Fanhua Targets Burgeoning Middle Class Chinese Consumer

  PRIME SERIES  


Fanhua, Inc. (FANH:  Nasdaq) is an insurance agency representing life, property and casualty products to China consumers.  Additionally, the Company provides claims adjusting services for insurance providers.  The company has its roots in two operations founded separately over twenty years ago and focused on car rental services and automobile emergency services.  A series of acquisitions and new business starts have helped form Fanhua’s insurance-focused business model. 

These strategic investments have given Fanhua the capacity to capitalize on a wave of change in the mainland China economy  -  a fast growing middle class.  Indeed, the Chinese consumer is in a state of metamorphosis.  Rising incomes have helped grow the middle class population group by seven times since the turn of the century.  With new found disposable income the group is purchasing cars and homes as well as providing for their future through education and savings.   Now consumers want to protect their accomplishments.  Insurance has become a key element in the evolving China economy.

Foothold in Rapidly Evolving Industry

Fanhua has an enviable competitive position in China’s insurance sector.  The company has retail market presence with sales and services offices as well as a large and growing sales representative network in a number of desirable urban centers where the middle income target group can be found. Importantly, aggressive adoption of digital technologies such as mobile applications and social media platforms is making it possible for Fanhua to reach an even wider audience.

Modernization of its distribution methods appears to be a key to success for Fanhua in the fast-moving insurance market in China.  The company is leveraging both business-to-business and business-to-consumer technologies using Internet websites, mobile applications and the widely accepted WeChat messaging, social media and payments platform. 

Fanhua launched its CNpad portal for auto insurance sales agents in January 2012.  Since then the company has added other platforms for both sales personnel and consumers.  The most recent innovation is the Lan Zhanggui platform launched in September 2017 to serve independent sale agents.  In addition to transaction processing, there are features for policy comparisons and proposals. 

As of December 2018, the Company claimed over 800,000 users had registered with Lan Zhanggui, of which 150,761 were considered active by having sold at least one insurance policy in the year.  Active users on the platform delivered 97.2% of total new life insurance sales during the full year 2018, making clear the importance of digital technology in competitive distribution of insurance products and services in the China market.

Low Hanging Fruit on a Big Tree

According to Atlas Magazine, a provider of insurance news, the rate of insurance usage in China was just 0.10% in 1980.  By the turn of the century, 1.59% of China’s consumers had begun taking advantage of insurance policy protections.  The pace of adoption has accelerated in the last two decades, bringing the overall insurance penetration rate in China to 4.42% at the end of 2017.  Life policies appear to have the greatest appeal, reaching a penetration rate of 2.59% compared to 1.83% for all other insurance types.

Yet by comparison to neighboring Hong Kong and Taiwan where insurance usage rates are 15% and 16%, respectively, mainland China remains largely uninsured.  The international law firm of Winston & Strawn LLP estimates that at the end of 2017, China’s protection gap was as much as RMB124 trillion (US$18 trillion).  This suggests there will be ample opportunity for Fanhua to capture market share for many years to come.

Industry under Scrutiny

The China insurance market is a enticing for its growth potential.  However, there are risks.  China’s insurance industry is under new, more intense scrutiny.  The central government through the CIRC and now the CBIRC has moved steadily in recent years to tighten regulation of the insurance industry, particularly the corporate activities of insurance providers.  There appears to be new enthusiasm to monitor and enforce the quality and adequacy of capital reserves.   New solvency regulations require a mark-to-market dynamic and shift away from the book-value accounting practices that had tempted some insurers to undertake risky investments. 

As a consequence there is potential for disruption in Fanhua’s revenue stream if one or more of its significant insurance company partners are singled out for regulatory action.  In 2018, three of Fanhua’s contracted insurance companies accounted for over two-thirds of the company’s total net revenue. 

Regulatory reform also presents opportunity for Fanhua.  In November 2017, China’s central government moved to relax limits on foreign shareholding in the capital of domestic insurance companies.  At the end of 2017, only fifty foreign insurers  -  28 in life insurance and 22 in non-life categories  -  accounted for just 6% of China’s life insurance market and 2% of the non-life market.  According to the Insurance Association of China, in the first four months of 2019, foreign insurance companies increased market share by 1.8% year-on-year to 6.8% of original insurance premium income.

Fanhua has already signed distribution agreements with the China affiliates of Liberty Mutual Insurance and American International Group (AIG).  Fanhua management believes its robust sales agent network and well established Internet and mobile platforms are appealing to foreign insurance providers who want to quickly and cost effectively capture a share of the China market. 

Profits and Cash Flow Generation

Fanhua’s revenue in the most recently reported twelve months totaled RBM 3.6 billion (US$617.5 million).  Life insurance sales now provides the majority of revenue for the company, reaching 82.7% of total sales in 2018,  compared to 59.3% contribution to the top-line in the previous year.  Fees from claims adjusting services climbed to 9.4% of total sales in 2018, surpassing revenue from P&C insurance sales at 7.9% of the total.

The company has a decades-long track record in earning profits by offering high quality products to consumers and leveraging relationships with reliable insurance providers. Recent profits have been elevated through critical strategic decisions by Fanhua’s management team to divest of unprofitable brokerage operations and to fundamentally change sales tactics from a dedicated sales team to a platform model for property and casualty insurance products. 

Fanhua converted 15.1% of revenue to operating cash flow in 2018, a dramatically higher rate of cash generation than the previous year when the sales-to-cash conversion rate was 3.7%.  Consistent delivery of positive cash flow bodes well for future growth investment.  It also supports continuation of the quarter dividend and the share repurchase plan, both of which deliver returns to shareholders.

Ownership and Valuation

A valuation exercise using both the dividend discount model and comparable method suggests the intrinsic value of the ADS is $37.45 while the implied future price at year end is year-end 2019 is $41.00.  The analysis implies undervaluation at the current price level and potential for future price appreciation.

Fanhua shares are closely held.  Senior executives and directors hold a significant stake, totaling 21.1% of outstanding ordinary shares.   The company’s remaining co-founder and director is the company’s single largest individual shareholder with a stake representing 14.6% of total outstanding ordinary shares.  Another significant block of shares is locked up in an employee stock program.  At the end of June 2019, a total of 280.0 million shares or 14.0 million ADS had been invested in the plan and are held by three separate legal entities for plan participants.  The largest of the three plans holding 200 million shares (10 million ADS) represents 14.7% of shares outstanding.

As of March 31, 2019, the Company’s depositor for its ADS held approximately 48.1% of the ordinary shares outstanding at the time or approximately 30.1 million ADS.  Management indicates that subsequent to new ADS issuances and repurchases by the Company through its 2019 shares repurchase program there are now approximately 31.9 million ADS outstanding.  We estimate that the constructive flotation of ADS is approximately 17.9 million, plenty for institutional and retail investors alike to take serious long positions.

Outlook

Top-most among catalysts for the FANH ADS price is likely to be strong quarterly sales and earnings comparisons throughout the balance of 2019.  The company’s quarter reports have become more and more detailed in content particularly related to productivity metrics.  That is making it easier for investors to track and evaluate period-to-period performance. 

Nonetheless, not all shareholders have been happy.  Fanhua is facing a shareholder lawsuit filed in early 2019.  The case is at an early stage with both plaintiff and defendant filing initial briefs with the court, but no trial date has been set.  News of the various steps in the legal action could roil trading in the ADS.

The shareholder lawsuit makes it clear that Fanhua has been vulnerable in the past to so-called ‘short and distort’ stock publications.  Such reports often offer up innuendo and conjecture as proof of nefarious conduct by insiders.  To sort through it all investors are highly dependent upon the veracity of the company’s financial reports and the thoroughness of the auditors. 

Fanhua’s auditor, while an independent public accounting firm and affiliated with a prestigious U.S. accounting firm, is not currently inspected by the U.S. PCAOB, the private sector non-profit organization set up to promote accuracy and independence in audit reports.  The PCAOB has not been allowed to inspect accounting firms in the PRC which are auditing Chinese companies that trade on U.S. exchanges.  There is a risk that the Company’s filings, which are reliant on audits performed by its accounting firm, could be rejected by the U.S. Securities and Exchange Commission (SEC) in the future.

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.

Crystal Equity Research has issued a rating and recommendation on Fanhua ADS under the CER Reports series for issuer subscribed research coverage.  The report is available at the Crystal Equity Research website.

Underwriters of the Prime series may have a beneficial interest in, serve as agents of, or act as advisors to the companies mentioned herein.