Shares of hyper-growth Chinese retail coffee chain Luckin Coffee (NASDAQ:LK) stock plunged lower on Thursday, April 2, after the company announced that its financials have been significantly overstated.
Specifically, LK stock dropped a whopping 80% to all-time lows as the company revealed in an U.S. Securities and Exchange Commission filing that its COO and certain reporting employees had fabricated several transactions. Those fake transactions amounted to about $310 million between the second and fourth quarters of 2019.
That’s a huge number for this company. The consensus estimate for 2019 revenues was $740 million. My modeling had them down at $720 million. If $310 million of that was from fake transactions, then Luckin’s 2019 revenues will actually be somewhere around $410 to $430 million, or less than 60% of what Wall Street had been expecting.
On top of all that, China is still battling a hangover from the novel coronavirus, and Luckin management now has a huge trust issue with investors.
It’s no wonder LK stock lost 80% of its value in a hurry.
This selloff, however, may be overdone. Here’s why.
In essence, Luckin Coffee overstated its transactions by about 70%.
That’s bad. But it’s not a fatal blow. Despite the financial fiasco, Luckin remains a hyper-growth coffee chain in China’s booming coffee market.
When you look at the long-term model for Luckin, there are two big growth levers: unit expansion and same-store sales growth.
The unit expansion lever is not impacted by this financial fiasco. The company didn’t overstate the number of stores it has opened. Indeed, Luckin has still gone from nine coffee houses at the end of 2017 to 4,500 at the end of 2019.
Ask anyone in urban China. These stores are popping up everywhere.
Management has said that they will open 10,000 stores by 2021. I had previously modeled for the company to grow to 20,000 stores by 2025. These targets do not change because the company overstated transactions in the back-half of 2019.
What does change, however, is the model for same-store sales growth.
The average Starbucks (NASDAQ:SBUX) store does about $1 million in annual sales. At the start of 2019, Luckin’s coffee houses were averaging about $150,000 in revenue per store. That number crept all the way up to about $260,000 in the third quarter of 2019. Given this rapid uptick in unit volumes, many analysts — myself included — had modeled for Luckin’s stores to, at scale, have unit volumes around $500,000 or more.
This is no longer likely.
Instead, the math checks out so that Luckin’s average unit volumes in 2019 will be about $125,000. I still think this number can grow to about $250,000 over time, as Chinese consumers increasingly shift toward heavier daily coffee consumption. That is, however, a far cry from the $500,000-plus unit volumes I was previously expecting.
In the SEC filing, Luckin Coffee stated that expenses were also substantially inflated alongside revenues.
That’s good news. If costs weren’t inflated — and revenues were — then that means Luckin’s “true” profit margins were significantly lower than what was reported. But, if both were inflated presumably by a roughly equal amount, then Luckin’s true profit margins are largely in line with what the company has been reporting.
Zooming out, I still believe this company can, at scale, print 15% profit margins, lower than but comparable to Starbucks’ 20% profit margins. Lower than because of lower unit volumes. Comparable to because both are coffee houses, and Luckin’s smaller stores have smaller expenses.
The SEC filing forced me to update my model in three major ways:
Those are some major reductions. Still, if Luckin can earn $2 per share by 2025, then LK stock is incredibly undervalued below $7 today.
A market-average 16-times forward multiple on $2 in 2025 earnings per share, implies a 2024 price target of $32 — more than four-fold the current price tag.
There are two key takeaways from the SEC filing. One, Luckin Coffee is not growing as quickly as everyone thought. Two, the company is still growing very quickly.
Right now, the market is pricing in the first takeaway, and ignoring the second. That’s reasonable. There are trust issues here which will prevent the market from pricing in the second takeaway for some time.
Still, over time, management will restore that trust, Luckin will continue to grow alongside a booming China retail coffee market, and LK stock will bounce back in a big way from today’s all-time lows.
So, for contrarian investors with time on their side, the recent plunge in LK stock looks like a long-term opportunity.
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