Luckin Coffee (OTC:LKNC.Y), which recently surpassed Starbucks as China's top coffee chain (by total number of stores), recently stunned investors after it admitted to fabricating sales figures last year. Its stock price plunged from $26 to just over $4 before it was halted on April 6, and sparked serious concerns about other U.S.-listed Chinese stocks.
Three other Chinese companies recently joined Luckin in that unflattering spotlight: TAL Education (NYSE:TAL), GSX Techedu (NYSE:GSX), and iQiyi (NASDAQ:IQ). Let's see if investors should also be wary of these three high-growth Chinese stocks.
1. An education giant: TAL Education
TAL is one of the largest tutoring and online education companies in China. It went public in 2010 at $10 per ADS and currently trades above $50. It dazzled investors with its robust growth in revenue, which surged 47% annually last quarter, and student enrollments, which jumped 66% to 2.32 million. The COVID-19 pandemic also lit a fire under TAL's stock as more students attended its remote classes.
But in early April, an internal audit revealed that an employee "conspired with external vendors" to inflate revenue at its new Light Class business by forging contracts and other documents. TAL didn't disclose the exact percentage of fraudulent revenue, but it noted that its Light Class business accounted for 3%-4% of its estimated revenue for fiscal 2020.
TAL's stock initially fell after the report, but rebounded after the market digested the news. Investors seemingly accepted TAL's claim that the fraud was the action of a rogue employee instead of top executives, but the misstep raises serious concerns regarding its marketing practices -- especially as competition heats up in China's online education market.
2. A high-growth education underdog: GSX Techedu
GSX Techedu is a smaller online education platform that competes against bigger players like TAL and New Oriental Education. GSX is turning heads with its triple-digit revenue and earnings growth, and its stock has tripled since its IPO last June.
However, GSX was recently hit by fraud allegations from two prolific short-sellers, Grizzly Research and Citron Research. In February, Grizzly claimed GSX inflated its revenue and enrollment numbers. Earlier this month, Citron echoed Grizzly's arguments, calling GSX the "most blatant stock fraud since 2011" and claiming its growth rates and margins were "too good to be true" -- especially when faced with aggressive promotions from rival platforms like TAL and New Oriental.
Citron claims GSX overstated its revenue by about 70% through duplicate class bookings, and noted it was excluded from state-backed media surveys of top online education platforms in China -- despite its claim of being the country's "third-largest online K-12 large-class after-school tutoring service provider in China." GSX has denied the allegations, claiming the reports contained "numerous errors, unsubstantiated statements, and misinterpretation of information," but investors should still keep an eye out for any future developments.
3. The "Netflix of China": iQiyi
iQiyi, one of the leading video platforms in China, was spun off from online search leader Baidu (NASDAQ:BIDU) two years ago. The stock remains just slightly above its IPO price of $18, held down by ongoing concerns about its slowing growth and lack of profits.
iQiyi's revenue rose 52% in 2018 but dipped to just 16% growth in 2019 amid tougher competition from rivals like Tencent Video. However, research firm Wolfpack Research and short-seller Muddy Waters -- which accused Luckin of fraud before its admission of guilt -- claim that iQiyi inflated its revenue by 27%-44% last year.
Wolfpack alleges iQiyi inflated its user numbers by 42%-60%, overstated the revenue it generated from sub-licensing its content to other platforms, and falsified its expenses to burn off the fake cash. The firm also claims iQiyi's fraudulent behavior predates its IPO -- which implies that Baidu either overlooked or ignored those problems.
iQiyi claims the report contains "numerous errors, unsubstantiated statements, and misleading conclusions and interpretations" regarding its business, while Mizuho analyst James Lee defended iQiyi's accounting practices. Nonetheless, the charges cast a dark cloud over iQiyi, which is struggling to grow its subscriber revenue, and Baidu, which relies on iQiyi's revenue to offset the slowdown in its ad business.
The key takeaways
Investors should always be careful when investing in Chinese companies since they generally don't open their books to U.S. auditors and use complex variable interest entity (VIE) ownership structures to prevent overseas investors from directly owning stakes in the company.
Chinese companies have defrauded U.S. investors before, and some companies even raise money on U.S. exchanges, go private again, then re-list their shares on Chinese exchanges for more money. I'm not saying TAL, GSX, and iQiyi belong with those bad actors yet, but investors should do their due diligence and research the allegations against these companies.