Fool me once, shame on you. Fool me twice, shame on me. This is the attitude investors often take with companies that have been involved in accounting fraud, and it’s why recovering can be wildly difficult. But this is exactly where Chinese coffee chain Luckin Coffee (OTCMKTS:LKNCY) finds itself today. Luckin stock was battered earlier this year by nasty accounting scandal.
Not so long ago, Luckin stock was riding high, trading over $50 per share. Today, after losing more than 95% of its value, Luckin fetches about $2.20 per share.
And adding insult to injury, the stock got booted off the Nasdaq exchange and now trades over the counter.
After a tumble like that, it’s fair to ask: Might the worst be over for Luckin stock? After all the chaos of 2020, could Luckin Coffee be a cheap way to play a post-COVID recovery in Chinese consumer spending? Let’s do a deep dive and find out.
What Happened to Luckin Stock?
Before we jump in, let’s review exactly what happened. Luckin was caught inflating its sales figures, and not by a small amount. The fraudulent sales were estimated at over $300 million in the second through fourth quarters of 2019. To put that in perspective, that’s roughly a quarter and a half’s worth of revenues for Luckin.
Luckin’s CEO and COO were given the boot, and Chairman Lu Zhengyao is reportedly facing criminal charges. The company hasn’t released financial statements since late 2019, and it’s still unclear when it will restart its reporting.
Suffice it to say, the company is a mess. And valuing it is next to impossible given the lack of reliable data. How do you measure it’s price-sales or price-earnings ratios when the sales data itself is known to be false. But just for grins, let’s give it a try.
Running Some Numbers
Over the trailing 12 months, Luckin stock has done about $2.35 per share in revenues – or at least that’s what they reported. Let’s play it safe and reduce that figure by about 40% to $1.41. At a current share price of $2.25, that amounts to a price-sales ratio of 1.6.
That’s not particularly cheap, and even less so given the cloud of scandal hanging over the company.
Furthermore, the company wasn’t profitable even before the accounting scandal. Investors were buying into an unprofitable company because the (fabricated) revenue growth was off the charts. Now that that revenue growth has been proven to be false, what exactly are investors buying?
Furthermore, Luckin’s business model is still unproven. China is a tea-drinking country where coffee is still something of a novelty. To Luckin’s marketing team, that represented an opportunity. And maybe it still is.
But it’s unclear if Luckin’s kiosk model is really the right way to convert non-coffee drinkers. To the extent Starbucks (NASDAQ:SBUX)has been successful in China, it is because it tailored stores to Chinese tastes and created a pleasant place to sit down, socialize with friends or simply get out of the house. That’s really not how Luckin works.
Recovery From Scandal Takes Time
It can take otherwise viable companies years to recover from a major scandal. As an example, Volkswagen (OTCMKTS:VLKAF) struggled to keep its share price above its 2015 pre-emissions-scandal prices.
And VEREIT (NYSE:VER) – formerly American Realty Capital Properties – committed accounting fraud that still hangs over the company today, despite a total purging of upper management and a major rehabilitation campaign. The shares trade for barely half their pre-scandal highs, and this is an American REIT with tangible real estate properties – a long way from a Chinese coffee startup.
This is to say that, while Luckin stock could enjoy a nice run from these prices, it’s a risky bet. Far more established and reputable companies have had a hard time recovering from a scandal like this, and we have very little in the way of usable financial information.
I’d recommend steering clear of this one for now.
Charles Lewis Sizemore, CFA is the principal of Sizemore Capital Management LLC, a registered investment adviser based in Dallas, TX. As of this writing, he did not hold a position in any of the aforementioned securities.
