Chinese stocks have been under pressure in recent months as U.S. authorities look to tighten their reporting requirements with plans to delist those failing to comply. As a Chinese company with a track record of inaccurate reporting, Luckin Coffee (OTC:LKNC.Y) is definitely in the crosshairs of this new push. But these regulatory challenges don't overshadow the stock's bull thesis. Let's dig deeper.
1. Regulation keeps management honest
Luckin Coffee was arguably the impetus for U.S. authorities to clamp down on U.S.-listed Chinese stocks. Starting in 2019, the company falsified around $300 million worth of retail sales, leading to multiple lawsuits, a C-suite reshuffle, and calls for more regulation of Chinese equities.
In 2020, Congress passed the Holding Foreign Companies Accountable Act (HFCAA), designed to open Chinese companies to more comprehensive U.S. audits.
This move directly affects Xiamen-based Luckin Coffee, which in April was added to the Securities and Exchange Commission's (SEC's) list of companies operating from jurisdictions where local laws prevent American authorities from conducting proper financial investigations.
The good news is that Luckin is already delisted from the NASDAQ and now trades in over-the-counter (OTC) markets with less strict reporting requirements. And instead of being a headwind, the regulatory pressure could benefit shareholders by keeping management honest. If Chinese authorities allow Luckin to meet U.S. reporting requirements, the stock could become more trustworthy to U.S. investors -- a bullish catalyst for its stock price.
2. Luckin's business is firing on all cylinders
Lack of trust might be the main thing holding Luckin's stock back, because its business is booming. According to management's fourth-quarter earnings release, net revenue soared 81% year over year to $381.7 million, driven by a pivot to franchise-operated stores, which saw their contributions jump 248% to $70.4 million.
Luckin now boasts 6,024 stores with 1,627 (27%) operating through franchise partnerships.
Image source: Getty Images.
A franchise business model can help Luckin Coffee expand faster by bringing in motivated partners with the capital and skills to run their stores. Many of the world's largest restaurant companies, like McDonald's and Dominos Pizza, have demonstrated the viability of this strategy.
With a market cap of just $2.2 billion, Luckin Coffee's valuation looks relatively cheap for a business growing at high double digits. The stock trades for a price-to-sales (P/S) ratio of just 1.8, which is significantly lower than its much bigger rival Starbucks, which trades for three times sales. Regulatory uncertainty is probably a big reason for the disparity.
Risk vs. reward
Risk often correlates with reward in the stock market. And companies facing uncertainty tend to trade for a discount, giving them more potential for equity growth when these challenges are resolved. Luckin Coffee's stock looks oversold because of delisting fears. Regulatory pressure could actually help improve its valuation by making its financials more trustworthy to U.S. investors.
