Beijing may pretend it has the coronavirus pandemic under control and insist there are no new infected cases. This week alone, however, the news of notorious accounting scandals in regard to two U.S.-listed Chinese companies surfaced, exposing yet another sickening event that has unraveled in China.
Luckin Coffee is a two and a half-year-old startup coffee chain in China founded with the intention to overtake American coffee chain Starbucks. Luckin’s growth speed has been astounding, from nine locations in 2017 to more than 4,500 locations across China in 2020, compared to Starbucks’ 4,200 locations.
Luckin boasts its success as being more of a technology company than a coffee company; customers use an app to order drinks, and the company uses the data it collects and artificial intelligence to improve its operations. Like many home-grown brands in China, Luckin’s impressive growth was achieved by underselling its competitors. Luckin’s coffee tastes average, but it is unbelievably cheap. Luckin’s latte costs about $1 versus $4 at Starbucks.
Luckin’s Luck Ran Out
Luckin was listed in the NASDAQ stock exchange in the United States in May 2019, giving the startup new access to foreign investors and additional credibility. It quickly attracted sophisticated investors such as BlackRock and Singapore’s Sovereign Wealth Fund.
The valuation of the company skyrocketed. At its height, it was worth about $5 billion with a share price of $51. Last quarter, the company claimed it was growing comparable-store sales by 166 percent, while more than doubling the number of new Luckin Coffee stores.
In the real market, however, when a company opens a large number of stores in the same geographical location, the comparable-store sales usually suffer because newer locations will attract more foot traffic. Luckin’s magnificent growth, therefore, seemed suspiciously unrealistic. Turns out, it was.
In January of this year, the U.S.-based Muddy Waters Research, a short seller that profits from exposing corporate frauds, said it received an anonymous report, which stated that “when Luckin Coffee went public in May 2019, it was a fundamentally broken business that was attempting to instill the culture of drinking coffee into Chinese consumers through cut-throat discounts and free giveaway coffee. Right after its $645 million IPO, the company had evolved into a fraud by fabricating financial and operating numbers starting in [third] quarter 2019.” The report went on to list other alleged fraudulent activities the company was involved in, while raising questions about some key management personnel’s troubled histories.
Luckin quickly “categorically denied” the anonymous report, claiming “the methodology of the Report is flawed, the evidence is unsubstantiated, and the allegations are unsupported speculations and malicious interpretations of events.”
The spread of the Wuhan coronavirus in the following two months took some spotlight away from Luckin. Then on April 2, all hell broke loose for the company. Through a regulatory filing, Luckin disclosed it found that its chief operating officer, Jian Liu, and several employees who directly reported to him had fabricated 2019 sales by about 2.2 billion yuan ($310 million). Since the company had previously reported that its net sales for the first nine months of 2019 were 2.9 billion yuan ($413 million), this revelation means the majority of Luckin’s 2019 sales numbers were fake.
Luckin’s stock price plummeted more than 80 percent that day, wiping out more than $2 billion from its market value and causing significant losses for many foreign investors, including Americans. Then on April 6, U.S. bank Goldman Sachs disclosed that Luckin’s Chairman Charles Zhengyao Lu defaulted on a $518 million loan. NASDAQ ultimately halted the trading of Luckin stock the same day.
Bad Things Come in Threes
Luckin wasn’t the only Chinese company recently exposed for corporate fraud. Less than a week later, another U.S.-listed Chinese company, TAL Education Group, one of the largest education providers in China that offers K-12 after-school tutoring services, revealed on April 8 that one of its employees had inflated the company’s sales by “forging contracts and other documentations.” The share price of TAL dropped 23 percent in one day.
The company said the employee in question was in police custody, but according to short seller Muddy Waters, TAL’s problem was way worse than what the company had disclosed. In 2018, Muddy Waters published a report alleging the company had “overstat[ed] its net profit by at least 43.6 percent” and “inflat[ed] its 2016 to 2018 pre-tax profits by up to US$153.2 million, or 28.4 percent.”
Back then, TAL denied any wrongdoing, saying the report contained “numerous errors, unsupported speculation and malicious interpretations of events.” Now it seems Muddy Waters was not only right but two years ahead of everyone else in recognizing TAL’s fraudulent activities.
Bad things usually come in threes. This week, Muddy Waters joined another short seller, Wolfpack Research, and accused the NASDAQ-listed Chinese video streaming company iQiyi of making up its 2019 revenue by up to 44 percent, while inflating its user number by 60 percent. For now, iQiyi is vigorously denying any wrongdoing. Investors will have to wait and see how long that will last.
Chinese Laws Facilitate Scandal
For foreign investors, the dependability of Chinese companies’ financial statements has always been a serious issue. The running joke about Chinese companies is that they have three sets of accounting books: one for the regulators, one for the investors, and one for the managers — and only the last contains the true information. In 2018, the Wall Street Journal reported that auditors declined to endorse 219 annual reports prepared by Chinese companies, which means these auditors either found serious issues with those reports or had expressed concern about the companies’ likelihood of survival.
Unfortunately, some of China’s home-grown accounting and auditing firms are just as unreliable as their corporate clients. Rather than acting as gatekeepers, these firms have turned a blind eye to their clients’ fabricated financial statements. The problem has become so impermissible and so prevalent that last year, the China Securities Regulatory Commission launched investigations of China’s homegrown accounting firms Ruihua and GP for suspected violation of securities law.
According to the Wall Street Journal, the Chinese authorities’ investigation found that one of GP’s corporate clients inflated its cash holding by $4 billion, and one of Ruihua’s corporate clients overstated its profit for four years until 2018 by $1.7 billion. As a result of these investigations, at least 23 of Ruihua’s corporate clients either delayed or canceled their fundraising plans.
While Beijing attempts to address corporate fraud by cleaning house from time to time, it is ultimately responsible for fostering such bad corporate behaviors in its policies. Chinese law requires that financial records remain in China. Beijing has prevented the U.S. Securities and Exchange Commission and the U.S. accounting board from inspecting China-based auditors of U.S.-listed Chinese firms by invoking national security concerns.
Foreign investors have limited legal resources to hold these Chinese companies and their management accountable. Because Beijing actively shields Chinese firms from U.S. regulators, these companies have no incentives to provide a true picture of their financial health to investors.
Coronavirus Exposes Corporate Fraud
While corporate fraud is nothing new in China, the coronavirus outbreak helped bring this new wave of scandals to light. China’s economy collapsed after the two months of lockdown. Corporate fraudulent activities that were previously easily disguised in a growth environment suddenly have nowhere to hide.
Just like how the 2008 financial crisis brought down Bernie Madoff, more scandals will likely emerge after the coronavirus outbreak. As Warren Buffett once said, “You only find out who is swimming naked when the tide goes out.”
China needs foreign investors to revive its economy, but these corporate scandals, along with reports of faulty exports of medical equipment, don’t help instill any confidence in investors. We already know that China’s official coronavirus-related data is not reliable. Now investors are questioning if that is also the case with financial data of Chinese companies. Beijing can no longer hide behind its nationalistic rhetoric and dismiss these concerns.
If Beijing doesn’t change its policies and address these corporate scandals immediately, by the time the pandemic is over, investors might not touch stocks of Chinese companies ever again. That will truly devastate China’s economy.