According to the old expression, one rotten apple ruins the bunch, but if that rotten apple works on Wall Street, it can do a lot more damage than that. The company that employs such a person often loses a lot of money and so do its customers; reputations carefully built over many years become tarnished or even destroyed. And all too often, shareholders suffer the biggest losses.
The following is a story about a company that looked like a dream come true - growing by leaps and bounds, dazzling investors with its soaring stock price, and by all indications well on the way to becoming a great growth stock. Everything was perfect - until the company was charged with fraud. What had started out as a dream, overnight turned into a nightmare for all involved. Hopefully, learning more about these events will sharpen our street smarts and make us savvier investors.
A Starbucks Wannabee
Countless consumers love going to Starbucks. They find it a great place to spend time with relatives and friends, talk about business or sports, and relax in a pleasant environment while enjoying a good cup of coffee.
But no one was more taken by this formula than China-based Luckin Coffee. Starbucks, of course, became wildly successful using this business model, attracting droves of customers on a regular basis and earning big bucks in the process. Luckin wanted to be just like them. And it was sure that by using a similar business model it could do even better
Initially it did, as Luckin began growing at breakneck speed. It was founded in October 2017 and just a year later they had 1,300 outlets. But the company's plans were far more ambitious than that.
In January 2019, Luckin announced plans to open 2,500 more outlets, a number that would make it the best-known coffee brand in China - even more so than Starbucks. Most of these were small takeout and delivery shops located in office buildings and college campuses; they were relatively inexpensive to open and easy to run. Investors liked this idea so much that Luckin easily raised a total of nearly $2 billion in several offerings in the US.
In 2019, its stock was listed on NASDAQ, where it was given a very warm welcome. Unlike many of China's high-tech IPOs, this one was easy to understand, logical, and appealing. The financial media became fans and began referring to the company as "China's Starbucks."
On May 17, the first day the stock began trading, shares jumped 20%, giving the company a market value of $4 billion - pretty good for a business just two years old. Luckin's sales were growing rapidly, the company was signing deals with food delivery services and other firms, and its stated goals of overtaking archrival Starbucks was on track. With the company firing on all cylinders, Wall Street gave it a market value of $12 billion.
Unfortunately, developments were not quite as upbeat as they seemed to be. Much of Luckin's rapid expansion resulted from subsidized sales, a strategy that enabled the company to enjoy very impressive growth in the short-term but that obviously was not sustainable. In order to make real profits, the company had to raise the price of its coffee dramatically, a move that would slow growth.
There were other important issues that needed to be addressed. There was a "bridge loan" from one of the company's banks, and the full details needed to be clarified. Many of the outlets from which Luckin was selling coffee did not have "regulatory approval." And there were other curiosities, too. For example, the number of cups the company said it was taking out of inventory did not match the number of cups of coffee it claimed to be selling.
Curiosity soon gave way to skepticism, then to suspicion, and ultimately to penalties. In September 2020, Chinese regulators fined a group of companies - Luckin among them, - a combined total of nearly $9 million for falsification of financial information.
The SEC began an investigation that was much more aggressive. It charged that from at least April 2019 through January 2020, "Luckin intentionally fabricated more than $300 million in retail sales by using related parties to create false sales transactions through three separate purchasing schemes."
According to Nikkei.com, in April 2020 the company admitted that at least $310 million of its sales over the previous three quarters had been fabricated, and it agreed to pay a penalty of $180 million to the SEC.
On Nov. 3, 2019, Luckin's stock was approximately $18.50. Just over two months later, on Jan. 12, 2020, it reached the all-time high of more than $50/share.
But investors don't take kindly to fraud and SEC investigations. When the company verified those reports, the shares dropped by 75% in a single day! And they went lower from there.
By mid-May, just four months after making the all-time high, the stock price was down to just $1.39, a sickening drop of more than 97%. In addition to huge financial losses, shareholders also suffered intense emotional battering as their investments quickly wilted to near worthless. The shares, which had listed on the NASDAQ in 2019 amid great pomp and flourish, were de-listed and the price crushed.
A New Hope?
In retrospect, investors who purchased shares at the low of $1.39 were not only brave but also savvy. According to Yahoo Finance, "The company presumably still had a decent amount of cash on the balance sheet. It had raised $865 million in January 2020 thanks to equity and debt offerings. Even if 2019 and 2020 revenue figures had been inflated, the business was at least real. There was still at least a chance for Luckin to resume its previous growth, in a perhaps more measured (and more ethical) manner."
Investors who bought at the low have done very well: The stock (symbol: LKNCY) has had its ups and downs since then (haven't most stocks?), but the overall trend is unmistakably higher. In mid-August, the stock was trading at $15/share, nowhere near the high of more than 50 on January 17, 2020, but also nowhere near the low. Yahoo Finance adds that "The rally has come in part because (the contrarian) bullish case proved to be valid. Luckin’s business is real, and it’s showing impressive growth. Profitability is in sight." Of course, there is no guarantee that all of the news about fraud has finally ended.
Despite all the regulatory bodies in the US and China, it turned out that in the end, a short seller blew the whistle on what was going on. In January 2020., after Luckin raised capital, the hedge fund Muddy Waters announced it was shorting the stock. It had serious questions about stated results and wanted answers. It hired nearly 1,500 investigators who recorded 11,000 hours of video to learn more about consumer patterns and analyze sales.
Among other things, a report they put together concluded that Luckin had inflated sales by 69% in the third quarter of 2019 and by 88% in the last quarter; moreover, rather than making profit as the company claimed, results were overstated and stores were actually losing serious money.
The events that unfolded at Luckin were a painful reminder that, despite all of the laws and regulations intended to protect investors, there are bad guys out there who are capable of skillfully manipulating them. And their activities are not limited to tiny, unknown companies. Fraud has been uncovered at very large and prestigious firms in energy, pollution control, precious metals, and telecommunications, to name just a few industries. Along the way, investors have lost many billions.
So what can investors do to protect themselves? A healthy dose of skepticism may be a good place to start. Also, company filings and investment recommendations are not Torah m'Sinai; while there is a tendency to believe the printed word, not every one of these is honest.
When an investment idea looks too good to be true, very often it is. Individual investors and others, anxious to make a few bucks on the market, can easily get sucked in to a bad situation and end up taking a financial hit. The best investment philosophy is still "Buyer Beware."
Sources: bloomberg.com; nikkei.com; sec.gov; yahoofinance.com; YouTube: Luckin Coffee Fraud Explained; Luckin Coffee Fraud - What Actually Happened