Luckin Coffee (LK) (OTCPK:LKNCY) is trying to rebuild itself after the discovery of fabricated transactions that greatly inflated its revenue. Luckin has shifted away from its prior strategy of growing through opening massive numbers of new stores, and is now attempting to reach corporate profitability with its current store base.
Luckin does have a large customer base, but it is uncertain how many of those customers it can retain if it reduces its advertising budget and promotions in a bid to reach profitability.
Luckin may have incurred over US$700 million in cash burn from Q4 2019 to Q2 2020, reducing its cash on hand to around US$780 million. It also faces significant potential legal liability from investor lawsuits.
Luckin has made some positive moves with the reappointment of Sean Shao as an independent director and the appointment of Marcum Bernstein & Pinchuk as its new auditor. Shao was supported by Centurium Capital and led the special committee that investigated the fraudulent transactions. His reappointment is a positive for governance at Luckin and its attempts to work towards profitability.
Luckin Coffee (and some third-party companies that were also implicated) were fined a combined US$9 million by the Chinese State Administration for Market Regulation. This fine is related to fake coupons that were used to help inflate sales.
This is a pretty minor fine compared to the roughly US$310 million inflation in Luckin Coffee’s revenues. However, Luckin Coffee also faces significant potential liability from investor lawsuits. There is a securities class action lawsuit in the U.S. District Court for the Southern District of New York, with Sjunde AP-fonden (AP7) and the Louisiana Sheriffs’ Pension & Relief Fund serving as co-lead plaintiffs.
Class action lawsuits often only recover pennies on the dollar from investor losses. For example, Tyco settled investor lawsuits for around $3 billion, which was only around 5% of the estimated $60 billion in shareholder losses.
Luckin Coffee’s market capitalization is down around US$12 billion from its peak, so a 5% recovery of that could cost Luckin Coffee US$600 million.
Luckin Coffee appears to have incurred significant cash burn since late 2019. It had US$632 million in cash and cash equivalents at the end of Q3 2019. It raised an additional US$865 million in net proceeds from its January note and ADS offering. This adds up to just under US$1.5 billion.
Luckin Coffee reported having an estimated US$780 million in cash and cash equivalents on hand at the end of June 2020. Thus, it may have had cash burn of over US$700 million in the nine-month intervening period.
Luckin Coffee is working on reducing its cash burn and reportedly was profitable at the store level in July 2020, although it still appears to be burning cash at the corporate level. The report mentioned that Luckin is attempting to reach corporate profitability in 2021. Luckin’s cash burn should be improved by the halt of its rapid store expansion plans, although it may need to significantly reduce discounting and advertising to achieve corporate profitability.
Stock And Bonds
Luckin’s cash position may be significantly dented by any settlement of the class action lawsuit. If it pays out US$600 million, then it would only have US$180 million left over, less any cash burn since the end of June. It also has US$460 million in convertible notes outstanding, so its net debt would be US$280 million in that scenario. Thus, Luckin’s cash position doesn’t appear to provide any safety buffer.
Luckin’s stock is down around 15% since I last wrote about it, while its convertible notes are up around 60%. The stock price appears to be a bit more reasonable now, valuing the company at an enterprise value of around 2x revenue. This assumes US$280 million in net debt and revenues near Q3 2019 levels (annualized). However, it remains fairly risky due to the uncertainty about whether it can actually deliver profitability, as well as the potential for settlements to be larger than my estimates.
Luckin has made some positive moves in terms of improving corporate governance and attempting to reduce its cash burn. However, it has also used up a lot of its cash over the last few quarters and faces substantial potential liability from investor lawsuits.
Luckin’s stock price appears somewhat more reasonable now, although I would still not categorize it as cheap given the uncertainty around legal settlements and its ability to achieve profitability. It does have a large customer base, but that customer base was achieved via significant cash burn, and it will likely have to make do with the remaining cash it has on hand now, given that access to new capital is likely to be quite limited for a while.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.