FAB Universal Dilution Date Deadline Looming

Nov. 7.13 | About: FAB Universal (FU)

Introduction

FAB Universal (NYSEMKT:FU) is a reverse merger Chinese media company that has been called out for paid promotions, rapid insider selling, and opaque investor relations communication. The shares of the company's common stock saw a dramatic rise above $11 per share before sliding below $5 and have recently begun a slow climb back towards $7. The company just announced their third quarter earning date, Wednesday November 13th, before the market open.

Once that 10-Q is filed, regardless of the results, there may be serious adverse consequences to long shareholders. Insiders are well aware of this, and have taken steps to prepare their portfolio's accordingly.

Update Since 9/26

Since my first article questioning the business model, public disclosures, and pending dilution, other authors have helped fill in the gaping holes of my short thesis (see here, here, and here). There was also a well publicized tweet (not mine) forewarning of dilution that had (apparently) immediate negative pressure on the stock, questions from NYSE about trading activity, and further insider selling.

There have also been a number of comments questioning things like my short thesis, my intelligence, and my morals. While I won't address the latter two, I did offer to revise or even reverse my short thesis provided FAB Universal address a few simple items related to transparency. Namely:

1) The company provides a directory of the physical locations of their media kiosks so that consumers can know exactly where they are located and investors can verify their existence. (like RedBox does)
2) The company provides a listing of their digital media library, so that consumers and investors can know exactly what content is available for distribution. (like Netflix does)
3) The company presents a sample portfolio of the more than 2400 mobile apps developed by FAB Universal or their subsidiaries that are available on iTunes, Google Play and Amazon. (like Mobisoft and the Golden Gekko does)
4) The company provides independent revenue numbers from each business line in the notes section of the next or as a press release from the last quarterly report. (like Wizzard Software Corp used to)

However, rather than address any of these issues, company insiders decided to sell more stock; including the CEO (see here), and the CFO, twice (see here and here) for a total sale of 40% and 50% of their remaining shares respectively. And, when the NYSE requested they comment by press release (8-K) on the unusual trading activity in the company's stock, they simply sidestepped the issue. The company did, however, confirm the dilution schedule and updated (backdated?) their investor presentation from their website.

Of course, this all begs the question of why bother revisiting the stock now? Everything originally claimed about dilution has been confirmed, while none of the concerns related to operations or the business model have been addressed. The only thing not known at the original publication was when was the conversion and dilution going to take place. Now we know.

Conditions for conversion

From the original press release (8-K) announcing the Share Exchange Agreement we find the exact conditions of conversion:

As additional consideration for the Digital HKCo shares, Wizzard will issue at the Closing 290 shares of its Series B Convertible Preferred Stock (the "Preferred Stock"). The Preferred Stock will have no dividend rights or voting rights or the right to receive any assets of the Company upon liquidation, dissolution or winding up. The Preferred Stock shall be convertible into shares of the Company's common stock in three (3) tranches upon the occurrence of the following conversion events:

(NYSE:I) upon the successful completion of the Corporate Governance Objectives for the four (4) consecutive and complete reporting quarters of the Company immediately following the Closing, UEG or its lawful designees shall have the right to convert the first tranche of 210 shares of Preferred Stock into shares of the Company's common stock;

(ii) upon the successful completion of: (NYSE:A) all of the Corporate Governance Objectives for the four (4) consecutive and complete reporting quarters of the Company immediately following the Closing; and (NYSE:B) a Revenue Objective requiring that the FAB Companies receive sales revenues of at least US$60,000,000 and net income of US$12,000,000 in fiscal year 2011, UEG or its lawful designees shall have the right to convert the second tranche of 40 shares of Preferred Stock into shares of the Company's common stock; and

(NASDAQ:III) upon the successful completion of all of the Corporate Governance Objectives for the six (6) consecutive and complete reporting quarters of the Company immediately following the Closing; and a Revenue Objective requiring that the FAB Companies receive sales revenues of at least US$70,000,000 and net income of US$14,000,000 in fiscal year 2012, UEG or its lawful designees shall have the right to convert the third tranche of 40 shares of Preferred Stock into shares of the Company's common stock.

Upon the occurrence of each conversion event, the three tranches of Preferred Stock will be convertible into a number of shares of common stock that will bring the overall equity position of the Company of the holders of the Initial Company Shares, the Preferred Stock and the common stock issuable upon conversion of the Preferred Stock, on a fully diluted basis as of the date of Closing, to 70%, 74% and 78%, respectively. The precise number of common shares issuable upon conversion of each tranche of Preferred Stock will be determined at Closing, based on the total number of issued and outstanding shares of the Company's common stock on a fully diluted basis at that time. The Company will deliver to UEG at Closing a Certificate of Designation of Preferences, Rights and Limitations of the Preferred Stock as filed with the Colorado Secretary of State.

Once the company files the 10-Q, it will have met the Corporate Governance Objectives for four consecutive reporting quarters immediately following the closing of the reverse merger between Wizzard Software Corporation and Universal Entertainment Group. This will trigger the conversion of the first tranche of special preferred shares issued to Universal. If the company reports sales greater than 60 million dollars (a level it has consistently been above since 2010) and income above 12 million dollars, both first and second tranches will be eligible for conversion.

Resulting dilution

As of the last 10-Q filed in August, FAB Universal had 20,805,860 shares of common stock, par value $0.001, issued and outstanding. Conversion of the first tranche will add 14,689,444 shares to the float. The second tranche adds an additional 5,488,364 shares to the float, for a total combines shares outstanding of 40,983,668 shares issued and outstanding.

Now, I would not be too happy if a company that I owned suddenly took away half of my value through dilution. And, I'm not sure how longs are going to feel once they see their EPS and Return on Equity cut in half, but a quick review of similar dilutions might give us a clue. J.C. Penny (NYSE:JCP) dropped 45% when shareholders were diluted by 35%.

We could look further back, to the dilution in financials like AIG (NYSE:AIG), Bank of America (NYSE:BAC), or Citigroup (NYSE:C), but to do so would not necessarily be fair given the economic environment at the time. But, in these scenarios, there was little to no selling of those new dilutive shares. I doubt that will be the case for FAB Universal.

Conclusion

Time to rehash the bullish talking points and pull out the Jim Rogers form 4's and Goldman Small Cap paid for "analyst" report. Not withstanding the speculative business model claims of outstanding growth in unverifiable locations and continued muddied reports we are asked to take on blind faith. Time to hedge, or better yet, go short.

Disclosure: I am short FAB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have open positions in FAB Universal Put contracts