Muddy Waters recently published a short report on Luckin Coffee (NASDAQ: LK) citing an anonymous source who said the coffee chain is inflating sales and moving losses into expenses. However, Aiden Research published an analysis encouraging investors not to panic because the report from Muddy Waters is not well justified.
Aiden Research is an independent research firm focusing on US-listed Chinese firms or US companies operating in China. Aiden Research responded to Muddy Waters’ key arguments and raised three major questions about the report.
1. Investigation Sample
As the short report mentioned, investigators were hired to run surveillance on Luckin Coffee stores, and covered 620 for a total of 981 days. Using the surveillance record, the report tried to argue that Luckin Coffee inflates the number of items sold per store. But if you do math, you will find the surveillance record simply translates into 1.5 days on average for each store. Can results from one particular store on one particular day be used to draw conclusions about all customer behavior? The 1.5 sampling store days sound insufficient to draw a robust conclusion.
Aiden Research raised a similar question regarding the 25,843 randomly gathered receipts from more than 10,000 customers. The methodology of the randomization was not clearly stated in the report. Aiden Research questioned whether confirmation bias might be involved or whether customers who spend less are more willing to share their receipts.
The short report is built on a seemingly large sampling base. However, these unanswered questions weaken its argument. Not to mention that the source of the report is anonymous, further diminishing the credibility of the report.
The short report tried to prove that Luckin Coffee has not achieved store-level profitability, citing evidence that the advertising expenses were possibly inflated and transferred to cover the operating losses. Aiden Research questioned why the emphasis of the Muddy Waters’ report was store-level probability, which is not a key indicator that investors should focus on. Instead, they should focus on Luckin Coffee’s overall profit margin, which has been improving. Aiden Research argued that the report’s focus on store-level profitability reduces its credibility.
There has long been debate about whether Luckin Coffee’s business model is sustainable. Aiden Research agreed it should be the focal point of the short report. However, the short report didn’t show enough convincing evidence on this argument. The core argument of the short report is that drinking coffee is nothing compared to tea in China, with caffeine demand much lower than in western cultures.
3. Business Model
Aiden Research felt this argument is fairly weak. Given the fact that both Starbucks and Luckin Coffee are battling to open more stores and expanding their service networks, the demand for coffee is growing in China. Aiden Research argued a more valuable discussion would be whether Luckin Coffee can maintain its growth in overall profit margins when subsidies are reduced or go away.
Muddy Waters published the short report during the current coronavirus outbreak in China. The interim impact on Luckin Coffee has been visible. However, the coffee chain recently announced plans to accelerate its unmanned self-services in order to offer customers safer and contactless products to help combat the coronavirus. Luckin Coffee announced on February 3 that it had partially resumed its store and delivery services. There are many variables in this Black Swan moment that could impact Luckin Coffee’s business.
As mentioned in Aiden Research’s article, “given the whopping 70% short interest ratio on LK, we would expect short-selling investors under great pressure and eager to see the price going further down.” Overall, Aiden Research didn’t believe the short report is well-justified and suggested investors avoid panicking and wait until Q4 results prior to further action.