Luckin Coffee (NASDAQ:LK) was supposed to be the up-and-coming growth machine out of China. Instead, LK stock has been halted for more than a month after suffering from a 79% decline in its last full week of trading.
What causes an 80% fall and a month-long trading halt? Fraud.
In March, the company’s special committee had found that Chief Operating Officer Jian Liu and several employees were inflating revenue. For many investors, accounting irregularities equals “sell” and that may be exactly what we have with Luckin.
To be clear, there are accounting irregularities here. It’s just a question of whether investors will bail or stick around after such a massive decline.
What’s Up With Luckin?
While the company may have fabricated up to $310 million in revenue — that’s a whole lot of coffee — it says it will maintain normal operations through the investigation. Of course, the novel coronavirus only complicates matters.
The fact that LK stock will continue its operations is actually good news. Pre-fraud, the business was well run. Growth was (seemingly) going bonkers and it wouldn’t be long before the company turned profitable amid all that revenue growth.
But with fraud in the picture, it’s hard to know how much or how deep the misinformation runs. On top of that, funding will now be very difficult for Luckin.
What bank will want to lend to them? Who will want to do business? Insiders are facing margin-call risk as the value of their stock collateral decreases significantly. Further, the falling stock price makes it difficult to raise capital in the equity market. In fact, it makes it almost impossible.
An inability to access additional funds will likely slow the company’s growth rate, whatever it actually is. That’s as Luckin is not yet profitable or cash-flow positive.
What Should Investors Do?
Unfortunately, most investors are not forensic accounting experts. Many professional investors and analysts missed the fraudulent activity here.
The company’s decision to continue operations should help in the intermediate term — provided Luckin pulls back on expanding. Because it was expanding so rapidly, cash burn was high.
If Luckin — which has not filed its annual report due to the investigation and Covid-19 — comes to the Street with honesty, a plan, and some positive, verified numbers, then maybe LK stock has some upside.
That said, if I’m not long Luckin now, there’s no way I’m buying this stock. Where there’s smoke, there’s fire. There’s hundreds of quality stocks to own right now and one that just fell 80% on cooked books is not one of them.
Pick Starbucks Over LK Stock
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For those that still want exposure to the coffee business, look no further than Starbucks (NASDAQ:SBUX). The company has operations around the world and has been aggressively expanding in China for years now. That expansion will continue for years to come too, as Starbucks looks to China as its growth engine.
Unlike LK stock, Starbucks isn’t caked in fraud allegations and investigations. It’s a well-run company that’s profitable and cash-flow positive.
SBUX stock is still about 25% off its 2019 high and the coronavirus isn’t doing it any favors. But the company has plans to reopen almost all of its stores here in the U.S. by the end of the week. Covid-19 will be a multi-quarter drag, but this is still a high-quality company.
Forecasts call for an 11% hit to revenue this year and 50% blow to earnings. So to be clear, there is certainly a negative impact at Starbucks. For now though, consensus expectations call for a big rebound in 2021. That is, for a doubling of earnings and an 18.5% rebound in sales.
It’s possible that investors will see another dip in Starbucks. A sub-$60 purchase would be an excellent cost basis for long-term investors, in my view. While investors could face more downside in the short term — particularly if there’s a large correction in the overall stock market — they can sleep better at night knowing SBUX isn’t set for a decline like LK stock.
Bret Kenwell is the manager and author of Future Blue Chips and is on Twitter @BretKenwell. As of this writing, Bret Kenwell is long SBUX.
