ZhongAn Insurance IPO Draws Attention to Low Valuation of Fanhua

  • ZhongAn has just completed an IPO and the money-losing company closed ts first day of trading with a market cap of US$12Bn, 4.9X book value.
  • ZhongAn’s revenues are almost entirely from online sales of non-traditional products (e.g. Shipping Return insurance) and novelty products (e.g. Phone Screen Crack insurance)
  • Fanhua acts as an agent for sales of traditional insurance policies (auto. life, health etc…) through a variety of O2O channels
  • Fanhua shares are currently valued at 13X trailing earnings and 1.2X book value
  • China’s insurance sector has strong long-term prospects.  Both companies are likely to continue growing much faster than the sector.

The Hong Kong IPO of ZhongAn Insurance (HK:6060) (press release) has drawn attention to Fanhua (FANH) which has been listed in New York since 2007.  Both companies benefit from long-term growth potential of insurance in China.  ZhongAn’s prospectus includes a forecast that the overall insurance market in China will grow at a CAGR of 9.6% over the next 5 years.

PRC Insurance Market ZA prospectus page 108

Insurance premiums will grow along with the expansion in the Chinese economy and also an expected growth in insurance penetration which currently lags other Asian and major international markets (source Fanhua 1Q Investor presentation)

Insurance Penetration Fanhua presentation

China has well-established underwriters of traditional life, property, and health insurance.  These companies have a large market presence and huge financial resources (market share data from CIRC):

China P&C Pie

CHina Life Pie

Both Fanhua and ZhongAn are achieving high growth through technological innovation:

  • Fanhua controls China’s largest network of independent insurance agents and provides them with an app (CNPad) which efficiently integrates marketing support and transaction processing.
  • ZhongAn primarily offers insurance services integrated with processing of transactions on third party websites (e.g. travel insurance offered as an option with tickets purchased on Ctrip).

The companies present very different opportunities for investors:

  • Fanhua is an established market leader with high growth, modest share valuation, and regular dividend payout.
  • ZhongAn is unlikely to ever earn significant profits from its current business despite rapidly rising transaction volumes, but the high valuation of the stock is a leap of faith that the company will realize future profits from application of”big data” analysis of customer consumption patterns to pricing of traditional insurance products.

Financial Results for comparison:

FANH ZA Income Statements

Key Ratios:

FANh ZA Ratios

Fanhua Business Review

Fanhua was founded in 1999 and grew with support of international private equity companies (Cathay Capital and CDH) and then went public in 2007.  The company expanded by opening new branches and acquiring established agencies.  In the past 2 years the number of affiliated agents grew rapidly without acquisitions as the proprietary CNPad app became a major competitive advantage because it enabled agents to do more business and the company to process transactions more efficiently.  Fanhua sees several drivers of future growth:

  • Deregulation of insurance policy terms gives consumers more choices and increases the potential role for independent professional agents.
  • Technology of the CNPad app encourages agents to join Fanhua.  An overview of CNPad functionality for agent recruitment is presented online here.
  • The established network of agents should be able to sell a broader range of financial services including mutual funds, wealth management products, and credit services.  When these products require licenses the referring agent will get a fee and the transaction will be processed at a branch with the appropriate trained staff.  Fanhua organized and retained a 15% ownership interest in Puyifund which has received a license to distribute mutual funds.  Additional detail is available at www.puyifund.com
  • Online sales of insurance products through the company’s ecommerce site baoxian.com and related wechat channel have generated modest premiums to date, but registration of over 1mm accounts provides valuable sales leads for company agents.
  • The company’s ehuzhu mutual aid program provides a free platform for which anybody can register to provide aid (up to 3RMB) and in turn receive aid in the event of certain medical needs.  The service is administered on a non-profit basis by Fanhua, but registration of over 1.8mm accounts provides valuable sales leads for company agents.

Fanhua’s primary business is transitioning away from P&C insurance sales (especially personal auto insurance).  P&C insurance sales provided high transaction volume but the company mentioned in the 2q17 conference call that gross margin was only 7.4% of revenues and left minimal return after related operating costs were 7.0% of revenue.  The company is changing P&C distribution from the past commission basis towards a “platform” basis where insurance companies will pay for listing their policies on the CNPad system used by agents.  Fanhua will no longer function as an intermediary for any completed transactions and agents will receive commissions directly from insurers.

Fanhua is now enjoying very rapid growth in its life insurance business.  The industry is less concentrated than P&C (see pie chart above) and small/mid sized firms see a significant benefit from using Fanhua’s agents rather than developing their own national sales force.   So far this year the largest providers of life policies through Fanhua have been Huaxia and Tianan, the #10 and #11 largest life insurers.

The transition in the P&C business makes it difficult to forecast Fanhua results for the next few quarters.  Reported revenues will fall due to removal of the P&C sales commissions, but it will be interesting to hear company commentary about the volume of P&C business transacted under the new platform model.  The company’s net income is being driven by the rapid growth of the agent network (328,000 at 6/30/17 up 117% yoy) and growth in sales of life insurance (+188% in 2Q17 vs 2Q16).  The company’s insurance P&C business has traditionally been stronger in the second half of the year (58% of 2016 revenues were in 2H16), but the life insurance industry does more business in the first half.

Fanhua is in strong financial condition with no long term debt and net working capital of $486mm ($7.87/share).  The insurance agency business is asset-light because the company does not need to hold reserves against potential claims.  Fanhua can finance its expected growth using its large cash position and return a substantial portion of operating earnings to shareholders through a recently announced quarterly dividend policy (minimum 50% payout ratio).  If this policy had been in place over the past year then the dividend yield over the past 12 months would be about 3.8%

Fanhua’s stock price over the next year may be significantly affected by the fate of shares purchased at an average price of $5.53/ADS by an employee ownership plan in 2014 using $41.5mm of loans from the company (LINK).  The original term of the loan was 2 years, but maturity was extended to June 2018.  In May 2017 the company filed a Registration Statement that would enable the employees to sell those shares, but it was withdrawn in June with the explanation that the employees “do not desire to sell their shares in a public offering in the U.S. at this time”.  The loan maturity could be extended again, but the initial filing of the Registration Statement hints that employees are looking to realize their gain in one way or another.  It also suggests that management may do whatever it can to maximize the price of FANH shares over the next year.

ZhongAn Business Overview

ZhongAn (ZA) was founded in 2013 by Alibaba to provide services related to ecommerce transactions.  The company describes itself as the largest “online-only” insurance company in China which obscures its position relative to many better established insurance companies which have both online and offline distribution and Fanhua which acts an an agent both online and offline.  ZA’s initial business was insurance covering the cost of return shipping of goods to merchants on the Alibaba controlled platforms TMALL and TAOBAO.  The concept of integration of insurance service into ecommerce transactions has been expanded to other “ecosystem partners” such as sale of travel policies through Ctrip and so on.  The advantages of this business model are:

  • extremely rapid growth in number of customers served
  • very efficient operation that reached a peak transaction processing volume of 13000 policies/second in 2016

The disadvantages are:

  • All of the transaction value is captured by the ecosystem partner.  39% of ZhongAn’s 2016 premium revenue was paid back as fees to ecosystem partners.
  • Partnerships are non-exclusive.  Other insurance companies can offer shipping return insurance via TMALL and travel insurance via Ctrip etc…
  • Premiums for ZA’s specialized policies are very low.  Average premiums received per active customer in 2016 were only 9.9RMB (US$1.52).
  • Policies like Drone Accident Insurance and Mobike e-Commerce Platform Liability Insurance appear to be suited to the desire of the ecosystem partner to boost transaction prices.  These policies have low loss ratios, but likely have very low real value to the customer except perhaps for a psychological feeling of being safe and responsible.

ZhongAn’s revenues rose 49% in 2016, but the company might not make any money even if volume in its current products/channels increased 500%.  To date ZA has done a very limited amount of business in traditional insurance policies (life, health, P&C).  However it is possible that the huge database of customer behavior accumulated through the ecosystem partners may hold valuable predictive signals about underwriting risk of traditional insurance policies.  As an example, AI analysis of data might reveal that a person getting a weekly shipment of baijiu is at above average risk of accidents.  It’s very plausible that the company’s “visionary management team” and “strong data analytics capabilities” will discover patterns with real economic value, but it will take years to accumulate enough loss underwriting experience for these patterns to be discovered and tested.  It’s very hard to quantify the value of that potential right now.  The market says US$12Bn.  Time will tell.

What if?

ZhongAn’s IPO has provided capital far in excess of current insurance regulatory requirements and the company’s high market valuation implies high investor expectations for company performance.  It will take years to accumulate and test the ability of “big data” analytics to maximize the profitability of insurance underwriting.  It will take years for ZA to grow its current very low market share in traditional insurance products.  Higher value products like life insurance may always come with higher customer service expectations that require more human interaction.  ZhongAn could address many of these issues by acquiring a significant equity stake in Fanhua.  Potential benefits to ZhongAn would be:

  • Immediately accretive by financial metrics
  • Growth of ZA exposure to traditional insurance product lines and profitability could come much sooner than currently expected by investors and would therefore be likely to receive a favorable market reaction.
  • Asset-light acquisition would significantly increase ZhongAn’s market presence without increasing regulatory capital requirements.
  • Connection with a very large network of established agents that would enable ZA to improve personal customer service and develop new O2O marketing strategies.
  • Consolidation would reduce potential online competition and also prevent Fanhua from falling under the control of a rival internet group.

Potential benefits to Fanhua would be:

  • Possible premium price depending on the degree of control acquired
  • Favorable market reaction highly likely if a minority interest is acquired, possibly through ZA purchase of some/all shares held under the employee ownership plan.
  • Consolidation reduces potential online competition
  • Broader range of product offerings and management insights would enable existing Fanhua agents to become more productive.

Any such transaction would have to balance the different current market roles of Fanhua (as an agent) and ZhongAn (as an underwriter).  Both companies currently sell insurance through their own websites, but these sites are not the primary distribution channel for either company.  ZA is actually one of the companies whose policies are currently offered for sale through Fanhua’s baoxian.com (LINK).  Fanhua has established relationships with 92 insurance companies so a transaction with ZA would have to be structured and managed in a way that did not harm Fanhua’s other partnerships.

In 2014 Fanhua indicated that it was interested in cooperation with China’s major internet companies (i.e. Alibaba, Tencent, Baidu), but that the company’s first priority was to strengthen its own business in order to increase its bargaining power in any such negotiations (2Q14 conference call transcript).  A transaction with ZhongAn could be consistent with that approach.

Disclosures and Notes:

The author is a Fanhua shareholder and believes that greater public awareness of the facts in this article could be of benefit to himself and other public shareholders. Investors are encouraged to check all of the key facts cited here prior to making their own investment decisions.

The author suggests that an investment in Fanhua would be beneficial to ZhongAn, but the author is not aware of any expression of interest by ZhongAn in such a transaction.

The author suggests that an investment by ZhongAn would be beneficial to Fanhua, but the author is not aware of any recent expression of interest by Fanhua in such a transaction.

The large block of Fanhua shares held by the employee ownership plan could encourage company management to maximize shareholder value in the near-term.  However there is also a risk that registration and public sale of these shares could significantly depress the price of Fanhua stock.

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