What do you call a sad cup of coffee?

Scott Williams

Fiftyone Capital

A Depresso... But in this case, Luckin Coffee!

From a standing start less than three years ago, Luckin Coffee (LK US) went public on the US market in May 2019 and reached a peak market capitalisation of an astounding US$12bn by January this year! Luckin was the new kid on the block but had incredibly surpassed Starbucks to become the largest coffee chain in China with +4,000 locations, a milestone that took Starbucks two decades to accomplish. However, the high flying stock came to a shuddering halt following the uncovering of fraud and is now down 90% from its peak.

The company first came across our radar late last year as a potential long. It had many of the hallmarks of a potential quality growth name: a massive addressable market with strong tailwinds, multiple growth avenues, lucrative economics at scale and a strong value proposition centered on convenient takeaway premium coffee at a lower price point. As with many early-stage high growth businesses, Luckin was yet to breakeven but it had an ample cash war chest and rapidly improving margins. On a first pass look at their operational metrics, we calculated that daily customers per store seemed too low to make economic sense and average customer spend also appeared to be on the high side. We thought this may have been an analytical error, but ultimately our unease with the numbers combined with the company's rich and runaway valuation prompted us to quickly shelve the idea on the long side.

In November 2019, the company reported quarterly revenue of US$215m, a staggering six-fold increase on the year prior! Some five months later, the company disclosed that an internal investigation had uncovered US$310m in fabricated transactions. Frauds are incredibly difficult to detect, even for the most seasoned investors (Some of the company's backers include some of the world's most powerful investors such as Blackrock and GIC). 

Even noted short sellers Muddy Waters and Citron couldn't agree on Luckin. The two engaged in a twitter war in January with Muddy Waters taking a short position following receipt of an anonymous report alleging fraud at Luckin while Citron defended the company saying it was 'on fire'. Turns out they were both right, Muddy Waters correctly positioned for a short and Luckin was indeed 'on fire', just not in the favorable sense.

Luckin appears to be yet another Chinese company that took advantage of US capital markets (we recommend watching the China Hustle on Netflix for those bored in self-isolation). Unfortunately, this was one that slipped past us on the short side... but we thought a great case study to share and learn from. Frauds are notoriously the hardest shorts to catch and profit from - but at least we weren't long! 

Scott Williams
Portfolio Manager
Fiftyone Capital

Scott is the Executive Chairman at Fiftyone Capital. As the previous CEO, Scott founded the company to manage not only his own wealth, but the wealth of other investors and families looking for a safe harbour for their capital.

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