Value traps are companies that may seem cheap at first glance, but get progressively cheaper and cheaper until their stock destroys all the wealth investors can put into them. Such phenomena are quite common for companies that enduring considerable declines in their core operations, or are cooking their books to make their business look more attractive.
From a company that fabricated its financials, to another that's embroiled in insider trading controversy, to another that faces allegations that its technology is non-existent, the stocks all have one thing in common: having fallen from great heights and appearing deceptively undervalued. Let's look at why these companies are value traps and why investors should avoid them.
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1. Luckin Coffee
Luckin Coffee (LKNC.Y -0.64%) had high hopes of disrupting the Chinese coffee industry. Founded in 2017, the company began on a journey of rapid expansion across China, opening nearly 5,000 stores across the country by the end of 2019, eclipsing Starbucks' goal of opening 6,000 stores in the Middle Kingdom by the end of 2022.
However, that dream came crashing down in April as an internal review of its financials found its COO had fabricated at least $310 million of its $732 million in revenue last year. In addition, short-seller Muddy Waters conducted an independent investigation of the company that found it relied on mass distribution of free coffee coupons for the sake of growth. At one point in time, Luckin Coffee allegedly gave nearly half of its coffee for free to solicit new customers, while its core members received no such perks for their loyalty.
The Nasdaq stock exchange has delisted the stock for failing to file its financial statements since the third quarter of 2019. Since its all-time high in April, the stock is now down over 90%. For investors who find it tempting to buy the dip, however, there are many reasons to stay away from the stock.
Most crucially, it is simply not the cultural norm for people to drink coffee in China, where the average Chinese person only drinks 0.014 cups of coffee per day. That's astonishingly low compared to the 1.1 cups of coffee the average American drinks on a daily basis.
Keep in mind, the reason behind the company fabricating its financials was to "demonstrate" that it had the potential to outcompete Starbucks. Now that the house of cards has come crumbling down, it is difficult to see how Luckin coffee can generate genuine consumer traffic at thousands of its stores. With so many players in a hypercompetitive market, the worst is probably yet to come for Luckin coffee.
2. Eastman Kodak
In late July, shares of digital camera company Eastman Kodak (KODK -1.93%) looked like they were finally about to turn around seven years of underperformance, with the announcement that the Department of Defense (DoD) will be awarding the company a $765 million loan for it to manufacture generic drug ingredients.
Fast forward three months later, and Kodak stock is once again going through tough times, after allegations of rampant insider trading in anticipation of the deal announcement and questionable tax avoidance tactics by one of its board members forced the DoD to halt the deal.
In September, a law firm hired by Kodak cleared the company of any wrongdoing, which ironically brings up a new problem of conflict of interest rather than inspire confidence. The company is still pending outcomes of an investigation by the Securities and Exchange Commission (SEC).
Even if the company miraculously gets the loan back, take note that it's still a loan as opposed to an equity investment. The generic drug sector is already highly saturated as it is. Suppose Kodak invests hundreds of millions in new manufacturing facilities and sees little return on investment. In that case, it has little chance of paying back the DoD, as a $765 million debt is almost 64 times the size of Kodak's annual cash flow.
Unfortunately, the advent of smartphones is rapidly rendering digital cameras archaic, as well as squeezing out traditional photo printing services. During the second quarter of 2020, Eastman Kodak's revenue decreased from $307 million in second quarter 2019 to $213 million, while its non-cash operating loss (EBITDA) increased from $1 million to $7 million over the same time period. The stock is now down nearly 85% from its high of $60 per share in July.
3. Nikola
At one point in time, electric car company Nikola's (NKLA -2.41%) market cap soared to as much as $34 billion after it disclosed that it discovered a breakthrough in vehicle battery technology. Unlike its competitor Tesla Motors, however, Nikola did not disclose the chemical composition of its supposed battery, nor any information about which university it partnered with to develop the technology.
With the help of short-selling firm Hindenburg Research digging through some financials in September, it turned out that Nikola made its breakthrough claim days before it signed a letter-of-intent to acquire car battery start-up ZapGo, who in turn boasted that they had developed a groundbreaking carbon-ion battery that is significantly more energy efficient than commercially available variants.
Before the acquisition could go through, ZapGo's President of U.S. Operations resigned over prostitution and tax fraud allegations. The two companies are now embroiled in a lawsuit with Nikola alleging ZapGo made false or misleading statements regarding its technology. ZapGo took the initial steps to declaring insolvency in July, which is highly uncanny for a company possessing a major technological advancement.
We will not know for sure until after the fact whether or not Nikola actually has the capacity to deliver its promise on a revolutionary battery. The odds, however, are not good. According to General Motors employees who have witnessed Nikola's operations, the company's battery and fuel technology were inferior to that of General Motors'. Both the SEC and the Department of Justice are investing allegations of misconduct against Nikola.
If drowning in controversy isn't enough, Nikola's financials are also nothing to be excited about. In the second quarter of 2020, the company generated just $36k in revenue, compared to a stunning net loss of $100 million. That's mind-boggling for a company with a market cap of $9 billion. In just four months, shares are down over 70% from its high in June.
