The unfortunate demise of Luckin Coffee Inc. has been an ever so rapid one, leaving a bad taste in investor’s mouths.
The once desirable Luckin Coffee Inc. (NASDAQ: $LK) is now facing multiple lawsuits amidst its accounting and reporting scandal. Luckin’s stock was up 10.22% on the other day despite being a fundamentally broken business.
The Chinese coffee company was founded in Beijing in 2017 and went public in May of 2019. As of January 2020, the company was worth US$12 billion and, it managed over 4500 stores, exceeding the number of Starbucks stores in China.
Luckin was seen as a success story and labeled one of the few successful China IPO’s of 2019 in New York, which made chief executive, Lu Zhengyao, a billionaire with his 20% stake. People believed that the ‘coffee wars’ were genuinely beginning.
Let’s Take a Look at the Financials
- Total net revenues from products in the quarter were RMB1,493.2 million (US$208.9 million), representing an increase of 557.6% from RMB227.1 million in the same quarter of 2018.
- The average monthly total items sold in the quarter were 44.2 million, representing an increase of 470.1% from 7.8 million in the third quarter of 2018.
- The average total net revenues from products per store in the quarter were RMB449.6 thousand (US$62.9 thousand), representing 79.5% from RMB250.5 thousand in the same quarter of 2018.
- Store level operating profit in the quarter was RMB186.3 million (US$26.1 million), or 12.5% of net revenues from products, compared to a loss of RMB126.0 million in the third quarter of 2018.
The company attributed its growth to its “distinguished value proposition of high quality, high affordability and high convenience,” as well as their ability to “enrich [their] product offerings,” such as their launch of Luckin Tea.
The company praised itself for taking on a different approach than the “outdated western” model. Instead, they targeted white-collar millennials by having over 90% of their stores inside office buildings or on school campuses.
They also stated that “technology is at the core of [their] business” through their cashless system, where customers pay through their app or another online payment platform such as WeChat.
Also, they price their products 25% lower than Starbucks, accompanied by heavy discounting and promotions.
We call that a honk of good-old-BS.
The astronomic numbers were imaginary (like many of the numbers out of China on almost everything – a house of cards).
The End of Luckin Coffee’s Sugarcoated Story
On January 31st, 2020, an anonymous report, published by Muddy Waters Research, found that the company was indeed in “muddy waters” as it had committed fraudulent activities.
The evidence included “thousands of hours of store video, thousands of customer receipts, and diligent monitoring of the company’s mobile application metrics,” demonstrating inflated per-store per-day sales number, the net selling price per time, its advertising expense and its revenue contribution from other products.
The report also stated that the Chinese Coffee company had inflated its number of items sold every day by at least 69% in the third quarter and 88% in the fourth quarter of 2019.
On April 2nd, 2020, Luckin Coffee disclosed to the world that an internal investigation found its chief operating officer, Jian Liu, had fabricated the second to fourth quarters of 2019 sales by about 2.2 billion yuan (US$310 million).
The investigation is still ongoing, and the company is said to be complying with regulatory agencies in both the United States and China.
The shares tanked 81%, hitting an all-time low of $4.90 that morning.
IBR smelled the burn while the stock was still trading $44,67 per share – and everything seemed fine.
As of May 12th, 2020, both the chief operating officer, Jian Liu, and the chief executive officer, Jenny Qian Zhiya, were fired, and both resigned from the company’s board.
The company advised investors following the scandal outbreak:
“Investors should no longer rely upon the company’s previous financial statements and earnings releases for the nine months ended September 30th, 2019, and the two quarters starting April 2nd, 2019, and ended September 30th, 2019, including the prior guidance on net revenues from products for the fourth quarter of 2019, and other communications relating to these financial statements.”
Lawsuits are Bombarding Luckin Coffee
In line with the scandal, dozens of different law firms have solicited to file lawsuits against the fraudulent coffee giant.
Caixin Global, a Chinese media company that focuses on investigative journalism, reported that Lu Zhengyao, chairman of Luckin Coffee, may face criminal charges due to emails found during an investigation which showed he instructed colleagues to commit fraud.
According to the Wall Street Journal, banks have sued and won the right to sell tens of millions of dollars worth of Luckin stocks owned by the chairman, to collect the money he owes them.
The chairman currently owes $324 million to the banks as he defaulted on his extended margin loans.
As a result, the courts have demanded 131.25 million Luckin shares in China, worth about $63 million, to be transferred to accounting firm KPMG for liquidation.
An additional 196.88 million shares, worth about $126 million and owned by the chairman’s sister, are also expected to be liquidated for repayment of the loans.
Block & Leviton LLP, a national securities litigation firm, announced on April 2nd, 2020, that a class action lawsuit has filed against Luckin Coffee, and the officers for securities fraud. Investors who purchased shares between November 13th, 2019, and April 1st, 2020, have been encouraged to contact the law firm for evaluation.
Kyros Law Office also altered investors of $LK, on June 4th, 2020, that it too is looking into filing suits against the coffee chain due to securities fraud violations, after investors lost millions of dollars invested in the company. The law firm advises investors who have put over $100,000 into the company before April 6th, 2020, to contact their law firm.
Could the News Possibly Get Any Worse?
It can almost always get worse.
On May 19th, 2020, the Nasdaq ordered a delisting notice to Luckin, making the future of the shares uncertain. The stock dropped even further from April 2nd, 2020, to $1.33 following this news.
In addition, the fall of Luckin has invited political scrutiny.
On May 20th, 2020, the U.S. Congress passed with unanimous consent, the Holding Foreign Companies Account Act.
Chinese companies, such as Luckin Coffee, are shielded from audit checks by foreign government regulators, leading to inflated earnings and profits and misleading investors. Under this act, “a foreign-owned company that refused to comply with the PCAOB’s audit requirements for three consecutive years could be delisted,” according to the legislation.
“Had this legislation already been signed into law, U.S investors in Luckin Coffee likely would have avoided billions of dollars in losses.” – Rep. Brad Sherman, a California Democrat on the House Financial Services Committee.
Why is the LK Stock Still Rising?
On Tuesday, the Nasdaq sent an additional written notice stating that the company failed to file its 2019 annual report, serving as another reason to delist Luckin’s shares.
Nonetheless, Luckin has experienced rises in its stock price quite frequently. Luckin Coffee’s share price has rebounded nearly 300% from its lows in recent days.
What could be fuelling the rise?
Investor irrationality? Inefficient markets?
Other than rumors of asset sales and takeovers by a larger company, it could be entirely possible that short-sellers are closing their positions, causing investors causing upward price movements.
However, this is only temporary; once the short-sellers have closed their positions, the shares price could plummet again.
Indeed, speculators could be buying the stock, hoping that the company can recover from this fraud scandal. However, this could be a far-fetched assumption considering the chain was unprofitable before inflating the numbers. Nonetheless, the investment bank, Houlihan Lokey, has been hired by Luckin to provide financial and strategic advice.
What’s the Verdict?
Ultimately, Luckin is a silent yet deadly portfolio killer.
With more than a handful of executives to blame for the downfall of this company, one can only imagine fraud is an intrinsic part of the company’s corporate culture.
Although culture is unobservable from a financial statement, it has a tremendous impact on the long-term performance of a company.
If you aren’t convinced yet to ditch Luckin’s stock, perhaps the unsustainable business model will sway you in the right direction. Its growth-at-all cost business model produces huge losses, creating insignificant value to shareholders.
Additionally, the company has defaulted on loans showing signs of weak capital and weak debt financing capabilities.
Luckin’s selling tactic is through discounts and promotions – if customers aren’t willing to pay full price, what does that say about their product?
Whether they’ll be able to continue to provide these offers in the future is questionable. Will Luckin’s customers remain loyal to them without these offers?
Most likely not.
The stock price is likely to remain volatile in the weeks ahead as more information (and lawsuits) comes to the surface.
The ship has capsized and is taking in water fast – very fast. We wouldn’t touch the stock with a 10-feet pole.