Fanhua, Inc. (NASDAQ: FANH)

SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) Fanhua, Inc. (NASDAQ: FANH) A Questionable Company with a History of Alleged Fraud, Potential 79-100% Downside “The work that I’m doing now, it’s not for the faint of heart,” said Markscheid, who travels to China for board meetings from his home near Chicago, in Wilmette, Illinois, eight to 10 times a year. “I’ve been sued quite a few times.” -Stephen Markscheid, Independent Director of Fanhua since 2007, interviewed in a trade journal. Source: https://www.insurancejournal.com/news/national/2013/06/18/295902.htm Market cap $1.7 billion ADV (3 mo) 240k shares EV/Revenue 2.4x Share price $26.15/ADR Short interest 1% to 2.4%, estimate1 EV/EBITDA 21.3x 52 wk high/low $36.83/$8.69 Borrow cost -91 bps/GC P/E 21.5x Target price $0 to $5.49/ADR Prices/valuations as of market close 8/24/18, per Bloomberg, Capital IQ, and our analysis. THIS ARTICLE REPRESENTS THE CURRENT OPINIONS OF SELIGMAN INVESTMENTS CONCERNING FANHUA INC. (FANH). Funds and accounts managed by Seligman Investments currently have short positions in FANH and therefore stand to realize significant gains in the event that the price of its stock declines. Although Seligman Investments does not expect to announce in the future any changes to its opinion concerning FANH, that is subject to change at any time. Following publication of this article, Seligman Investments intends to continue transacting in FANH’s stock, and it may cover its short position and/or be long, short, or neutral at any time hereafter regardless of the views stated herein. This article is for informational purposes only and does not constitute investment advice or a recommendation to purchase or sell any particular security or to pursue any particular investment or trading strategy. Seligman Investments cannot guarantee that any projection or opinion expressed in this article will be realized. Seligman Investment’s opinions are based on the public information and sources cited in this article, but Seligman Investments cannot and does not provide any representations or warranties with respect to the accuracy of those materials. In no event shall Seligman Investments or any of its affiliates be liable for any claims, losses, costs or damages of any kind, including direct, indirect, punitive, exemplary, incidental, special or, consequential damages, arising out of or in any way connected with any information in this article. Related parties and affiliates of Seligman Investments manage other funds and accounts aside from those managed by Seligman Investments. These other funds and accounts may have (i) a long, neutral, or short position in FANH’s stock or other securities and instruments and/or (ii) different opinions concerning FANH than those expressed in this article. In addition, such other accounts may trade in the same securities or instruments of FANH at the same time, in the same or opposite direction or in a different sequence as the accounts managed by Seligman Investments. Summary Fanhua (FANH) is a Chinese company that trades in the US via an ADR. It resells life insurance through an agency/commission model via a network of sales agents, serving as an outsourced sales channel for sub- scale insurers. The company claims to have 631,000 sales agents, and has been characterized as “China’s leading independent insurance distribution channel” in a sell-side report.2 1 SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) Unknown to some investors, Fanhua was previously known as CNinsure (prior ticker: CISG), and now trades under a new name and ticker. The corporate name change may make it difficult for investors to discern the company’s checkered and turbulent past. CNinsure’s stock crashed in the wake of allegations of fraud, followed by an abrupt collapse in its growth rate and margins. The company went public in the US in 2007 and peaked in 2010 at $28/ADR, before falling to $5 after a research firm published a series of meticulously detailed reports, similar to reports that exposed companies such as Sino-Forest, Orient Paper, and others during the offshore reverse-merger wave earlier this decade. Shareholders alleged that the CEO and CFO engaged in “a fraudulent scheme and course of conduct that operated as fraud.”3 CISG became an abandoned stock and hovered between $5-8 for years, an impressive feat relative to the de-listings and bankruptcies among its cohort. The company then changed its name to Fanhua in December 2016. The name change initially had little effect, but the stock picked up steam when the company re-gained sell-side coverage by a prominent US bank in late 2017. As the company re-acquired a measure of institutional sponsorship and validation, the share price exploded. In the past year, the stock has risen from about $8/share to a recent high of $37 in June 2018 – a remarkable, parabolic move for a stock that until recently was orphaned and traded below the value of its cash for long stretches of the past seven years.4 Based on due diligence of SAIC filings and other public information, we are deeply concerned about the company’s business practices. We believe that these practices bear a worrisome resemblance to those alleged in 2010, and that they have intensified as the stock has recently plateaued. Our concerns center on the company transferring cash to insiders via related-party transactions; overstating the size of its operations; acquiring companies from undisclosed related parties in suspicious transactions; reporting questionable revenues and earnings, with sharply elevated receivables to a firm not disclosed as a related party; discrepancies between earnings and cash flows; involvement with individuals who have been sanctioned by regulators in Hong Kong or who are linked to companies with histories of embezzlement, de-listing, bankruptcy, or SEC prosecution; and high dependence on questionable partners/customers, in this case ones that are a focus of regulatory action in China. Given FANH’s history and current dynamics, our target price is $5.49 per ADS, a 79% decline from its last close. We believe shares may be worth $0. The last time investors purchased stock at these levels, it declined 85%. We believe a similar outcome is brewing. In particular, we note further accounting discrepancies in the most recent quarter, reported last week on August 20, that lead us to question the reported results. Accounts receivable spiked and are up 52% year-over-year while total revenues are down 4%. The company reported rising margins and the highest EBIT and earnings in a year, yet operating cash flows are negative – red flags that typically appear near a tipping point. A summary of our conclusions, as detailed in the following 79 page report: • Fanhua, when it was still named CNinsure, was accused of fraud, after an independent research firm published various allegations in 2010/2011. We review these allegations in great detail, as they suggest patterns that investors can use to detect what is currently unfolding. Please note that we use both company names interchangeably in this report, as it is the same enterprise. (p. 7-15) 2 SELIGMAN INVESTMENTS | Fanhua, Inc. (NASDAQ: FANH) • The cast of players from the prior episode is still in charge or otherwise involved with the company. Our review of the timeline of events in 2010/2011 leads us to conclude that management has a long pattern of engaging in behavior that we believe most investors would find troubling. Recent events indicate, to us, that the team has failed to absorb the lessons of the last debacle. • In the aftermath of the last episode, management attempted to take the company private in partnership with a private equity firm. The proposal was withdrawn a few months later. A Financial Times article at the time indicated the PE firm spent $10mm on due diligence and “uncovered things in the course of due diligence that led the firm to call off the deal” such as “accounting issues” and “discrepancies” in the books.5 (p. 16) • The US bank that initiated coverage of Fanhua in October 2017 with an overweight rating – coverage that we believe was responsible for the stock coming back to life – abruptly suspended its rating, price target, and estimates on July 2, 2018, despite issuing six bullish reports in that span and as recently as May. No explanation was provided, except “due to policy reasons.” This is reminiscent of virtually the entire sell-side terminating coverage in the aftermath of the alleged fraud in 2010/2011. As far as we can tell, per Bloomberg and the company’s investor relations page, the only remaining firm covering FANH is CICC in China. • We believe the company is grossly exaggerating its number of insurance sales agents, and hence its potential for growth. Sales force size and growth are the company’s most critical operating metrics, highlighted in virtually every press release and conference call since their IPO. Our analysis suggests that the actual size of its sales channel is a mere 1/20th of the reported number. We find this to be deeply troubling, as it is reminiscent of allegations raised in 2010, which centered on unsustainable and questionable practices related to its sales agents. We also note risks arising from the multi-level marketing element of Fanhua’s sales force, given the regulatory scrutiny that these structures are currently facing. (p. 17-23) • A vast majority of the company’s life insurance revenue, approximately 80%, is derived from just two partners. Fanhua’s partners – effectively customers – are life insurers that supply and underwrite the policies that Fanhua distributes in exchange for commissions, which comprise most of its revenue.

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