Luckin 2.0? Freefalling Cloopen Flags Potential Irregularities, Spooking Investors

Key takeaways:

•      Cloopen said it formed an independent special committee to look into employee misconduct and transaction irregularities discovered by auditor KPMG

•      Even before the disclosure, the company’s stock was freefalling amid U.S. law firm allegations that the company made false or misleading statements

By Warren Yang

An association with anything fraudulent can send a stock into freefall – a lesson that cloud-based services provider Cloopen Group Holding Ltd. RAAS is quickly learning from an unfolding drama that has spooked investors.

The case sounds strikingly similar to another scandal involving former highflyer Luckin Coffee LKNCY, underscoring why the U.S. securities regulator has threatened to delist Chinese companies unless Beijing permits their auditors to cooperate in its investigations. But while Luckin was worth billions of dollars when its scandal broke, Cloopen is far smaller and thus less likely to attract as much attention or wreak as much havoc on investors.

In its announcement last Tuesday, Cloopen said it had formed an independent special committee, initially comprising three independent board members, to start an internal investigation into potential employee misconduct and transaction irregularities after auditor KPMG raised red flags. The panel can also hire legal advisors and forensic accountants.

While going over Cloopen’s results for last year, the auditor discovered misconduct by several employees, including the fabrication of documents. In addition, irregularities related to some customer transactions caught the auditor’s eye.

KPMG, which had been Cloopen’s auditor since 2018, quit last month, citing general deficiencies at the company. Those included insufficient personnel with enough knowledge about U.S. accounting rules, a lack of documented policies and procedures for financial closing and inadequate controls over processes related to revenue recognition and purchases.

These lapses seem to portray a company with dubious credentials for a New York listing, adding to bigger controversy over the U.S. Securities and Exchange Commission’s (SEC) inability to access Chinese companies’ audit records, which Beijing considers “state secrets.” A large number of New York-listed Chinese stocks are now facing potential delisting under a U.S. law that requires foreign companies to make their auditor records accessible to the SEC, although Beijing and Washington have been in talks to resolve the standoff.

Cloopen didn’t dispute any of KPMG’s findings. Instead, in what seems like an admission that wrongdoing indeed took place, it estimated that the staff misconduct and transaction irregularities affected 5%-10% of revenue for the second quarter of last year and 15%-20% in the following three months, pending verification by the special committee. Unsurprisingly, the company has missed its deadline to report results for the fourth quarter of 2021 and the whole year to the SEC.

Even before announcing the internal probe, Cloopen shares were already down more than 70% this year. At less than a dollar, they are worth a tiny fraction of the $16 they fetched in one of the largest IPOs by Chinese companies just over a year ago. The latest news sparked another 13% daily plunge, though the stock later recovered and closed Wednesday at $0.7640. Still, in addition to everything else, the company must now find a way to bring the price above the minimum $1 threshold or face a risk of being delisted over this more technical matter.

Precipitous Slide

Cloopen’s stock has been on a precipitous slide even as it has posted decent growth in revenue – though the brewing scandal could throw some of that growth into question. The company’s revenue grew 48% year-on-year in the first nine months of 2021, with its gross profit increasing even faster, indicating improving margins. Perhaps investors didn’t appreciate ballooning operating expenses, which led to a wider net loss for the period. But a growing company like Cloopen often needs to ramp up investment to gain competitiveness that eventually can lead to profits.

A more plausible explanation for the stock’s fall from grace may be growing suspicion about Cloopen’s disclosures.

Concerns first appeared as early as December, when Cloopen was fined by Chinese authorities for providing inaccurate data, according to Chinese media. The company only paid a small fine for that, which made the punishment look like a slap on the wrist.

But then an army of U.S. law firms announced class action lawsuits against Cloopen, alleging it had made varying false or misleading statements. A keyword search of “Cloopen” and “class action” on Google yields more than one full page of announcements issued by law firms dating as far back as last Christmas Eve.

It’s not clear if the December fine opened the floodgate of lawyers circling Cloopen. Without referring to the penalty, the accusers alleged the company failed to disclose a growing number of customers were refusing to pay, which led to a large increase in account receivables and allowances for doubtful accounts. They also claimed the company didn’t reveal it had massive liabilities related to the fair value of some warrants in its IPO documents.

It wasn’t clear if any of the threats have resulted in actual lawsuits so far. Even so, the damage has been done, sending the company’s shares on a downward spiral. What’s more, Cloopen never responded to any of the allegations publicly.

Instead, it has taken a major development like the resignation of KPMG for the company to finally acknowledge that it does have problems. The irregularities Cloopen disclosed appear to be a whole new set of issues separate from the wrongdoing alleged by law firms. Which begs the question: How big a mess is Cloopen really in, and are any new shock disclosures on the horizon?

The company’s woes are unfolding almost exactly two years after the Luckin scandal, which began with an anonymous report accusing the Starbucks challenger of massive sales inflation. The company responded by launching a similar internal probe to Cloopen’s, which ultimately found that its 2019 sales and expenses were inflated to the tune of more than $300 million. Luckin shares were subsequently delisted from Nasdaq, and it eventually filed for bankruptcy.

As its own Luckin moment brews, Cloopen’s shares are now trading at a price-to-share (P/S) ratio that barely exceeds 1 based on the company’s 2020 revenue. That’s a far cry from the 6.5 for U.S. cloud communications giant Twilio TWLO based on its 2021 sales, among stocks of companies with comparable businesses.

And the worst of it all is that such a metric doesn’t mean much if the company’s data can’t be trusted to even be accurate. It’s anyone’s guess how the scandal at Cloopen will develop from here, though things certainly don’t look too positive. That means investors have plenty of reasons to stay away from a scandal that could easily become a Luckin 2.0.