[Editor’s note: This story was written prior to the news that Luckin Coffee allegedly fabricated its sales. Given these allegations, all investors should approach this stock with great caution.]
On Jan. 31, 2020, notable short-seller Muddy Waters posted a short position against Luckin Coffee (NASDAQ:LK). The investor accused the company of inflating its item sales count per store. LK stock largely brushed off the bearish attack. And Luckin’s assertive response to the report only strengthened investor confidence in the company’s prospects.
The high-quality coffee provider issued a rebuke against the short seller. It said that “the methodology of the Report is flawed, the evidence is unsubstantiated, and the allegations are unsupported speculations and malicious interpretations of events.”
In particular, Luckin Coffee said that the short report posted inaccurate numbers of items per store sold each day. In fact, the company uses a third-party payment service provider. Those records easily negated the numbers posted in the short report.
Luckin Coffee’s item per order is strong. Plus, advertising expenses are not overstated in its third-quarter 2019 report. Finally, the firm tracks orders in real time. And because it has tough internal controls over the way it recognizes and reconciles revenue, it cannot inflate net revenue numbers.
In effect, the company is a data-driven firm that may produce results on the fly. Its unique business model allowed the company to quickly grow in China. It disrupted the coffee drinking market and prevented Starbucks (NASDAQ:SBUX) from building a moat in the region.
Efficiently Run Company
LK stock is performing well relative to the market because of its historically strong growth. In the third quarter, net revenue grew by over five-fold. This is due to a higher net effective selling price per item. The average customer bought many items per transaction because Luckin is offering what they want. With more store installations, customers will gain greater awareness of Luckin Coffee’s brand.
The company is not pinning its growth on coffee alone. It has a Luckin Tea initiative. And this initiative is less likely to fail because Luckin is building its tea shops through a partnership model.
LK stock continued to trend upward as the company opened its first Luckin Tea store in October 2019. It is confident that by offering tea products around the country, customers will start to buy them. Users may also create accounts linked across apps, further driving brand awareness and unit sales.
On the supply side, the company’s partnership model splits the responsibilities between the company and the retail partner. The partner is responsible for hiring staff, daily operations, site rental and renovation. Luckin Coffee only needs to offer branding support. The company enjoys the advantage of growing more customers through more coverage while spending less on operating expenses and capital expenses. This ultimately lifts LK stock and keeps investors happy as the share price rises.
Luckin Coffee has a strong moat that enables it to enjoy a decline in the cost of materials, rentals and other operating costs. So, as its brand name becomes better known, sales and marketing (S&M) expenses fall sharply.
For example, in the first quarter of 2018, S&M expenses were 420% of net revenues. By the third quarter of 2019, this figure fell to 36.2%. This suggests that investors may reasonably set a 12% discount rate in a 10-year discounted cash flow model. This implies that LK stock has a fair value of $55.57.
Chris Lau is a contributing author for InvestorPlace.com and numerous other financial sites. Chris has over 20 years of investing experience in the stock market and runs the Do-It-Yourself Value Investing Marketplace on Seeking Alpha. He shares his stock picks so readers get original insight that helps improve investment returns. As of this writing, Chris did not hold a position in any of the aforementioned securities.