China Consumer

In hot water

Luckin Coffee runs into trouble as Heytea raises fresh funds from Hillhouse

Luckin-Cup-w

A sour taste: new questions about its sales figures

As the saying goes, if it sounds too good to be true it probably is. Luckin Coffee, an investor darling after it raised $650 million in an initial public offering on Nasdaq last May, burst its own bubble last week, with news of an investigation into its former chief operating officer Liu Jian, who may have inflated company revenues by at least Rmb2.2 billion ($300 million).

The Chinese challenger to Starbucks has long relied on subsidies to drive sales. In just three years, it has opened more than 4,500 stores, surpassing Starbucks as the largest coffee chain in China. But more sceptical analysts have voiced doubts about its accounting for some time.

In January US short-seller Muddy Waters made public an anonymous report pointing to possibly fraudulent behaviour at the company. The claim was that a research group had a team of more than 1,500 people monitoring customer traffic at a representative sample of Luckin’s outlets. And what they were finding was that the numbers didn’t add up (see WiC482).

At the time Luckin denied the allegations, describing them as “misleading and false”. But even in China, many weren’t convinced about its stellar sales growth.

“To be honest, the business model of Luckin has always been very questionable… While it is cheaper than Starbucks after the subsidies [its coupons often start with discounts of about 35%], there are options other than Starbucks in China. And after the discounts, Luckin is not any cheaper compared with Family Mart, McCafe and KFC… So that forces Luckin to issue 60%, 80% off coupons and even free coffee to attract consumers. Is there any way this company is not bleeding cash?” Sina Finance wondered. “While its left hand keeps putting out one PowerPoint slide after another to entice American investors, its right hand keeps issuing discount coupons in China.”

Commentators have also doubted that such a widespread falsification of sales could be the doing of the former COO alone. “Seriously, to fabricate Rmb2.2 billion ($312.31 million) worth of sales on an operating income of Rmb2.9 billion, are we supposed to believe that only one person could do that?” National Business Daily thundered.

“Lu Zhengyao, as the chairman of Luckin Coffee, you should stand up and assume all responsibility, apologise to the public and investors. Anyone with a brain knows that to put the blame on one person is a joke. You can’t cover up one lie with another,” it protested.

Not that Lu isn’t feeling the pain. Goldman Sachs has already seized and sold the Luckin shares he offered as collateral after he defaulted on the terms of a $518 million loan. That pushed Luckin’s share price lower, which has dropped more than 80% since the scandal was uncovered. Shares in Hong Kong-listed rental car platform Car Inc, also controlled by Lu, fell through the floor too.

Tea chain Heytea should be happier about Luckin’s woes. Luckin’s retail tea brand, Xiaolu Tea, has been trying to muscle in on the same market, including products that bear a resemblance to Heytea’s famous cheese-tea, which is known as naigai cha in Chinese (it’s a cold fruit tea topped with a layer of frothy cheese).

Once again, discounts often feature in Xiaolu’s strategy: bubble tea that costs as much as Rmb27 elsewhere is being offered for just a few yuan in the battlefield markets.

“Compared with Luckin’s over-the-top marketing, Heytea is decidedly low profile,” an industry observer told Marketing, a magazine, of the rivalry. “Does Heytea have brand ambassadors? No. Does Heytea offer subsidies? Definitely not. Heytea spends all of its attention on product development, constantly releasing new flavours. It even tweaks old recipes to see how it can improve them.”

The business model has struck a chord with investors. Heytea recently closed a financing round that reportedly valued the company at Rmb16 billion, led by Asia-focused private equity firm Hillhouse Capital and Coatue Management, the US fund behind ride-sharing giants Lyft and Grab.

The size of the investment was not disclosed but Heytea was valued at Rmb9 billion last July.

“To be honest, you consider it a major victory to even be included in the fundraising,” one seasoned investor told Huxiu.

Heytea’s sales network is growing as well – albeit not at the same breakneck pace as Luckin’s. It reported operations at 390 stores in 43 cities in 2019, against 163 outlets in 2018. Its ordering app on WeChat added a further 15.8 million users over the year, with total users reaching 21.5 million.

Founded in 2012, Heytea started out from a 15-square-metre shop in the mid-sized city of Jiangmen, about 100 kilometres from Guangzhou in southern China. Previously known as Royal Tea, it changed its name because its popularity had spawned too many copycats. Today its beverages are typically priced between Rmb20 and Rmb35 per cup. That’s roughly the same as a coffee from Starbucks but a lot pricier than rivals like Taiwanese milk-tea outlet Yi Dian Dian, which sells its drinks for an average of Rmb14.

Many of Heytea’s outlets are in ritzier shopping malls, with slick decoration. But what really sets it apart from its rivals is innovation. Its founders made a clear break from more traditional milk-based teas, experimenting with fruit tea drinks and introducing fresh ingredients rather than relying on concentrates.

In 2017, it introduced naigai cha (the cheese-tea) as a novelty product. The new composition took the country by storm and fans queued for hours to try it. Impatient customers even hired people to stand in line for them (see WiC359).

Unlike Luckin the chain has avoided celebrity endorsements, preferring to rely on word-of-mouth marketing. The long lines for the cheese-tea were fantastic PR, for instance, and the brand has been clever with its social media strategy, encouraging millennials to post photos of their favourite drinks.

“Once the fans become loyal, they madly promote the products to their friends. That’s how Heytea has taken over the market,” an industry blogger explains.

Envious of Heytea’s valuation, competitors are trying to grab their own share of the Rmb400 billion tea market. In late February, Bloomberg reported that Heytea’s biggest rival Naixue had filed for an initial public offering in the US that could raise as much as $400 million. That plan has been delayed by the coronavirus outbreak, which has torpedoed market sentiment (Luckin’s scandal might add another nail to that IPO’s coffin). Naixue’s last fundraising round was in 2018, when it was valued at Rmb6 billion.

To grow further, Heytea has unveiled a sub-brand called Mini Heytea. Targeting grab-and-go customers, it offers tea-based drinks for between Rmb8 and Rmb16, a step down from its more premium prices. But customers looking for a bargain on Heytea’s favourite fare will be disappointed as Mini Heytea does not offer any of the famous cheese-foam options.

“When it comes to light catering [like tea, coffee and desserts], consumers only remember the top few big brands. You need to be the number one,” Zhao Lin, one of the co-founders of Naixue, told the media.

As for Luckin, being number one in terms of stores has probably propelled it faster into crisis. We reported in WiC439 that questions were being asked about how the chain was growing so fast and we even asked whether Luckin could be “the next Ofo” – a high-profile bike-sharing app that burned vast amounts of cash to drive growth before crashing nastily.

Last June a court in Tianjin ruled that Ofo had no assets to pay debts to suppliers and customers. It is now part of the Alibaba empire, with its bike fleet a fraction of its former size, according to the South China Morning Post. It has also converted its bike-sharing app into more of an e-commerce platform.

Like Ofo – whose users rushed to redeem their deposits when news of its troubles broke – customers of Luckin rushed to cash-in their coupons once the news about its likely cash crunch became more widely known. Such was the pressure that the coffee app’s server crashed. Many of its outlets couldn’t handle the sudden volume of purchases and by 2pm they were suspending new orders for the day. That was a sales surge of sorts, but not the kind that Luckin bosses would have wanted…


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