Luckin Coffee (LK) made headlines in early April when the company announced that an internal investigation found fabricated transactions amounting to $310 million between the second and fourth quarters of 2019. In other words, around 65% of the sales reported in this period were merely accounting gimmicks, not sales. With this, trading of LK stock was halted by Nasdaq pending the results of an investigation. This trading halt will come to an end today, on May 20, and many investors are searching for answers for a few important questions, including the all-important question of what happens to Luckin Coffee stock with this delisting decision. In this analysis, Beat Billions will provide answers to all these questions. (Hint: it might not be as bad as it sounds.)
Will shares drop drastically today?
This is the most likely scenario and there are two reasons behind this expectation.
- Shares have been halted for more than a month and many investors are looking for a way out of this Chinese company due to the significant level of uncertainty regarding its future as an American-listed company. This will lead to selling pressure.
- Bad news might not just be over yet. Both Chinese and U.S. regulators are on Luckin’s tail and are seeking for answers. The company might eventually have to pay fines or engage in legal battles with regulators to prove the company is now in a better position to avoid malicious practices in the future.
Both these factors, combined with the pessimistic broad market sentiment, will likely lead to a steep decline in Luckin Coffee stock today once trading resumes.
What happens when shares are delisted?
Many novice investors even fear this word, but there are no demons in the word “delist”. Even after getting delisted, or deleted from Nasdaq or the S&P 500, shares of a company continues to trade. There are primarily two ways a stock would continue to trade after the delisting process is complete.
- Over the Counter Bulletin Board, or what is commonly referred to as the OTC market.
- Pink Sheets.
Companies trading with the Pink Sheets quotation system are not even required to meet the SEC requirements such as periodically filing financial statements and other relevant documents, which makes investing in these securities a very risky bet.
The primary disadvantages of being delisted are attached to the ability of a company to raise debt. For instance, credit rating agencies are likely to lower their rating for companies that are recently delisted from a major index, and the cost of debt will naturally rise. If there are loan covenants attached to the listed-status of a company, it’s likely that creditors will make a run on the company requesting them to repay the loans at the earliest possible.
For investors, however, little would change in the short term. A company being delisted from Nasdaq can not and should not be used in isolation to conclude that the prospects are bleak. It’s important to draw a line and differentiate between getting delisted from an index to filing for bankruptcy. In Luckin Coffee’s case, shares would be delisted from Nasdaq and its ability to raise debt at attractive rates will be in jeopardy. However, this is not an indication that the company will eventually cease to exist.
Will Luckin Coffee survive?
Beat Billions believes that there is a good chance of Luckin Coffee surviving this ordeal. Before we discuss why, we would like to remind our readers that accounting scandals of any scale should be looked at as a clear indication of poor management. The company has reportedly fired a few top executives, including the CEO, in a bid to revamp its strategy and to show its commitment to upholding the highest standards. However, prevention is better than cure, and the scandal taking place in the first place is the only indication an investor needs to conclude that the management is not as capable as they sound.
Some major changes are expected in the top-level executives of the company, and we hope these newcomers will be law-abiding citizens, to put it bluntly!
Back to why we believe Luckin Coffee might survive.
True, the majority of sales reported in 2019 were fabricated. What is also true is that Luckin Coffee operates over 4,500 stores in China, and consumers are once again flocking to these stores as mobility restrictions are being eased. It would be not prudent to assume that Chinese consumers will avoid Luckin Coffee because of this accounting scandal, and chances are that many of these consumers are not even aware of what this means. It’s only reasonable to assume that the company will slowly but steadily get back on its feet as Chinese consumers get back to pre-coronavirus spending habits.
Second, Luckin Coffee had $775 million in cash at the end of September last year. Fabricating sales is one thing, but there’s no reason to believe that this reported amount of cash is inaccurate considering the funding activities of the company in 2019. Without accounting for a possible fine, the company is in a strong position to remain solvent until sales recover. Beat Billions believes the accounting scandal alone will not push Luckin Coffee to bankruptcy.
Third, the company is looking to expand and establish itself as the undisputed market leader in China, brushing away the threat from Starbucks. To do this, the company is not only focused on increasing its store count, but also on offering innovative products. For instance, Luckin Coffee launched Luckin Tea in September last year in a bid to benefit from the tea-drinking habits of the Chinese. Tea, as we learned from our colleagues from China, is far more famous than coffee in China.
Luckin Coffee is expanding into other business sectors as well and the company recently launched a campaign to promote lifestyle products, ranging from face masks to Apple Airpods. The idea is to upsell these products in the mobile application in a separate segment. This business line is something that we do not agree on. The time, money, and energy spent on this campaign should better be used to improve the strength of its core business operations as China is already flooded with e-commerce behemoths and a consumer might not want to use a coffee ordering mobile app to shop for high-tech items.
Will there be a short squeeze?
A short squeeze, in case you’re not aware of it, is the term used to define an increase in the share price of a company resulting from the flight of short-sellers. To profit by shorting a stock, an investor needs to borrow the stock of a company and then successfully cover his short position in the open market after the market price falls significantly below the price at which he borrowed the stock.
The short interest in LK stock spiked once the accounting scandal came to light in early April.
Because trading of LK stock was halted soon after, the short interest remains at a very high level of 24%, amounting to 31 million shares. Many of these short sellers are waiting to pounce on the next opportunity to cover their short position to complete their trade, and this could actually boost the Luckin Coffee stock in the coming days. This might not necessarily happen today, but we would not be surprised if LK stock gains traction temporarily based on a short squeeze.
Investing in small-cap stocks is not easy. But, when this is done correctly, investors can expect stellar returns in the long run. This is where Beat Billions can help you by uncovering hidden truths about the small-cap stocks you follow and by digging deep into the prospects and financials of a company.
Luckin Coffee stock will most likely receive a beating today, but there’s a possibility of a short squeeze as well. In any case, Luckin Coffee does not seem to be in a precarious situation that would end up in bankruptcy. At least, not for now.
A study conducted by The Journal of Finance to determine the impact on the share price resulting from the additions and deletions from a major stock market index concluded below.
There is a permanent increase in the price of added firms but no permanent decline for deleted firms. These results are at odds with extant explanations of the effects of index changes that imply asymmetric price response to additions and deletions. A possible explanation for asymmetric price effects arises from the changes in investor awareness. Results from our empirical tests support the thesis that changes in investor awareness contribute to the asymmetric price effects of S&P 500 index additions and deletions.
As we can see, there is no permanent decline of the market value of deleted firms from major indexes. The directional movement of Luckin Coffee stock, therefore, would be determined by the financial performance of the company in the coming years and the ability of the company executives to instill trust among market participants and other stakeholders.
**If you enjoyed this article, please consider signing-up for Beat Billions by providing your e-mail address in the box above. You will then receive a SINGLE daily e-mail with all the articles published on Beat Billions.
**Come back again to read more on small-cap stocks. We publish multiple times a week.