On April 2, 2020, shares for Luckin Coffee closed 75.57% lower after six trading halts as the company announced that it had uncovered as much as 2.2 Billion yuan worth of unconfirmed sales from the second quarter of 2019 to the fourth.
Once hailed as the “Starbucks of China,” Luckin Coffee has witnessed a meteoric rise by going public in just two years after its establishment in 2017. However, its cash-burning strategy driven by steep discounting has been a controversy since day one.
Last April, Jack Qinghong Yang, Practice Professor of the EMBA Program at Tsinghua University PBC School of Finance and a seasoned investor on Wall Street, warned in a Caixin Weekly article about the dangers of bargain hunting for internet companies, believing it to be an unwanted byproduct of their profit model and, ultimately, of the growth incentives put in place by venture capital.
The bargain hunting “industry” results from a distortion of the incentive mechanism by early stage investors. And companies that are most “friendly” to bargain hunters would bear the brunt of a tightening market.
—Jack Yang
Shared mobility giants have been seeking to list on the NASDAQ exchange. Lyft stock dipped below its debut price merely days after IPO, and lost more ground in the days that followed. Uber filed for IPO on April 11 in 2019, but as its profit margins on principal businesses dropped quarter after quarter over the past year, its IPO is expected to be priced much lower than its USD 120 billion valuation pitched in 2018.
For this new wave of internet companies using generous discounts to attract customers, their future profitability has received wide attention from the public. Meanwhile, with the imminent launch of the Sci-Tech Innovation Board, there has been growing debate on how much of a technological edge that businesses of the so-called new economy truly possess, and much of that debate centers on bargain hunting, which stems from the profitability model of many internet companies.
Most internet companies attract customers by offering complimentary or discounted services. The value of those transactions depends on the nature of the platform. For WeChat, Facebook, and other social platforms that incorporate social networking, more users would mean greater loyalty, and, therefore, higher marginal effect on those discounts. But for specialized platforms – such as Lyft, Uber, and regular e-commerce businesses – a larger customer base does not translate into a more loyal one, so the customers lured by discounts will not bring sustainable value.
Therefore, specialized platforms need to be extra cautious when subsidizing customers, because they may draw a large number of bargain hunters who seek only to turn the discount coupons and free gifts into cash that they can spend elsewhere. For example, when some e-commerce platforms tried to build a following by selling products below cost, many brick-and-mortar businesses and professional bargains hunters swooped in to buy in bulk and profit from resale. This has been a thorny issue for the platforms as the discounts, then, do not produce the intended benefits.
Bargain hunting is similar to seeking arbitrage opportunities in the financial market. For instance, in a triangular arbitrage, one can earn a risk-free profit by exploiting the exchange rate discrepancy among three different currencies. The existence of this opportunity points to structural flaws in the transaction system, which push up the transaction costs. The more arbitrage opportunities exist in a system, the less efficient that system is. Fortunately, technological advancement is helping systems to spot and correct these failings. In a modern market, there are few opportunities for triangular arbitrage, and even if they do surface, they would only last a few seconds – capturable by high-frequency trading programs – with gains much lower than one percent.
But for now, Chinese startups are still giving plenty of opportunities to bargain hunters. One internet-based coffee chain offers a wide range of complimentary or heavily discounted products to achieve breakneck growth. This practice, however, has drawn professional bargain hunters, who have set up online Taobao stores to resell not only coupons but also the coffee itself. In fact, the coffee chain burned through hundreds of millions of yuan in last year alone, losing the profit of two cups of coffee for each cup sold, and a significant portion of that went into the pockets of the bargain hunters.
Bargain hunting’s becoming an industry speaks to the number and persistence of arbitrage opportunities and the abysmal inefficiency of the underlying system, which should serve as a warning sign for investors and entrepreneurs. And when bargain hunters flock to a business, it means its investors are overly optimistic. Globally, a decade of low interest rates and quantitative easing has turned investors much less risk-averse. FOMO (fear of missing out) has taken hold and driven many to being overly obsessed with the size and growth of a target company, at the negligence of management soundness and profitability. For the entrepreneurs, FOMO manifests in the crude management practices of their “buying customers” business model, that customer loyalty and sales and management efficiency have been abandoned for short-term sales growth.
In 2018, over 80% of the companies filing for IPO were unprofitable – even higher than the peak of the 2000 dot-com bubble. It is still too early to tell how sustainable this growth-over-profit mentality is; but the low interest rate environment which gave rise to it, is likely to persist for some time, given the suspension of the US-led interest rate hike and balance sheet shrinkage. Unlike 2000, this time the primary market is giving strong and continuing financial backings to the startups, as if raising a group of children who are still unweaned at ten years of age. When can these “kids” become independent? As Lyft and Uber IPOs show, the secondary market is now taking a more conservative, wait-and-see approach.
The fact that bargain-hunting can become a profitable industry is indicative of the miscalculated incentives of investors, leaving many startups struggling to make a profit. Once the market tightens, these bargain-hunter-friendly businesses are most likely to be the first to fight for survival. This is especially true for specialized platforms, whose competitive edge lies in the quality and efficiency of services, not simply the number of customers. Entrepreneurs should have the foresight to pursue differentiation, so as to be better prepared for the challenges and opportunities brought by the changing market environment.
