Luckin Coffee (NASDAQ:LK) was poised to become the Starbucks (NASDAQ:SBUX) of China, after hitting a market capitalization of $3 billion in less than two years. Now the Starbucks comparison seems farfetched at best. Instead, LK stock now belongs in the company of disgraced organizations Worldcom and Enron.
Reports of murky accounting transactions and subsequent internal investigations halted trading of the company shares from April 7 to May 19. LK stock’s initial public offering price was $17 per share in May of last year. The stock reached a high of $51 a pop on January 17. Since then, it has shed 97% of its value.
An extended trading halt has raised serious questions about the company’s ability to continue for the foreseeable future. An analyst at Quo Vadis Capital believes that the stock will be wiped out from the market. Apart from its legal woes, many analysts worried whether Luckin Coffee’s business model is sustainable enough to match up to the likes of Starbucks in China. Let us analyze the company’s current positioning and the best course of action for its investors.
The Scandal
The scandal can be traced back to an anonymous report published by research firm Muddy Waters in January. The 89-page report alleged several instances of fraud that occurred at the company throughout 2019. The report said that there were credible claims that the items per store in the third and fourth quarters of 2019 were inflated by at least 69% and 88%, respectively.
Furthermore, the report accused that the company was inflating its net selling price per item by 12.3% to sustain its business model artificially. The third-quarter expenses were also exaggerated by 150% to overstate funds to inflate revenues.
Besides the accounting misdemeanors, the report shed light on certain red flags within the company, including the presence of board members who had been imprisoned for illegal operations and had served on the boards of several questionable Chinese companies.
After vehemently denying the allegations, on April 2, Luckin announced that an internal investigation had uncovered fraudulent transactions worth $310 million last month between the second and fourth quarters last year.
COO Jing Liu and several employees were subsequently suspended, and a committee has been formed to investigate the matter and recommend appropriate actions. In light of these allegations, the Nasdaq halted trading of Luckin Coffee shares on April 7, and investment firm Goldman Sachs had also taken enforcement action.
Vulnerabilities in the Business Model
Luckin Coffee’s meteoric rise and its recent accounting scandal have diverted attention from its real problem — its business model. The company has operated its strategy of “cheap, cheaper, cheapest” to try and beat Starbucks in China. The company has a two-fold mission — increase store count and the cups of coffee sold. To accomplish this goal, it has set up small pickup shops with minimal capital requirements at a furious pace across China.
It uses a mobile app to assess its consumer preferences, which simplify its operations. To top it all off are its free coffees, which are offered to every new customer. However, this is in complete contrast to the business model that Starbucks has employed to significant effect.
Starbucks provides an “affordable luxury” away from your work and home environment, intending to make it a comfortable place for people to enjoy a cup of coffee. It is now entrenched in the American urban landscape and has quickly become the benchmark for its unique business model. It operates a three-fold strategy, which includes targeting the appropriate market segment, effective execution, and constant innovation.
The company targets customers at the upper end of the income spectrum, providing them with comfort and quality. With its robust execution, it provides a complete package of quality service, great coffee, and a comfortable environment for people to hang around. On top of that, it continues to add more innovative products such as its gourmet-type drinks to keep things fresh. Luckin Coffee’s strategy is one-dimensional and easily replicable, making it a sitting duck for hungry competitors looking to enter the market.
What the Future Holds for LK Stock
There are a lot of unanswered questions concerning Luckin, which leaves its shareholders in a fix. Investors can breathe a sigh of relief that the company’s shares have started to trade again, which means that they can potentially sell off their investments without going into the over-the-counter market.
Commenting on the company’s current predicament, John Zolidis, the president of Quo Vadis Capital, stated that the most likely outcome is a complete wipe-out for the equity holders. Zolidis believes that the company would probably have to start closing its stores soon, which will further damage the business. Aside from that, he believes that the company never had a viable business model as it grew too quickly and acquired a customer base without proving the economics.
Bottom Line
It’s no secret that Luckin Coffee is currently in a big mess. Its accounting scandal has shattered the confidence of the market as its stock has virtually lost its entire value. However, even without the scandal, it was inevitable the company would find itself in a quagmire due to its one-dimensional business model. Therefore, LK stock is a sell for me.
As of this writing, Muslim Farooque did not hold a position in any of the aforementioned securities.
