be what Luckin will do, it is self-evident.

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Danger Signal 3: Luckin Chairman Lu Zhengyao transferred 137 million yuan from Shenzhou Automotive to his related company, Wang Baiying, through the acquisition of Baovo Automotive. Youmc, Baovo and Wang Bai will pay 5.95 billion yuan to BAIC Futian Motor for more than 12 months. Now, Wang Issin’s new coffee supplier is next door to Luckin’s headquarters.

This deal with Lu Zhengyao is worth mentioning. The transaction can be summarized as follows:

In January 2019, a man named Wang Baiying bought a company for 3.97 billion yuan and sold the company for 4.11 billion yuan in March 2019, making a profit of 137 million yuan in just two months. More interestingly, Mr Wang is a related party to Mr Lu, who actually made 137m yuan from Shenzhou’s Uber.

Founded in 1919, The Company was once Germany’s top four carmaker (the other three were Volkswagen, Mercedes-Benz and Opel), but went bankrupt in 1963. In 2014, BAIC Futian paid 5 million euros to acquire a 100% stake in Beijing Baovo Automobile Co., Ltd. and tried to re-introduce the established car brand into the Chinese market. After several years of poor operation, in October 2018 BAIC Fukuda Motor announced plans to sell 67% of Its Shares to Changsheng Xingye (Gate) Enterprise Management Consulting Co., Ltd. through the Beijing Property Exchange, a deal that cost 3.97 billion yuan. As the announcement issued by BAIC Fukuda on January 16, 2019 shows that Changsheng Xingye is a shell company established specifically for the transaction, which was established on December 3, 2018, and is the controlling shareholder of the company, the legal person Wang Bain.

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On March 18, 2019, Shenzhou Yuqi (Lu Zhengyao as controlling shareholder) announced plans to acquire 67 percent of Baovo for 4.11 billion yuan, just two months after BAIC Fukuda sold the same asset to Changsheng Xingye. Details of the transaction can be found in the Premium Car Announcement (file number: 2019-34).

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In other words, Changsheng Xingye made a profit of 137 million yuan in just two months by acquiring a 67% stake in Baovo Motor and quickly selling it to Uber.

On December 26, 2018, three weeks before Changsheng Yingye acquired Baovo, Youmc provided a credit guarantee for BAIC Fukuda, which made it clear that the guarantee was for “convenience” for Changsheng Xingye to acquire the target assets (i.e. Beijing Baovo) as it provided a 2.4 billion yuan shareholder loan to Baovo Automobile. In other words, Uber is not only a priority to be aware of Changsheng Xingye’s intentions to buy Baovo, but also helped broker the deal, providing a $2.4 billion credit guarantee.

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Uber supported Changsheng Xingye’s acquisition of Baovo, which overpaid 137 million yuan. It is an open secret about Wang’s close personal relationship with Lu Zhengyao. (Reference article Lu Zhengyao “Shenzhou Past”: hit your man Liu Yihai, and Wang Baiying is the same window). Wang Baiying and Lu Zhengyao were EMBA students at Peking University’s National Development Research Institute from 2006 to 2008. Wang, who worked in healthcare after graduation, had no experience in the automotive industry before acquiring Baovo. Baovo’s shares are owned by BAIC Fukuda and then to Changsheng Xingye, and then to Yuqi, which appears to favour Lu Zhengyao personally rather than the public shareholders of Shenzhou Auto, as the deal effectively transferred 137 million yuan in cash to Wang Baiying, an undisclosed affiliate of Uber.

In addition, we see worrying signs that Uber may face cash flow pressures following its acquisition of Bowser. Regarding Changsheng Xingye’s acquisition of Baovo, the payment to BAIC Fukuda will be paid in full by January 15, 2020.

However, on January 18, 2020, BAIC Fukuda announced that 1.48 billion yuan was outstanding and overdue. In other words, Changsheng Xingye paid BAIC Fukuda Rmb2.49bn for the purchase of Baovo, with the remaining default amount of RMB1.48bn.

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In addition, Fukuda Motor has 4.67 billion yuan outstanding shareholder loans to Baovo, of which 1.88 billion yuan will expire in July 2020 and 2.59 billion yuan will expire in January 2021. The above 2.4 billion yuan shareholder loan is guaranteed by Shenzhou Yuqi (838006.CH). Coupled with the overdue payment of 1.48 billion yuan in acquisitions, Changsheng Xingye and Baovo will face 5.95 billion yuan in cash outflows in the next 12 months, and cash flow pressure is enormous.

Changsheng Xingye is an undisclosed related party of Shenzhou Auto (838006 CH) that acquired Baovo, so its payment default and cash flow pressure can be traced back to Shenzhou Auto. In the 1H19 interim document, Shenzhou Auto disclosed that Baovo had been transferred to the company on July 29, 2019.

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However, there has been no further disclosure by Shenzhou Auto. Shenzhou Auto has not released its financial results for the third quarter of 2019, even though it has been nearly four months since. On October 31, 2018, the third quarter report was officially released.

In addition, Shenzhou Auto held only 758 million yuan in cash balance, compared with 2.6 billion yuan (i.e. 1.9 billion yuan net debt) as of June 30, 2019. The company also reported revenue of 1.9 billion yuan, down 49% year-on-year, with a net loss of 653 million yuan for 1H19 and an operating cash inflow of only 306 million yuan. Baovo itself is a loss-making company (a net loss of Rmb2.545bn in 2018), and Shenzhou Auto may need a lot of external financing to repay Rmb5.95bn to Budweiser-Fukuda over the next 12 months, not to mention support Ingw’s business development.

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After Lu Zhengyao cashed out in March 2016, Shenzhou Auto is now the largest shareholder in Shenzhou Car Rental.

However, according to the 1H19 interim report, the company has committed to using its Rmb3.89bn stake in Shenzhou car rental to finance the project. Shenzhou Auto owns 631 million shares, accounting for 29.77 percent of the total share capital of Shenzhou car rental. Based on the share price of HK$6.18 as at 28 June 2019, the market value of these shares is HK$3.9 billion. In other words, Shenzhou Auto has committed almost 100% of its shares in 1H19, echoing Red Signal 1.

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While the transaction between Changsheng Xingye and Fukuda Automobile is pending, Wang Baiying established The International Trade Co., Ltd. on August 23, 2019. We know from Tianyou that 95% of the company is held by Wang Baiying.

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The main business esthest of International Trade Limited includes coffee machine sales and the supply of food ingredients, matching Luckin’s supply chain.

We obtained a sample sales contract from The Seeker International Trade Co., Ltd. to prove that the requisitioner sells coffee machine and other related equipment.

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In addition, the requisitioner obtained a food business licence in October 2019, and its business scope includes “wholesale wine, beverages and tea”.

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More interestingly, we found that the registration address of the requisitioner was located next to luckin’s Xiamen headquarters. Luckin has two headquarters (Beijing and Xiamen), one of which is located in Building D of Xiamen International Shipping Center. The registered address of the requisitioner is Xiamen International Air Shipping Center Block C, next to luckin Xiamen headquarters.

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The requisitioner is not a separate case, but another company, Zhongcheng Supply Chain Management Co., Ltd. The company was founded on December 3, 2019, and Wang Bein briefly became a legal person on December 13, 2019 (later transferred to Liu Yanling). The recruiter is located next to luckin Xiamen headquarters, and Zhongcheng is in the same building as Luckin Xiamen, which is based in the same unit. No wonder China’s business also includes “wholesale wine, beverages and tea” (i.e. the supply of food ingredients).

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To sum up, Mr. Wang has set up companies to supply coffee machines and food ingredients, and “by coincidence” they are located next door to Luckin’s headquarters. Investors should be cautious about potential transactions and associated risks between these companies and Luckin.

Danger Signal IV: Luckin recently raised $865 million through the issuance and issuance of convertible bonds to develop its “unretailed” strategy, which is more likely a convenient way for management to suck up large amounts of cash from the company.

In early January 2020, just eight months after going public, Luckin raised another $865m in new capital, despite having $5.5bn in cash on its balance sheet. According to various investor meetings/telephones, the company aims to install two “unmanned retail” machines by 2021: 10,000 Luckin coffee instants and 100,000 Luckinpop minis.

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Essentially, these products are vending machines. Executives say the price of coffee selling machines is 120,000 yuan each and 15,000 yuan per pop MINI. The plan is to channel Luckin’s online traffic to these vending machines, which management expects to be more profitable than their off-line stores because of the lower costs. The average price of coffee is expected to be $16 per cup, with a minimum cost of $6 per cup (assuming 80-100 cups sold per day) and a recycling period of only 6 to 12 months.

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Our tracking of the machine’s location shows that there are currently 11 machines running and all coffee selling machines in the office building.

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But these assumptions are too optimistic. Existing stores sell at an average price of 10.9 yuan per cup, and based on our receipt, it’s hard to understand why customers are willing to spend 47% more on a vending machine.

In order for the coffee vending machine to generate meaningful sales, the product must be sold at a discount, not at a significant premium. In addition, a 120,000 yuan coffee machine pay-off period of 6 to 12 months, we calculated that each coffee machine needs to sell 122 to 220 cups of coffee per day, the average price is 9 yuan / cup.

However, Luckin’s competitors have installed a number of coffee vending machines, and although selling coffee at much cheaper prices, it has suffered a significant growth bottleneck. It has installed 2,000 coffee vending machines, 770 in Beijing, 230 in Shenzhen, 180 in Guangzhou, 120 in Shanghai and 120 in Tianjin, according to marketing materials from coffee vending machine operator You coffee. The average daily sales volume per machine is only 6.5 cups, the average price is about 8 yuan. Two other major coffee makers offer single-digit daily coffee sales at similar average prices. Machines for these operators cost only $2-30,000, far less than Luckin.

If the Coffee Fast Bowler wants to be as successful as management claims, Luckin’s competitors will only need to install a coffee machine in the same location. To make matters worse, rivals of these vending machines are already planning to eat into Luckin’s physical stores. They plan to install 20 vending machines around Luckin’s high-traffic stores and hit the company’s customer base with low-cost competition.

The broader “no-retail” market has seen a wave of startup bankruptcies in the past two to three years. It was once a popular concept in China’s venture capital industry, but the actual performance of no-retail start-ups has been pretty bad. Unmanned retailers need to invest heavily in equipment and inventory and still rely on workers to supply and clean/maintain their products, so they are not necessarily cost-effective. Competition from existing convenience stores and limited SKUs is putting pressure on the growth of traffic to unmanned retail sites. Even JD.com, a deep-pocketed, online-heavy e-commerce giant, said: “It’s a huge deal. US) also exited the unmanned retail container market at the end of 2018.

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While seller analysts are busy quickly creating $13.2/ADS value based on the announcement of a “no-man’s retail” strategy, we caution investors that the new business may be the perfect way for management to suck up a lot of cash from the company.

As indicated above, Lu Zhengyao had previously transferred RMB137 million from UCAR Inc. through a transaction with baiyin Wang, an undisclosed affiliate. Baiyin Wang, on the other hand, now owns a coffee machine supplier, which was established in August 2019. Investors should be aware of this “coincidence” and be on high alert, given the huge capital expenditure plan for coffee/vending machines, which will reach Rmb2.7bn over the next two years, and far higher than the cost of machines in the market.

Credit Suisse’s valuation of Luckin’s unmanned retail business

According to the DCF model, Credit Suisse values Luckin Coffee’s unmanned retail business at $13.2. Given that the results depend on Luckin’s execution, industry competition and consumer sentiment, credit suisse provides investors with a scenario for analyzing bull/bear conditions. The bank draws on key assumptions based on discussions with companies, industry experts and local market participants.

Source: Credit Suisse report “Luckin Coffee Spinning up the flywheel” by Credit Suisse on 15 January 2020

Luckin announced its smart unmanned retail strategy at a press conference earlier this month, and its chief executive, Qian Zhiya, said, “The more the more the better, the denser the better,” said Qian Zhiya, chief executive of Luckin, who announced its smart unmanned retail strategy at a press conference earlier this month. “The “infinite” expansion plan for coffee vending machines is the ideal way to transfer “unlimited” funds from the company to third-party suppliers. We recommend that EY closely review its machine suppliers, with particular attention to related party transactions.

Red Flags V: Luckin’s independent director, Sean Shao, is now/has served as a director of some very suspicious U.S.-listed Chinese companies that have taken huge losses to public investors.

According to luckin’s prospectus, its independent director, Sean Shao, has served as a director of several US-listed Chinese companies after 10 years at Deloitte. We conducted a detailed study of these companies and found that four of the 18 companies were accused of fraud (CHME, ADY, GRO and YONG) and five were accused of reverse takeovers , all of which were the largest of the notorious Chinese fraud companies that emerged between 2011 and 2012.

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The SEC recently charged Agria Corporation (GRO) and its executive chairman with fraud. The SEC found multiple fraudulent activities at the company between 2010 and 2013. On the other hand, Sean Shao was a long-time independent director of the company and served as chairman from 2008 to 2017.

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Almost all of The Company that Sean Shao owns has taken huge losses to public investors. Since going public, nine of the 18 companies have lost more than 50 per cent and eight are on the verge of bankruptcy. The companies’ share prices are down an average of 66 per cent from their highs. While share price volatility is the norm, it is at least doubtful to implicate so many underperforming companies.

The exception is Taibang Bioholding Company (CBPO). But it’s worth noting that David Hui Li initially invested in the company through Warburg Pincus and privatised it after it started its own private equity fund, Centurium Capital. Centurium Capital is also luckin Coffee’s largest non-managed shareholder, selling 5.5 million ADS shares when Luckin subsequently issued 13.8 million ads in January 2020 and currently owns 18.1 million ads (7.1%). As noted in the second point above, David Hui Li also directed Warburg Pincus to invest in Lu Zhengyao, the last listed company of Luckin, and was the second largest shareholder (after Lenovo) when the shenzhou car was listed. It appears that the company’s management, major private investors and independent directors appear to have a long-term close cooperation.

Another interesting figure is that 10 of the 18 companies’ most recently disclosed annual reports have been invalidated because of major flaws.

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Danger Signal 6: Luckin co-founder and chief marketing officer Yang Fei, a former co-founder and general manager of Beijing Word-of-mouth Interactive Marketing Planning Co., Ltd. (“word-of-mouth interaction”) has been sentenced to 18 months in prison for illegal operation. Then word-of-mouth interaction with Beijing Hydrogen Dynamic Siwei Technology Co., Ltd. (hereinafter referred to as “Hydrogen Dynamic Ive”) became the related party. HydroIve is now a subsidiary of Shenzhou Car Rentals and is in the process of trading with Luckin’s related parties.

Yang Fei is luckin’s co-founder and chief marketing officer, who designed the user growth model. Prior to Luckin’s establishment, he was chief marketing officer of UCAR (838006 CH), a subsidiary of Lu Zhengyao, chairman of Luckin. In 2013, Yang Fei was arrested as co-founder and general manager of Word-of-Mouth Interactive and sentenced to 18 months in prison for illegally operating a criminal network for the paid removal of information services. According to Caixin.com’s detailed report, whitewashing negative comments is a major business for word-of-mouth interaction. Under Yang Fei’s leadership, word-of-mouth interactive bribery of the owner or editor of an online forum/website to remove negative comments related to its customers and to provide services to post and promote positive reviews in order to forge positive brand images. Depending on the difficulty, the fee is between 200-3000 yuan. In July 2007, Yang Fei founded the company with a small number of people and limited funds, but within six years he developed into a company with a team of several hundred people, with an annual income of 70 million yuan, with a compound annual growth rate of more than 50%. On October 17, 2013, Yang Fei and word-of-mouth interaction were seized by the police. Another fact to consider is that Yang was reportedly due to remain in prison until April 16, 2015, but he became UCAR’s chief marketing officer in March 2015, a month before the release date.

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Luckin’s prospectus also shows that, as an affiliate of Shenzhou Car Rental sand and its chairman, Lu Zhengyao, he provided $6 million and $5.9 million worth of advertising services to Luckin in the nine months ending In 2018 and September 2019, respectively. Hydro dynamic Yiwei is a Chinese advertising company listed on the new three boards, Shenzhou car rental holding a 30% stake in its shares, and Yang Fei is the founder of Hydrogen Dynamic Siwei. The company’s prospectus and SkyCheck data show that word-of-mouth interactions were renamed “Beijing RoyalWay Media Co., Ltd.” (“Royal Way”), its parent company, Beijing Royalway International Media Media Co., Ltd. (“Royalway International”) was a related party to hydrogen dynamic. Today, according to the company’s address, Hydrogen Power, Royal Way International and Royal Way are located in the same building. Please refer to the summary of the organization chart and the certificate of relationship below.

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Beijing Word-of-mouth Interactive Marketing Planning Co., Ltd. changed its name to Beijing Yanqiao Culture Media Co., Ltd.

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Source: Sky Check

Data show that the addresses of both companies are in Beijing Chaoyang District, eight Lizhuang Dongli 1 CF28-D.

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As a former core member of UCAR, He has been close to Luckin’s chairman and chief executive, and has even written a book promoting Luckin’s growth model. However, his name never appeared on any documents on Luckin, UCAR or Luckin’s official website.

Yang Fei has appeared on several occasions as luckin co-founder and Chief Marketing Officer (CMO).

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Figure 1 for luckin IPO site, Figure 2 for the fawn tea launch site.

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(The original picture is in English, and Zhitong Finance has been sorted into Chinese edition)

Yang Fei’s book “Flow Pool”

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However, Yang Fei’s name is not on Luckin’s management list, nor on UCAR’s management list.

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The data comes from the official website

Yang Fei’s name also did not appear on Luckin’s official website.

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The data is from Luckin’s official website.

Part II: Business that basically collapsed by the third quarter of 2019

Business model flaw One: Luckin’s claim to core functional coffee demand is wrong, with Chinese an average of 86 mg/day caffeine intake already comparable to that in other Asian countries, but 95 percent of that is from tea.

Unlike market leader Starbucks, Luckin’s management focuses only on meeting Chinese’s functional needs, namely caffeine, but doesn’t realize that China is a “stubborn tea-drinking” society – a caffeine that needs tea products to meet. “Coffee is a very healthy, functional drink that keeps people awake and energetic … and it’s a very healthy, functional drink,” Luckin’s chief executive, Qian Zhiya, said at the 2019 Global Partners Conference. Young Chinese have a strong demand for coffee due to caffeine intake. “Luckin’s core value proposition is to provide more coffee products. By eliminating the price premium in Starbucks’ business, it makes its pricing attractive, easier to obtain and with comparable quality models. Indeed, China’s demand for caffeine does exist, and coffee consumption is still low compared with its international counterparts. Nevertheless, given that Chinese consumers’ caffeine intake has been met from tea, the functional needs of coffee may still be a niche market.

As shown in the figure, after joining the World Trade Organization at the end of 2001, Chinese consumption of tea accelerated. Per capita coffee consumption has also seen a decent increase, but the absolute level remains low.

Historical consumption of coffee and tea per capita in Asian countries

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Note: Coffee consumption data are from the International Coffee Organization (“ICO”) (China, Hong Kong and Macau) and FAO (Japan, Korea, India and China, Taiwan). Tea consumption data are from FAO: FAO, China National Bureau of Statistics, World Bank.

Most importantly, caffeine from tea accounts for more than 95% of the Chinese’s average caffeine intake, while the total caffeine intake from Chinese is 86 mg/day, which is comparable to that of South Korea, a developed country dominated by caffeine from coffee in Asia. Given China’s 60 per cent urbanization rate, China’s per capita urban consumption may be more than 140 milligrams, comparable to Japan’s. Another “stubborn tea-drinking” society, India, has shown a similar level. There is very little room to create additional caffeine demand for coffee consumption.

Daily per capita caffeine intake (tea and coffee)

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Note: According to Caffeine informer, 1 gram of dried green tea contains 10-20 mg of caffeine (assuming 15 mg). 1g dried black tea contains 22-28 mg of caffeine (assuming 25 mg). The 12-ounce cola contains 34 milligrams of caffeine. 15 g of coffee beans contains 150 mg of caffeine. Source: UsDA, Caffeine, World Bank.

A comparison of coffee per capita consumption in various countries also shows that per capita coffee consumption is driven mainly by culture rather than economic development. China’s per capita coffee bean consumption lags far behind developed countries such as Japan and South Korea, but also lags far behind developing countries such as Vietnam, Indonesia and Laos. According to the Us Department of Agriculture (USDA), global coffee consumption is concentrated in Western and former Western colonies – the European Union, the United States and Brazil, at 28%, 16% and 14%, respectively. In developing countries in Asia, more Westernized developing countries such as Vietnam (formerLy French) and the Philippines (formerly Spanish and American colonies) consume high coffee consumption. In contrast, coffee consumption is low in tea-cultured countries such as China, India and Sri Lanka.

Comparison of per capita coffee beans and coffee consumption in Asia

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Note: According to Starbucks guidelines, 10 g of coffee powder requires 180 ml of water. 1 large latte is equivalent to 15 grams of unroasted coffee beans. Source: UsDA, World Coffee Organization, World Bank.

Comparison of coffee consumption per capita with GDP per capita

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In addition, coffee is unlikely to play a greater role in the caffeine consumption of Chinese consumers in the future for the following reasons:

In recent years, the overall consumption growth of coffee beans has slowed to a CAGR of 3-4% in recent years: The USDA and ICO show that in recent years, the growth of Chinese average coffee consumption has slowed to a CAGR of 3-4%.

Chinese consumption of unroasted coffee beans

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According to a report by the American Group, there are differences in store coverage and growth rates for freshly squeezed tea and coffee. By the third quarter of 2018, there were about 410,000 now milled tea shops in China, four times the number of current milled coffee shops. In terms of growth rates, the number of tea shops continued to grow, with the number of current coffee shops falling from 121,000 in the third quarter of 2016 to 105,000 in the third quarter of 2018. Therefore, coffee supply network coverage is not a problem, just not enough demand.

Number of now-milled coffee shops and now-grinding tea shops

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Starbucks knows that the business needs of coffee shops in the A-C category are far greater than Luckin’s focus on Category D. As a result, Starbucks is willing to pay high rental and renovation costs for space and style in China. Chinese consumers are happy to pay for a stylish place to offer drinks/food for a meeting or leisure, rather than coffee itself. Starbucks’ operations in China are further evidence of this:

The bulk of consumption is not coffee: coffee accounts for only 40-45% of total sales (more than 70% of Starbucks China sales come from beverages, and coffee accounts for 59% of beverages), according to Starbucks Investor Day in China. Mocha and lattes are the most popular coffees. Functional coffees such as American coffee/Italian espresso are in the minority. The rest of the drinks are tea, star ice and other drinks.

Only 10% of Starbucks’ revenue comes from D-type feature demand: According to industry research, Starbucks members contribute 50% of total revenue, while functional beverage users account for only 20% of membership revenue

In China and the U.S., the income mix at different times of the day: The strongest functional requirements are usually in the morning, while breakfast accounts for more than 50 percent of U.S. income. However, according to Starbucks China Investor Day, breakfast accounts for only 16% of Starbucks’ revenue in China (24 per cent for lunch, 30 per cent in the afternoon and 31 per cent in the evening).

Shopping center location dominance: Coffee shops located in office buildings are more about functional use of staff, while coffee shops located in shopping centers are more about space, style or casual beverage shopping. According to management, 70-80% of Starbucks China’s stores are located in shopping malls, mostly in the heart of first-tier cities, such as Beijing’s CBD or Shanghai’s Lujiazui.

Most customers choose to shop: Luckin often claims that 70% of Starbucks’ orders in China are takeaways. Such data is biased. According to one study, Starbucks counters usually set orders as takeawayby by default, and orders are converted to in-store meals only if customers need a cup instead of a paper cup. The use of paper cups is close to 70%. However, paper cups are also often used in-store. Takeaway orders should only account for 30-40% of total orders, and the actual number of takeaways should be lower, given the high occupancy rate in stores.

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As a pioneer in the Chinese market, Starbucks has established the broadest network of prime location stores, providing quality coffee experiences in store decoration, service and product quality. Starbucks’ continued performance over the past 20 years has allowed it to build an unparalleled high-end brand with a unique business model, with long-term rentals in prime locations below the market average and opening up space for consumers to charge “rents” by selling them high-priced coffee.

In other words, Starbucks is a successful “coffee version of WeWork”. Not surprisingly, Starbucks is the only coffee chain in China that has made a significant profit. All of its competitors, including Gosda Coffee, Pacific Coffee and Korea Coffee, have found it difficult to replicate the success of Starbucks’ 20-year-old brand value and accumulated store portfolio, with 71 of them struggling to make a profit in China. Luckin, on the other hand, has taken a completely different direction, focusing on the functional requirements of coffee, which is only a niche market in China.

In the table below, Murswater lists the main differences in business models and cultures between Starbucks and Luckin to help illustrate the differences in their business models

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(The original picture is in English, and Zhitong Finance has been sorted into Chinese edition)

Starbucks’s claim is based largely on the books “Pour Your Heart” and “Going Forward: How Starbucks Struggles to Survive Without Losing its Soul.”

Business model defect two: Luckin’s customers are highly price sensitive, generous price promotion is the driving force to retain them; Luckin’s attempt to lower the discount level (i.e., increase the effective price) while increasing same-store sales is an impossible task

Market size aside, we recognize luckin’s success, which delivers more than 20.5 million cups of coffee a month free or cheap, consumes a lot of cash, and opens 4,500 stores in two years. As of the second quarter of 2019, the company had accumulated losses of RMB2.9 billion in just six quarters, with a cumulative total of 22.8 million customers traded. It perfects the art of user recommendation on WeChat: existing customers recommend a new customer to get a free cup of coffee at the same time; sharing a link in WeChat Friends or Microgroup will result in 20 randomly formed coupons ranging from 82% to 32% for other customers to use in the lottery.

China watchers are so surprised by Luckin’s continued deep discounts and the scale of Luckin’s expansion and the rising losses that they call Luckin a “real nationalist big company.” Because its business model is to raise money from foreign investors to subsidize Chinese consumers.

Unfortunately, the customer acquisition strategy, centered on free coffee plus coupons, has led to a highly price-sensitive customer base. The chart below shows the impact of product discount levels on retention rates and transaction values.

Group analysis clearly shows that 1). Luckin’s retention rate and quality of new customers are lower and lower than in earlier years, and 2. Retention rates for the entire group are determined by the level of discounts rather than the length of the customer’s use. Luckin divides users into different user groups based on the month in which they first purchased their products and compares retention rates for different user groups, as shown in Figure 15 below.

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Luckin’s new customer retention rate typically drops to 35% or less at M1 (the second month after becoming a Trading Customer for Luckin), and M1 retention rates are usually one of the highest in the queue life cycle. At any given time, more than two-thirds of people in each group will remain inactive throughout the group’s life cycle, which means they will only be attracted to a free cup of coffee and will not continue to choose to buy.

In terms of quarterly behavior, 1Q has a high retention in 2018, with a retention rate of 30% to 35% after one year of use. From the second quarter to the fourth quarter of 2018, the quality of new users has been declining, with user retention rates ranging from 25% to 30% or even 20% to 25%. M1 retention rates recovered in the first and second quarters of 2019, but quickly fell to 20%-25% or less in the first few months.

Luckin’s most recent customer retention rate by month

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In summary, Luckin typically loses most of its new customers after drinking its first cup of coffee for free; its first customers are its high-quality core customers, with a significant increase in the percentage of non-core customers as the number of customers grows.

We then group queue behavior by calendar month in the chart below to show how active all queues are during a specific calendar month. The following table clearly shows that all Luckin customers perform the same in each calendar month except for the first month after becoming a new customer.

In the first half of 2018, retention rates declined gradually, reaching their lowest level in July-August 2018. Starting in August 2018, retention rates will begin to pick up between the second half of 2018 and December, with a high retention rate of 1Q in 2019 (exceptionally low retention rate in February 2019 due to Spring Festival and Luckin target office requirements). Retention in the second quarter of 2019 was significantly lower in June 2019, the lowest monthly retention rate for customers since December 2018.

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We get the level of its discount from the company’s documents and presentations. The discount level was increased in the first quarter of 2018 to the first quarter of 2019, but attempted to reduce the discount level in the second quarter of 2019, directly corresponding to the retention rate trend above. As a result, changes in retention for each queue are much more correlated with the discount level for each calendar month than with the year of the queue: the higher the discount, the higher the retention rate, and vice versa.

Luckin Quarterly Effective Price

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Luckin also discloses the transaction value of each customer group (based on the listing price rather than the effective selling price). We group queue behavior by calendar month to see how the value of transactions changes for each queue. The value of the company’s customer base transactions shows a pattern similar to the above retention rate. First, all queues behave the same from one calendar month to another, and second, when the team moves in the same direction, the newer customer queues perform significantly less than the older one in the same month. Finally, transactions in list prices continued to grow from the second quarter to the third quarter of 2018, as the company increased its discounts.

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It is worth noting that turnover in the second quarter of 2019 was higher in order, especially for early customers. This is partly due to a 10-week special promotion of “Full” 7″, which splits 5 million cash!” The promotion lasts from March 11 to May 19, with an average of about 150,000 customers buying seven items a week. In the second quarter of 2019, the average monthly purchase of only 4.5 items per trading customer was only 4.5 (according to management, the average monthly purchase was 27.6 items). Another possible factor is Luckin’s launch in the second quarter of 2019 of a major new product category, Fawcin Tea, which was tested in Beijing/Shanghai in April and rolled out nationwide in May. In addition, we will discuss the positioning and competitiveness of Luckin tea products later.

Luckin’s existing trading customers have seen a decrease in the number of items they buy each month.

Based on the disclosed data, we also calculated the average number of items purchased by existing customers each month, excluding the number of items purchased by new customers. As mentioned above, Luckin attracts a large number of new customers because of the free first cup of coffee, which has since become inactive. As a result, we estimate that the average purchase volume of new trading customers is about 2.3/month/trading, well below the average for the following month and beyond.

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The proportion of new customers to total transactional customers has declined as Luckin has grown in size, resulting in an increase in the average monthly total purchase of items per trading customer. If we do not take into account the impact of new customers, luckin’s existing trading customers will purchase a peak of 6.2 items per month in the third quarter of 2018 and then steadily decline to 5.5 in the second quarter of 2019 (the first quarter of 2019 was exceptionally low due to the Chinese New Year in February).

The decline in the number of items purchased per trading customer corresponds to the price discount list discussed above: higher discount levels helped drive customer spending to peak in the third and fourth quarters of 2018, when the effective price fell rapidly from 63% of the listing price in the second quarter to 49% in the fourth quarter. As discounts waned in the second quarter of 2019, Luckin’s customers also bought fewer goods each month.

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The receipts we recently collected for the company’s fraud investigation are another piece of evidence. In theory, in Luckin’s longest-running cities, brands should accumulate more loyal customers who are willing to buy Luckin’s products at less discounts (a goal that management has long targeted and told investors). In 20 newer cities, Luckin spends a lot of money to “educate” consumers to drink coffee, so discounts are higher. However, real income shows little correlation between the level of discounts and the city’s operating history.

Comparison of average effective prices and discount levels in Luckin cities (from left to right by operational start date)

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It’s not surprising that Luckin’s customer base is at a discount. In fact, the company has been focused on using coupons/discounts as its primary customer acquisition and operational strategy. Luckin’s customers interact with Luckin from day one through coupons/free coffee, not through people/styles/services/cultures. Consumers are very sensitive to Luckin’s discounts.

First of all, you can’t shop without coupons or discounts. Even management has publicly stated that the long-term discount rate for all products should be 67%. Luckin has a large number of coupons on its app and at WeChat: top-up coupons (buy 1, buy 2 send 1, etc.), share coupons generated by links, half-price coupons for WeChat official accounts, coupons for inactive customers for a week, coupons for months of inactive customers, and coupons for other non-coffee products after purchase. Despite claiming to be an internet company, Luckin’s app is relatively straightforward; it doesn’t have any common user-involved features such as mini-games, check-in rewards, time-limited snaps, and more.

Second, to reduce operating costs, Luckin has adopted a strategy of minimizing human engagement from every perspective, including services. Its coffee machine is fully automatic: employees can make coffee at the push of a button. Store employees are not required or motivated to interact with customers unless they have to. Customers order online and then take coffee through a QR code.

Starbucks, on the other hand, has shown that its key asset is baristas, because the connection between barista and consumers is a core competitive advantage. It calls baristas “partners” and full-time and part-time employees are paid more than the industry average. The company also tries to instill its culture and philosophy into its “partners” and then instills them in its clients through partners.

Third, Luckin’s store decorations are also minimal and modular: it is designed to meet delivery and self-delivery requirements, offering small or zero seats. According to our research, the average capital expenditure per store is about RMB450,000, the store decoration budget is about RMB1000-2000 per square meter, and the standard standard level of catering services is RMB4000-6000 per square meter. Renovation takes only 3 days, and stores can open 2 weeks after the lease is signed, while Starbucks/Costa is 3 months old. Based on its core strategy, Luckin needs to slash spending and offer customers only discounted products.

Our consumer survey shows that current and potential perceptions of the Luckin brand are highly correlated with the low price of their products. In fact, the top three consumer setypes of perceptions of Luckin are: 1. More discount coupons, 2. cost-effective, and 3. Low prices. For Luckin’s existing customers, they agree and choose to continue buying Luckin products. Luckin, on the other hand, is rarely associated with high-quality, convenient and white-collar brands.

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To make matters worse, Luckin’s coupon-centric approach to the extreme hurts premium customers: a normal, smart business usually has a loyalty program to reward loyal customers, and Luckin’s “dynamic pricing” discriminates against those premium customers.

Starbucks has 9.1 million active members, contributing 50 percent of its revenue. From December 2018, Starbucks members will be available free of charge and will be divided into three different levels based on the cumulative amount of spending. As shown below, the higher the level, the more benefits/coupons members will receive. The company uses loyalty programs to increase stickiness and customer loyalty.

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Luckin, on the other hand, does not have a membership program or points system. Customers don’t get any additional benefits from more consumption or more frequent consumption. On the contrary, customers who spend less will get more discounts. Luckin has a user retention program that sends a large number of discount coupons to customers who haven’t bought it for a week. If a customer doesn’t order for a month, the discount will gradually increase to 82%.

This coupon structure is also well linked to the high correlation between retention rates and discount levels discussed above: active customers get smaller coupons. Luckin’s strategy is to reactivate marginal consumers with larger discounts, while core customers do not enjoy any additional benefits. Management has also frequently said that their strategy is to use big discounts to attract new customers, help them develop coffee habits, and then raise the average price, i.e. price discrimination against loyal customers.

Taken together, the truth about Luckin’s business model is that discount levels are a key driver for its price-sensitive customers. “When the company increases the discount on its products, the customer increases the expenditure, and when the company wants to “raise the price” by lowering the discount level, the customer becomes less active and buys fewer products.”

In addition, as the number of Luckin stores continues to grow rapidly, further increased store penetration will dilute existing stores. Our survey of real business indicators shows that by the fourth quarter of 2019, sales per store began to decline despite management’s further increase in discount levels (46 per cent).

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The new “no-retail” strategy is another potential problem for Luckin: management claims that their coffee vending machines (coffee EXPRESS) are of the same quality as those sold in brick-and-mortar stores and should therefore be priced at the same price; Luckin’s coffee is made from fully automatic machines, not by professional baristas.

The coffee machines used in the stores can be divided into three levels of automation. Costa and Pacific Coffee use semi-automatic machines that require on-site baristas to hand-craft espresso and steam milk. Starbucks and McDonald’s use semi-automatic machines with automatic concentration: espresso comes out of the machine, but baristas need to complete the milk heating process. Convenience stores such as Luckin, KFC and 7-ELEVEn all use fully automatic coffee machines: employees can make lattes at the touch of a button.

KFC and convenience stores choose fully automatic machines because their employees have a lot of other things to do, and Luckin uses them because they minimize labor costs and barista training. Luckin only takes half a day to train a new barista, while Starbucks takes two weeks to train their baristas. Luckin’s coffee machines are better in quality and capacity than KFC’s, but the latter is cheaper.

From the customer’s point of view, coffee made by experienced baristas is considered to be of high quality: the quality of the coffee is higher, and the barista has an influence on the choice of the customer. For example, in the above customer survey, Luckin’s customers did have a high level of awareness of Luckin coffee, possibly because Luckin’s stores and employees were primarily engaged in coffee making. However, emphasizing luckin’s drone to produce the same coffee would run counter to the customer’s existing perception and the reason it was more expensive than KFC or convenience store coffee, both of which are fully automated coffee.

Business Model Defect iii: Defective Unit Economy (Single Store Data) No Chance of Seeing Profits: Luckin’s Broken Business Model Is Doomed to Collapse

Before we look at Luckin’s single-store economy, it’s important to note that coffee is classified as a supply chain mature, standardized, and relatively high gross margin in different vertical sands in the food service industry. However, Starbucks is the only truly profitable coffee retail chain in China, suggesting that the key to profitability lies not in producing and selling products, but in finding viable business models at the store level.

There are three active beverage businesses in China that have proven successful business models: the third-largest space model (high ASP-large-stores such as Starbucks), the convenience store model (low ASP and shared storage, such as family, KFC coffee), and the milk tea model (low-low ASP-small stores, such as 1 point, Coco can all franchises, etc.). The reasons for each pattern’s success vary. But Luckin is sandwiched between the two. As fully discussed in Defects I and II: On the one hand, the limited end demand for coffee as a functional product limits sales, and on the other hand, Luckin is unable to increase prices while maintaining sales due to its highly price-sensitive customer base. When we add rental costs and head office costs, some of which are used to acquire new customers, to the cost, it is clear that Luckin cannot make a profit at the store level and the losses at the company level will be even greater.

Luckin’s actual sales and effective prices show that it is losing money at the store level.

As an offline catering service company, Luckin’s unit economy can be divided into three factors: revenue, sales costs, and store operating costs.

Revenue: Revenue is determined by items sold each day and by effective sales prices (i.e., after discounts). For example, we use the public 2Q figures for 2019 to calculate the number of 345 items sold per store per day, as well as the effective cost of RMB10.5 per item (net income divided by the total number of items sold) to calculate the store’s net income of RMB109,000 per month.

Cost of sales: The raw material cost of Luckin fresh beverages is 5.6 yuan per cup (the same as in the second quarter of 2019), which is 53.5% of the effective sales price. The mixed gross margin was 46.5%, equivalent to a monthly gross profit of $506,000.

Store operating costs: Luckin’s store operating costs include rent (15,000 /month), labor costs (3.0 yuan/product, according to management statements), utilities (5,000/month), depreciation of equipment and store renovations (450,000 upfront, 3-5 years of return on investment). We calculated Luckin’s store-level operating costs at $611,000 per month, which has limited the scope for further significant reductions.

Distribution allowance: Luckin’s takeaway business is done by Shunfeng. Because coffee delivery times are sensitive, Shunfeng’s delivery attendants usually wait at Luckin’s stores, which leads to higher costs. We estimate that the shipping cost per order is RMB9-10 (including VAT). On this basis, Luckin offers free delivery services for large orders (equivalent to a delivery subsidy of RMB 9-10 per order) (the standard for 13 cities is the order price of more than RMB55, and the standard for other cities is the order is greater than RMB35, according to the listed price, not at the effective price). For small orders, a delivery fee of RMB 6 (equivalent to rmb 3-4 per order) is charged. As a result, Luckin provides an average delivery subsidy of RMB5 per order.

Management does not include courier costs when calculating single-store operations. However, the delivery subsidy is directly derived from the sale and distribution of products and can be attributed to each store. In the second quarter of 2019, 19.8 percent of the goods were purchased by courier, the company said. We calculated an additional monthly delivery allowance of $7,800 per store, which further increased the financial pressure on single stores.

At the store level, Luckin’s gross profit of $5.06 million could not cover operating costs of 611,000 yuan and distribution subsidies of 7,800 yuan, and Luckin generated an operating loss of 183,000 yuan per store per month. More importantly, Luckin is still unable to break even cash flow at the store level without taking into account depreciation. In other words, Luckin’s up-front investment in equipment and renovations will never be recovered, as the stores that open stores burn money every month.

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“Since operating costs are largely fixed and raw material costs are proportional to revenue, items sold every day and discounted effective prices are two key factors for luckin store profitability.”

The sensitivity table below shows how these two driving changes, daily sales items and effective prices, affect Luckin’s stoel operating margin and the corresponding payback period in months. In the second quarter of 2019, luckin’s operating margin, including delivery subsidies, was negative 16.8%. At the same time, EBITDA remains negative, i.e. cash flow per store is negative.

Luckin’s stores typically have a three-year lease term, which means a payback period of 36 months. With a 53% discount (47% of the actual price at the listed price) in the second quarter of 2019, 800 or more items sold per day will need to reach this target.

Luckin’s management has been making it clear to investors that their long-term pricing strategy is not a “list price” but a “buy two and one”, or a 33 per cent discount. Let’s boldly assume that all products will meet this price target. In this case, a store needs to sell 200 items a day with a 36-month payback period and increase its average effective price by 43 per cent, but still has an operating margin of only 3 per cent.

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Taking a step back, our research shows that there are three viable business models for current beverages, and luckin lacks the competitive advantage to develop any of them.

In the catering service industry, the goods sold in each store are often negatively correlated with the actual price. Luckin’s competitors have found their way to balance sales and prices. Because of this balance, their investment in new stores can generate a reasonable ROI, which is the basis for making the business model viable.

“Third Space”: Over the past 20 years, Starbucks has built a high-end brand in China and successfully made the “third space” value proposition deep in people’s minds by selling coffee. As a result, Starbucks’ products are priced higher than their competitors, but still deliver more sales and profitable. While Luckin’s smaller store space saves upfront investment and day-to-day operations, its stores generate only 17 percent and 11 percent of Starbucks’ gross profit in a niche market that targets demand for coffee features. As points 1 and 2 of the business model defects mention, the success of Starbucks’ “third space” model depends on strong brand value and rent negotiation, while other followers such as Costa and Pacific are still struggling to make ends meet. Given the completely different store design and brand positioning, Luckin is unlikely to replicate the “third space” model.

“Convenience stores”: Competitors such as KFC and the family use existing stores and employees to sell coffee. Therefore, they only need to buy coffee machines and raw materials without any additional rent and labor costs. Although sales are much smaller, the “convenience store” model can achieve a similar level of return on investment to Starbucks. Luckin, on the other hand, is seen as a dedicated coffee shop (though it tries to convince investors that it is “using coffee to attract traffic and then selling tea, snacks, bread or anything else to consumers”).

Milk Tea Shop: 1 point, Coco and Luckin’s products are comparable. But in China, the target market for the two is “tea” far more than “coffee”. As a top tea shop, sales are very high in each store. Luckin Coffee is difficult to replicate because it primarily serves the functional coffee market, while Chinese tea largely meets the demand for caffeine. Structurally, the gross margin of the milk tea shop is also higher, at more than 60%, meaning luckin may need to increase sales per store to break even.

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For Luckin’s store-level economics to work, Luckin needs to raise both prices and sales, or the other while keeping one of the two stable. However, limited by market size and price-sensitive user base, Luckin has a hard time achieving both. The chart above shows how Luckin faked daily sales and unit prices in the third quarter of 2019, creating the illusion of store profitability. In fact, Luckin’s store-level operating margin, based on actual business metrics, could be negative 33% (including distribution subsidies).

Luckin’s best bet is to emulate the milk tea shop model, which is the small store and low-price model: it is essential that Luckin achieves a break-even store and maintains high sales per store per day. Unfortunately, the core problem is China’s limited demand for coffee as a functional product, especially compared to China’s larger tea and beverage market. As a result, luckin’s sales at each store are hardly as good as those at milk tea shops such as 1 Point and Coco.

Another factor behind Luckin’s limited sales is that most of its stores are located in office buildings to meet functional demand. The number of people in an office building in China is usually 2,000. The first requirement in Luckin’s own business development standards is for the new store to be located in an office with more than 1,500 people. We can also verify this by looking at the number of trading customers per store in Luckin per month: around 2000. The index peaked at 2,600 in the second quarter of 2018 (when fashion doesn’t have as many stores) and in the fourth quarter of 2018 (when discounts were high). In 2019, luckin stores are actively expanding, with a trend ingress in the number of transactions per store per month. If a geographical area of stores are too dense, it creates serious competition of the same kind, further limiting sales per store.

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Can Luckin switch to Starbucks’ model to improve its pricing power when sales are blocked? The answer is clearly no, because Luckin’s customers are highly price-sensitive and lack loyalty to Luckin’s products and brands, and cannot raise prices if Luckin doesn’t sacrifice sales significantly.

Two inherent flaws in Luckin’s business model have kept Luckin unprofitable. Luckin’s real situation in the third quarter of 2019 should be unexpected and sustained losses, and the economic efficiency of the unit has not improved. However, as we note in the hard evidence section above, management has begun to make financial fraud by pretending that its business model has turned acorner: miraculously, in the third quarter of 2019 and the fourth-quarter guidance, they were able to achieve a big increase in sales at each store with reduced discounts, and investors mistakenly believed their story and mistakenly believed that the business had turned a corner.

In addition to store losses, Luckin’s high and rising head office spending is compounded. At the corporate level, Luckin customer acquisition costs (“CAC”) are high: in the past few quarters, the CAC for each new customer has been mostly around RMB50, if we take into account the monthly retention rate of 25% (M1 -lt;35%, and then quickly dropped to 20%-25%), the monthly trading customer CAC has reached RMB 200.

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Management aims to have 10,000 stores by the end of 2021, meaning another 5,500 stores will open in the next eight quarters, or 688 new stores per quarter. Based on the true situation of 263 items sold per store per day, we deduce that luckin stores sell an average of 7,890 items per month. We also derive from commercial model defects, luckin’s existing trading customers buy an average of 5.5 items per month. As a result, Luckin needs to get 1,435 trading customers per new store each month. If new stores do not rush customers from existing stores (which is optimistic that urban penetration of their existing stores is increasing), we estimate that Luckin will spend $287,000 per new store per quarter, with 688 new stores spending $197 million per quarter on the cost of the new store.

In terms of general and administrative expenses, Luckin spent about Rmb76,000 per store per quarter (an average of Rmb228m divided by an average of Rmb228m in stores divided by the average number of stores 3,000). As a result, the additional general and administrative costs of 688 new stores will cost the company an additional Rmb52.2m per quarter.

On the other hand, luckin stores are far from breaking even. In fact, we calculate, it loses Rmb26,000 per store and Rmb17.9m per month at 688 new stores. In essence, Luckin’s expansion plans cost the store 53.7 million yuan per quarter under the current business model, and in other cases the same. Then at the company level lost another Rmb249.2m, adding a total of Rmb303m per quarter, which is still only in new stores! The more Luckin opens a store, the more its investors lose and the faster.

Business model flaw four: Luckin’s dream of “starting with coffee and being a part of everyone’s daily life” is unlikely to come true because it also lacks core competencies in non-coffee products. Its “platform” is full of opportunistic customers without brand loyalty. Its light-panel model is only suitable for the production of “1.0 generation” tea drinks that have been on the market for more than a decade, while leading fresh tea producers pioneered the “3.0 generation” product five years ago.

Luckin Tea (Little Deer Tea): 1.0 generation tea product pair 3.0 generation competitor

Fawclis tea is Luckin’s most important non-coffee product – coffee differs from the tea customer base and consumption scenario, so in theory, fawn tea can help target and attract customers outside of core coffee customers. Luckin started its trial run in Beijing and Shanghai in April 2019 and launched its stores across the country in May 2019. In September 2019, Fawchad Tea officially separated from the independent brand and hired Xiao War as a brand ambassador.

Coffee is more functional than tea drinks and is suitable for more formal occasions such as business. On the other hand, the buyers of tea drinks consume tea drinks for leisure and are mainly concerned with the taste of the drinks. While demand is not a constraint in the tea and beverage industry, the main challenge sits in supply chain management and in-store production.

Coffee is a commodity with a standardized supply chain, and automatic coffee machines can greatly simplify the in-store production process of coffee; On the other hand, our research shows that tea drinks, especially the “3.0 generation” products of the fawn tea pair, are the opposite, and they are more complex in terms of supply chain and in-store production.

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China’s tea and beverage industry has grown from 1.0 generation products (tea powder brewing) to 2.0 generation (tea and cream or milk), and then to 3.0 generation products (tea and cheese cover and fresh fruit). Correspondingly, the consumer of tea drinks has developed a keen taste in taste. From the following top ten tea brands can be seen, the current market 2.0 generation and 3.0 generation of products coexist.

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Generation 1.0: Standardized products brewed from tea powder. Major chains include Street, Happy Lemon and Mom and Couple. The product cost is low, but the taste is also poor.

2.0 generation: milk tea – pre-made tea (brewed with real tea), order with cream or milk and pearls. The main chain stores have Coco can and 1 point, are Taiwan brand.

Coco now has more than 3,000 stores, compared with more than 2,000 at 1 point. Both brands operate under the franchise model. This type of store area is very limited (no seats)

Due to supply chain constraints, these stores are limited to fruits with long shelf life, such as lemons, which is why they feature milk tea rather than fruit tea.

Mi seice ice city is another 2.0-generation chain brand, mainly located in low-end cities, the main low-cost products

3.0 generation: now made tea drinks, there is real tea, cheese cover, fresh fruit. Major brands include Magpie Tea, Nai Snow’s Tea and LeLe Tea.

The new generation 3.0 generation products are more than 2.0 generation of another major upgrade, raw materials are more high-quality, the corresponding product prices also increased from 10-15 yuan to 30 yuan

3.0 brand in-store decoration tends to be more in-house, but also to provide seats to better practice a “third space” strategy like Starbucks

3.0 generation products are more expensive from a material and labor perspective due to raw material upgrades and increased demand for the processing and processing of fresh fruits

Fawcin tea pair 3.0 generation tea drink, its product lineup mainly copied hi-tea, the latter is one of China’s most popular tea beverage brands. However, Luckin’s product development systems and supply chain capabilities are based on Starbucks and producted for coffee, which is fundamentally different from the 3.0 generation of tea products.

Coffee brands such as Starbucks and KFC mainly use premixed powders for tea drinks: tea and fruit are derived from tea powder and jam. These drinks are cheaper and easier to produce and are complementary to major coffee products. Luckin has been targeting a simpler in-store production process than Starbucks to minimize labor. While Starbucks mixes different raw powders, Luckin asks suppliers to mix as much of the raw powder as possible into concentrated paste, which can be easily mixed with water for tea.

Products developed for 3.0 generation tea drinks are the opposite: happy tea and leloteas prioritize better and fuller flavors over efficiency/convenience. In order to ensure quality and flavor, raw materials such as tea, fresh fruit and ingredients are usually sourced directly. The product manager will then undergo repeated testing and testing of different raw material combinations to achieve the best taste, and then promote it in the store. Tea is now done needing a larger labor force, because fresh fruit often needs to be peeled on the spot, cheese cover needs to be hand-disturbed.

Luckin’s management made it clear that the company would not be able to afford fresh fruit because of the sheer size of its more than 4,000 stores and its pursuit of in-store efficiency. Instead, it uses only NFC juices, jams and frozen fruits as alternatives. Luckin’s cheese cover ingredients are also made from powder. In addition, Fawka Tea products do not require additional equipment, which further confirms our view that Luckin’s tea drink is essentially a 1.0 generation product. Fawclis tea cannot replicate magpie products because of its different development and supply chain models.

The following image shows a range of fawn tea products: each drink’s texture is uniform and balanced, indicating that it is mixed from NFC juice jam; Limited fruits, mainly citrus with a longer shelf life, may be added for decorative purposes.

Luckin's short edit full text: Fraud and basic crash of business

Starbucks’ “Play Ice” range is launched in the summer of 2019, similar to the little deer tea above. Artificial coloring is quite obvious, and the fruit is also citrus-based. Some of these drinks even mix coffee elements. According to our research, Starbucks’ own feedback is that they are on the right track to attract younger customers with tea and drinks, but these products are not as attractive to target consumers as they would like.

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The image below shows a uneven texture of the tea products, with a noticeably layered tea, fruit and cheese cover. The colors are more natural and there are more fresh fruit smaller. The fruit is also much larger than Luckin and Starbucks, offering fresh flavours rather than juice or jam.

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According to our research, the taste of fawn tea fruit tea products is very different from the 3.0 generation products they are trying to imitate. There is a distinct taste of jam and artificial flavoring, but almost no taste of tea. The only product with pulp tastes like canned fruit. Customers also have limited choices about the sweetness level: most products are not sugar-free (feedback from Luckin stores suggests that sugar has been premixed in tea powder and jam). Limited customization reflects Luckin’s principles of specification and simplified in-store operations. However, it comes at the expense of the customer experience. According to the company’s milk tea distribution industry report, only 7% of customers will choose whole sugar / polysaccharide, and sugar-free is the first choice for milk tea products.

In short, Fawtan tea in the tea beverage market competition position is very low. It lacks product development, supply chain know-how, in-store production manpower to provide quality products. Compared with the 3.0 generation tea beverage brand, Fawka tea is not structurally competitive.

Deer tea is priced at 21 yuan, 24 yuan and 27 yuan before the discount, after the standard discount of 33%, the price range is 14-18 yuan, lower than the tea of Hi-Tea and Nishi, but still higher than 2.0 generation brand Coco can and 1 point. Other brands will not continue to use discounts to reduce prices. Since taste is a key factor in tea drinks and consumption only once or twice a week, fawn tea is likely to end up competing for price with an inherently low-quality product.

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Other products: low gross margin business, which is an inherent disadvantage

In addition to freshly made beverages, Luckin offers catering products from third-party suppliers, including 5 NFC juices, 3 lunch packages (salad/noodles), 21 light snacks (bread, desserts, sandwiches, etc.) and 20 snacks. We classify Luckin products from third parties according to distribution requirements and shelf life.

Lunch (salad/noodles) and light food (sandwiches, bread rolls, etc.) are perishable and need to be served in cold chains. They are initially priced at RMB35-38 and RMB13-24. With APP ordering and using a variety of coupons, Luckin offers a 34% discount on all lunch packages and light meals. According to our research, customers think Luckin’s lunch packages and light meals are of the same quality. Luckin’s salad, for example, has plenty of vegetables and fruits, but has very little protein and a common taste. Lunch and light food also require a cold chain supply every day, so the location of suppliers and cold chain logistics can be a constraint. In addition, Luckin is fairly conservative in the management of perishable food inventory. As a result, lunch and light meals are usually sold out before noon, which is quite rare in the restaurant industry.

NFC juices, baked goods and desserts are also available in cold chains. Luckin’s NFC Juice is a contract product from Zero Degrees Fruit Shop. The original retail price for NFC juice is RMB24. The discounted price is slightly lower than the offline retail price of Zero Fruit Shop. Baked products and desserts are $13-16 and $25, respectively, with discounts. Store staff need to unfreeze bakery products before selling, as they are also supplied through cold chain logistics. However, most of Luckin’s stores are not equipped with heating equipment, so Luckin’s bread products taste much worse than freshly baked/heated. According to our research, Luckin is suitable for stores based on a “modular” design model to accelerate the deployment of their new stores. At first, Luckin didn’t think about heating equipment, so there was little room for heating in existing stores. As far as we know, Luckin’s product team does not plan to add heating equipment, and customers can only heat their own food.

Snacks are easy to store and do not require a cold chain supply. Luckin’s snacks are aimed primarily at white-collar workers, with higher stock holding units (SKUs) than Starbucks and Costa. Luckin snacks range from 13 yuan to 30 yuan, after the discount price is 9-20 yuan. Luckin’s snacks are no different from other channels because they are private labels from third-party vendors and can be purchased through all major retail channels. Customers in LuckinAPP a single snack, do not see the zero food brand, bought only to find that these snacks are not luckin brand. We have compared the prices of Luckin’s snacks with the same products sold in other channels. Luckin’s discounted prices are the same as the retail prices offered at offline convenience stores, but on Tmall/Gindong and O2O food delivery platforms, the same products are 25% and 15% cheaper.

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According to Luckin’s quarterly report, its other products, ASP (price per item) and average cost of sales (COGS), are lower than their fresh beverage products. According to our research, Luckin’s products from third-party suppliers are already very low. The company already knows the cost of its suppliers and uses cost-plus methods to negotiate pricing. Therefore, luckin suppliers should have relatively low margins and there is very little room to further reduce the purchase price.

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Products other than Luckin Fresh Drinks are not competitive enough to generate new traffic in their offline stores. Luckin’s supply of products in this area is entirely dependent on third parties, and its own research and development capabilities are poor, so the product is not differentiated and competitive. Unlike coffee, Luckin does not have a uniform choice of brands for this category. The lack of heating equipment can make bakery products and lunches (such as noodles) taste much less. Snacks from third parties are also widespread in other retail channels and tend to be cheaper, such as online e-commerce platforms and offline convenience stores. Luckin’s position is much worse than that of these competitors, with a much smaller size, very limited product SKUs and a low level of supply chain/inventory management expertise.

Business Model Defect sin: The franchise business of Fawchad Tea has a high compliance risk and is not registered with the relevant authorities as required by law, as It did not meet the requirement to operate at least two direct stores for at least one year when it started operating the franchise business in September 2019.

According to the Regulations on the Administration of Commercial Franchising of China, the term “commercial franchising” refers to an enterprise (“franchisor” that has a registered trademark, a business logo, a patent, a know-how, and other business resources(“franchisee”) that licenses the operating resources it owns by contract. The franchisee shall carry out the operation under the unified mode of operation in accordance with the contract agreement and shall pay the franchise fee to the franchise.

Little Deer Tea has apparently shunned the franchise model: it names its third-party operators as “new retail partners” and stresses in particular that it does not charge franchise fees. Instead, the company requires “new retail partners” to source raw materials only from Luckin and charge a portion of the gross margin after the store breaks even.

However, the Beijing Higher People’s Court has made a judicial interpretation that any profit share or product increase has constituted a franchise fee. Therefore, whether or not the company calls it a franchise model, the business of Fawchad Tea is a commercial franchise, as defined by the regulations.

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Article 7 of the Regulations on the Administration of Commercial Franchising clearly stipulates that “the franchisor shall have at least 2 direct stores and shall operate for more than one year”. According to Luckin’s chief operating officer, Liu Jian, there will be no independent stores for FawcaU Until October 2019. As a result, Fawka Tea has not yet met the eligibility requirements set by China to become a franchisee.

In addition, Article 8 of the Regulations on the Administration of Commercial Franchising clearly stipulates that “within 15 days from the date of the first conclusion of the franchise contract, the business department shall be filed in accordance with the provisions of these Regulations”. However, we have not found any companies registered with these keywords in English (“Luckin Tea” and “Luckin”) and Chinese search terms in the Commerce Department’s Commercial Franchise Information Registration System (http://txjy.syggs.gov.cn/).

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The potential consequences of the violation of these regulations of fawn tea: Violation of Article 7: the competent department of commerce shall order the correction, confiscate the illegal income, impose a fine of 100,000 yuan to 500,000 yuan or less, and make a public announcement. Violation of Article 8: The competent department of commerce shall order the record within a time limit and impose a fine of not less than 10,000 yuan and not more than 50,000 yuan; The negative impact of not meeting the “legitimate business” provisions may far exceed the amount of penalties imposed by listed companies.