Luckin Coffee (OTCMKTS:LKNCY) had a dramatic rise and equally shocking fall. Luckin stock nearly tripled since its initial public offering a year ago, with shares hitting $50 earlier this year.
Since then, however, short sellers exposed widespread accounting fraud at Luckin. The company faked hundreds of millions of dollars of sales via fictional transactions. Members of top management resigned. The Nasdaq booted Luckin stock off its exchange.
Luckin had to give up its “LK” ticker and now trades as “LKNCY” stock on the lowly pink sheets. Shares are down more than 90% from their highs.
That’d normally be the end of the line. The company loses tons of money, used fraud to try to hide the losses; now the accounting games are exposed and the company collapses. This is 2020, however, so nothing can be that simple. Indeed, speculators have bid up Luckin’s shares since it was delisted.
Luckin stock has rebounded from $1 to $4 before scaling back to open this week at $3.72.
There seems to be some hope that Luckin will be able to get its back on track. The company still has thousands of stores, after all, and the allure of being the Starbucks (NASDAQ:SBUX) of China remains strong. However, investors should be careful. Even if Luckin turns things around, there’s no guarantee that the American investors will see any benefits from the comeback.
Will Luckin Go Private?
Last month, the Financial Times documented a common maneuver for U.S.-listed Chinese companies. If their share prices crash — particularly after fraud allegations — they commonly buy out their U.S. listing. Once they buy up the whole company on the cheap, they can then reposition it elsewhere at a far higher price.
According to the article, more than 90 Chinese firms have arranged “confiscatory” take-private transactions over the past 10 years.
The Times article highlights the case of Qihoo 360, a Chinese internet security firm. Qihoo’s shares originally soared in the U.S., but crashed after noted short sellers such as Citron Research raised questions about the firm. Qihoo’s founders bought out Qihoo at a depressed valuation of $9 billion in 2016, removing it from the U.S. market.
In 2018, with the fraud concerns out of the way, Qihoo relisted its stock in China on the Shanghai Stock Exchange, pulling in a shocking $60 billion market capitalization.
Consider how things played out from the perspective of an American investor. If you held Qihoo’s stock through all the short seller reports and fraud allegations, you ultimately got bought out for a pittance. Then insiders cashed in just two years later, reselling the company at a new 500% higher valuation. The daring investor that backed Qihoo during its time of crisis got left out in the cold.
Luckin and Game Theory
There are several possible outcomes here.
For one, Luckin could be a complete fraud through and through. The stock languishes on the pink sheets for a few years and then disappears. That’s bad for Luckin’s investors, obviously.
Or the new management could be honest and do its best to turn the company around. However, it fails as the company’s operating losses are too large and it can’t access additional capital to fund itself (since it is on the obscure pink sheets, after all). This is also a terrible outcome for Luckin stock owners.
Now think about the Qihoo scenario. Insiders may be fine with Luckin’s stock price crashing. They already raised a ton of money when the stock was at its peak valuation earlier this year. Why not use that cash to buy out the company now with the stock down 90%?
It’s highly unlikely that shareholders could block it; Luckin’s U.S. stock is owned in large part by traders and speculators rather than institutions that would fight for their activist shareholder rights.
Of course, things could go well. New management could be honest and have investors’ best interests at heart. That management team could also succeed in turning around the business, stemming its current gargantuan operating losses. And management could resist the urge to snap up the stock while it’s cheap and forlorn on the pink sheets.
Combined, however, that’s quite a few things that would have to go right for Luckin’s investors to get a positive outcome in this particular poker hand.
Luckin Stock Verdict
In the short run, anything can happen with Luckin stock. Trading access is dramatically reduced since the Nasdaq kicked it off their exchange. In a thin illiquid market, you can see incredible volatility – traders could make plenty of gains. In particular, it’s harder for short sellers to operate in delisted companies, so that allows squeezes to run further.
As a long-term investment, however, Luckin is dubious. You’re dealing with a company that committed brazen fraud and replaced the management team. It’s unclear what plan, if any, the new operators will have to try to save the company. And even if things go well, insiders could pull a Qihoo 360 and buy out the company for pennies on the dollar.
Investing in fraudulent delisted companies is a form of rampant speculation. Be careful, and don’t play with money you can’t afford to lose.
Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek. At the time of this writing, he held no positions in any of the aforementioned securities.