Description

I advocate a short position in the common stock of Fanhua, Inc. (“FANH” or the “Company”) – current price $3.05, as it is overvalued by the market with an intrinsic value of ~$1.28, representing upside of approximately 57%. 

The Short thesis for this $165M market cap Chinese based insurance distributor focuses primarily on questionable reporting and behavior (for the second time) by management, customer concentration, regulatory issues and low quality earnings. FANH’s valuation benefitted in part due to the market giving credit to management for pivoting the Company from P&C to Life insurance (higher margin) and the promotional activities of management. 

Description and Background

• FANH, is a US listed Chinese company that claims to distribute insurance products. Before Q4 2017, most of its income came from P&C insurance. In Q4 2017, FANH claimed to divest most of its P&C insurance business, as well as its insurance brokerage business. Currently, FANH is described in its disclosures as primarily a distributor of life insurance.
• FANH was previously known as CNinsure (ticker: CISG); the name change occurred in December 2016. CNinsure’s stock crashed over 70% in 2011 following allegations of fraud and an abrupt collapse in its growth rate and margins.
• FANH fka CISG went public in the US in 2007 and peaked in 2010 at $28/ADS, before falling to $5 after research firm OLP published a series of detailed reports in late 2010/early 2011, exposing the fraudulent activities of CISG. The same team at CISG now run FANH and it is essentially the same company aside from the name change.
• The business model of a typical insurance distributor is fairly straightforward in that it works as an outsourced sales force for insurance companies with the distributor taking a commission for policies its sales team is able to sell. P&C policies tend to be lower margin but sticky whereas Life insurance is higher margin with lower residuals. Key revenue drivers are policies written and the strength and productivity of the salesforce/agents.

Short Thesis

• Misrepresenting the size of its salesforce
  • Similar to CSIG, FANH is again misrepresenting the size of its insurance salesforce currently reported at 807,858 agents despite being stagnant from 2010 to 2015 and then growing over eight times since.
  • Not only was Revenue down 15.1% YoY but the number of agents is up 60% over the same period which likely means that either the salesforce isn’t helping drive revenue, it is overstated, or both.
  • The number of agents is surprisingly large for an insurance reseller. For context, China Life and Ping An (the largest) each have roughly double the number of agents but generate over $100B in Revenue each (versus $3.2B in Revenue for FANH). New China Life, with half the agents, generates $22B in Revenue.
• Customer concentration
  • As FANH exits the P&C business (now only 7.9% of total revenue), life insurance comprises 81.7% of total revenues.  However, 2 customers, Huaxia Life Insurance (41%) and Tianin Life Insurance (38%) comprise 79% of this revenue. 
  • Huaxia itself is in government crosshairs having been banned by China’s insurance regulator, the Chinese Insurance Regulatory Commission (CIRC), in December 2016 from selling life insurance for 3 months due to aggressive tactics using life insurance proceeds to invest in the stock market. Its chairman, billionaire Xiao Jianhua, has been in jail since January 2017 for "manipulating stock and futures markets" and "offering bribes on behalf of institutions".
  • As the Huaxia relationship ends, revenue will take a serious hit much like it did when P&C customer People’s Insurance Company of China (PICC), which comprised 45% of revenues at the time, abruptly stopped dealing with FANH in 2017 due to a suspected corrupt relationship. FANH then spun this loss as a pivot to life insurance which is largely what the bull case rests on (higher margin, bigger TAM etc.).
• Regulatory Issues
  • There are two important regulatory issues that affect FANH. The first impacts their ability to hire and retain agents while the second impacts the life insurance policies they sell.
  • In order to hire and retain agents, FANH offers equity incentives to agents with guaranteed rates of return. In addition to being clear violations, the CIRC has rules that crack down on abuses in the use of equity compensation. These rules were put in place to prevent multi-level-marketing/pyramid schemes which became prevalent with the sales of insurance policies. The inability to offer equity compensation in recruiting agents, especially from formidable and established competitors (China Life, Ping An etc.) that currently dominate the market, results in higher compensation expenses for FANH, lowering growth and margins. The CIRC regulations were one of the reasons the fraud exposed in 2010 collapsed.
  • Effective October 1, 2017, the CIRC issued Circular 134 banned the sale of high-risk life insurance products. FANH’s largest customer, Huaxia, is largely dependent on these products which explains the steady decline in the sales of annuity and universal products since 2017 which used to be the major contributors behind the rapid growth in life insurance premiums historically.
• Related party transactions
  • FANH has created a complex “equity compensation plan” known as the 521 Development Plan. It involved setting up funds to purchase 14M ADS’s (22% of the outstanding stock) using a combination of cash and loans. As part of this setup, $247M in cash would be used to purchase 8.5M shares from an undisclosed third party. This was actually not a third party but a founder of FANH (an intentionally undisclosed related party).
  • The 521 plan, a securities offering that was never registered with the SEC, is filled with conflicts that allow self-dealing, using investor money to pay executives, making forgivable loans to employees to purchase stock that isn’t reported etc.
  • FANH has completed numerous acquisitions, mostly of other insurance intermediaries. However, these acquisitions appear to be shell companies that are connected to the founders or senior executives of FANH. The Company either “buys” companies that still retain their existing ownership (rendering these fictitious transactions), transfer existing company assets to entities owned or controlled by executives or sell products for businesses controlled by the founders of FANH.
• Low quality of earnings – all numbers seem suspect
  • Revenues are down 15.1% YoY while receivables are up. Historically, other receivables rose sometimes as high as 300% which likely means that there was a lot of related party activity causing the jump in receivables. Loans to third parties comprised the bulk of other receivables except that these third parties all seem to be related parties.
  • It appears that the core insurance sales business isn’t very profitable with 67% of earnings coming from interest income, investment income, and the company’s 18.5% share in the CNF sub-prime lending business. Investment income (32% of earnings) consists of inter-bank deposits or collective trust products and apparently generates a 13% return on its $226M of short-term investments. The CNF business (29% of earnings) provides home equity loans to sub-prime borrowers, a fairly risky market in China. 
• Valuation
  • In a situation that is potentially fraudulent, one way to value the business is on a cash basis as that is its main asset. Using Cash and Short-Term investments, the cash value yields $1.28/ADS. This however, could be materially impacted lower in the event that management continues to pay insiders with company cash.
  • None of the reported numbers have any credibility (revenues inflated by receivables) coupled with suspect EBIT and earnings numbers since 2017 (prior to which EBIT and earnings were negligible).     
• Risk/reward
  • Upside here is limited as FANH becomes increasingly un-investable.

Risks

• Management could try to take the Company private again (first time was in 2010 as the initial fraud unwound – TPG spent $10M on diligence but then walked away).
• FANH could use more low-quality receivables or related-party transactions to construct revenue and earnings, leading to reported results that cause investors to remain bullish about the stock.
• Stock manipulation by management using other entities due to the concentrated ownership here.

Catalyst

Earnings

More related party transactions