Towards the end of January 2020, Muddy Waters Research posted a tweet regarding an unattributed 89-page report on Luckin Coffee (NASDAQ:LK). At the time, LK stock was trading at $32.49.
The report alleged that Luckin Coffee was a “fundamentally broken business.” The report also stated that “the Company had evolved into a fraud by fabricating financial and operating numbers.”
Muddy Waters Research concluded that they “view the work as credible.”
However, it didn’t take the Luckin Coffee long to come out with a press release that the report had “misleading and false allegations.”
Of course, the markets also disregarded the report. Even as LK stock trended lower in the recent past, it was primarily due to the broad market correction. Further, the markets were discounting the potential impact of COVID-19 on the company’s financials.
I don’t blame investors who had a bullish view. When I look at the company’s results for the third quarter of fiscal year 2019, it seems like a perfect growth story.
An expanding product line, decline in cost, positive store level profit margin and prospects of positive cash flows in few quarters. Perhaps the results were too good to believe, and that was the only clue for investors.
The LK Stock Crash on Fabricated Sales
On April 2, Luckin Coffee announced that the Board of Directors formed a special committee to conduct an internal investigation.
The reason: “Mr. Jian Liu, the chief operating officer and a director of the Company, and several employees reporting to him, had engaged in certain misconduct, including fabricating certain transactions.”
The press release further added that sales could be potentially inflated by 2.2 billion yuan from Q2 2019 to the last quarter of FY2019.
As this news hit the markets, LK stock plunged by over 80% to 52-week lows of $4.90. The stock closed 76% lower at $6.40.
I Expect Further Downside For LK Stock
In the coming weeks, the special committee is likely to present re-stated financials for the last few quarters. I believe that it will translate into another wave of selling. There are three reasons for this:
- Sales will be adjusted sharply lower and with actual numbers, Luckin Coffee will be far from a growth story, let alone a company that can take on Starbucks (NASDAQ:SBUX).
- Based on the trend in the fabricated results, LK stock was discounting positive operating cash flows in the coming quarters. I don’t see any prospects of profitability or positive cash flows even if the company survives this crisis.
- In January 2020, Luckin Coffee raised total proceeds of $865 million from the follow-on public offering and convertible bonds offering. The timing of raising funds is suspicious and investigations will provide clarity on funds being possibly siphoned-off. In addition, Luckin Coffee reported $776 million in cash as of Q3 2019. This can also be inflated if cash burn was under reported. If these points hold true, the LK stock will see another knee-jerk reaction.
Even with the stock plunging by 76% in one trading session, Luckin Coffee still trades at a market capitalization of $6.88 billion. I therefore believe that there is more pain in store for the stock.
My Final Thoughts on Luckin Coffee
After the 76% plunge, Kynikos Associates Founder Jim Chanos closed his short positions in LK stock. Chanos also raised an important point regarding the “overly aggressive class of mega-growth companies” from China. According to Chanos, these companies should be avoided “like the plague.”
The bigger question therefore is on how investor interest can be protected.
Specific to LK stock, there can be potential trading interest, but investors need to stay away even after the crash. With the current investigation restated financials, the stock has more room for downside.
If proceeds from the initial public offering and the follow-on offering are assumed to be siphoned-off, the stock will see another big wave of selling.
Faisal Humayun is a senior research analyst with 12 years of industry experience in the field of credit research, equity research and financial modeling. Faisal has authored over 1,500 stock-specific articles with a focus on the technology, energy and commodities sector. As of this writing, he did not hold a position in any of the aforementioned securities.