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After an unnecessarily long delay, on 12/10/13 FAB Universal (NYSEMKT:FU) finally responded, in part, to the numerous issues raised by others and myself. FAB admitted that one of their Chinese "VIE" subsidiaries sold $16.3 million in Chinese bonds without disclosing the issuance to the SEC and U.S. shareholders in violation of numerous Federal securities laws.
The illegal bond issuance was first exposed on 11/15/13. On 11/19/13 FAB CEO Chris Spencer acknowledged receipt of an email from me that contained a copy of the bond prospectus, clearly showing that FAB's VIE subsidiary was the issuer. Even though Chris had evidence in hand that proved the bonds were issued, he nevertheless authorized a press release the following day containing a "vehement denial" of all the allegations.
Chris's reckless behavior lured investors into buying millions of more shares of FAB before trading was finally halted two days later.
In today's report, I challenge FAB's response point by point, showing:
- FAB has failed to take the most basic step allowing investors to verify the existence of its media kiosks.
- FAB does indeed guarantee a minimum return on franchisees' investments.
- FAB has failed to acknowledge its removal of pirated content from its media kiosks.
- FAB's cash confirmations are meaningless.
- FAB's independent directors have yet to agree to meet with me to review the evidence.
Kiosk Business Misunderstanding?
In its response, FAB again failed to provide the locations of its media kiosks, the existence of which I continue to challenge. Instead, FAB asserts that:
"The short sellers have a fundamental, but understandable, misunderstanding of the economics of the Company's business. FAB does not buy, sell or own kiosks. Instead, it sells licenses to operate Intelligent Media kiosks and to use the software to run the kiosks through 40 independent regional agents who are responsible for signing up licensees, deploying the kiosks and reporting the number of installed kiosks."
I do not see where there is any misunderstanding. FAB's SEC filings are reasonably clear about the operation of the kiosk business, as shown below.
According to FAB's 6/1/12 Proxy, the FAB licensing program binds FAB and "each small investor" (the franchisee) as follows [Note: Spelling and grammar errors in the original]:
"FAB licensing program is a merchant program that binds the FAB and each small investor or vendor. Under this program and associated contract, both licensor and lincensee take their joint-business obligations as follows:
- The licensee pays for FAB Kiosk and other equipment and fixtures while the licensor (FAB Media) is responsible for the complete set-up of each FAB outlet from the location selection to construction or conversion, remodeling and equipment installation.
- All FAB outlets will be owned by the licensee, but supervised by a designated management company - Beijing Huzhong Culture Co., Ltd ("Huzhong Culture") in accordance with FAB's distinctive business formats.
- FAB kiosks are linked to the server station through the internet to remain updated. Such maintenances are operated by Huzhong Culture."
Furthermore, FAB's 2012 10-K contains a warning that:
"Our ability to generate revenues from Kiosks depends largely upon our ability to provide licensees networks of Kiosks in desirable locations throughout major urban areas in China. This, in turn, requires that we develop and maintain business relationships with real estate developers, landlords, property managers, hypermarkets, retailers, and other businesses and locations in which we are provided space for our facilities."
The indisputable points from FAB's SEC filings regarding its kiosk business are:
- FAB selects and maintains the locations.
- FAB builds out and installs the kiosks at the locations FAB selects.
- FAB, via Huzhong, supervises the kiosks in operation.
Critically, the FAB Chinese bond prospectus disclosed that Chairman Zhang controls Huzhong. FAB's SEC filings failed to make this same disclosure.
Thus the franchisees (or licensees, as FAB also calls them) are merely investors. It is therefore not surprising to see that FAB in the Proxy mentioned above, actually refers to the franchisee as a "small investor."
As I have explained before, given FAB's control over the kiosk location selection, build-out, and operation of each kiosk, FAB management should be well aware of the precise locations of each of the purported 16,820 media kiosks actively deployed. Publishing a list of the 3,954 Beijing media kiosk locations should be as simple as making a PDF of a spreadsheet, assuming the kiosks exist. There is no need to translate the Chinese addresses since an English list would be harder to verify.
Rather than printing out and publishing the list of media kiosk locations, FAB's Board has wasted a lot of time reviewing franchisee-licensing agreements:
"As part of its preliminary review, the Board has examined data concerning the licenses to operate kiosks entered into by the Company as of September 30, 2013, and has re-verified 12,866 licenses. Verification of the remaining licenses will continue until all licenses have been reviewed."
What was the point of verifying licensing agreements, when the physical existence of the media kiosks is in question?
FAB should simply publish the locations and let investors perform their own verifications. FAB's continued delay in publishing the locations only allows Chairman Zhang more time to cover-up his fraud.
3,954 Beijing Media Kiosks: No More and No Less?
FAB's response asserts that the company has deployed 3,954 media kiosks in Beijing as of 9/30/13. FAB has claimed to have precisely 3,954 media kiosks in Beijing since at least 2011, when FAB disclosed this exact same number in an 8/9/11 press release filed as an 8-K.
Therefore for the past two years, FAB would like investors to believe that its purportedly wildly profitable kiosk business in Beijing has not grown or declined by a single unit. This seems highly unlikely since FAB has an office in Beijing where FAB's Director of Franchisee Sales, Wang Lirong, promotes FAB's kiosk business to potential franchisees. As part of her sales pitch, she pointed out that she franchised a kiosk, herself, in March 2013, participating in FAB's Beijing media kiosk deployments this year. Even so, FAB's Beijing media kiosk count somehow remains stuck at 3,954.
Minimum Guarantee Shenanigans
Regarding the minimum guaranteed return FAB promises on Franchisees' investments, FAB responded:
"To date, the Company has completed a review of 75% of the license contracts and has not identified any instances of a minimum guarantee. FAB maintains that it has never entered into any agreement with an agent or licensee for a minimum return guarantee or stock payment by the Company. Any communication to the contrary was unauthorized and is unenforceable."
Therefore FAB seems to be saying that the sales brochure provided by FAB's Director of Franchisee Sales to my investigators was not approved by FAB. Neither was FAB's Chinese bond issuance approved by FAB. That does not mean that promises of guaranteed minimum returns were not made.
The guaranteed minimum return is clearly spelled out in FAB'S franchisee sales brochure. FAB promises that a franchisee's investment of 80,000 RMB to buy a media kiosk will be worth at least 90,000 RMB after two years, regardless of the profitability of the kiosk.
FAB's response does not mention whether the FAB Board reviewed the operating agreements that accompany the franchising agreements. The operating agreement that my investigators reviewed clearly states that Huzhong guarantees the franchisee's investment of 80,000 RMB per kiosk. Recall, again, that Chairman Zhang controls Huzhong, according to the Chinese bond prospectus.
The operating agreement references an acknowledgement letter agreement that on the surface appears to entitle the franchisee to have his/her kiosk bought back by FAB for cash or stock at a premium to the amount originally invested, in accordance with the terms set forth in the sales brochure. However, the acknowledgement letter contains a contradiction: the brochure promise that FAB "will" buy back the franchisee's kiosk is replaced by the statement that FAB "can" buy back the franchisee's kiosk after two years, creating a loophole for FAB to dishonor the promise made in its sales brochure.
Any potential franchisee who carefully reads the agreement would likely strike out the word "can" and replace with the word "will" before signing it, to match the language of the sales brochure. However, I wouldn't be surprised to learn that many franchisees do not catch the change of terms. In those cases, their 80,000 RMB investment is still guaranteed by Huzhong, according to the operating agreement, but FAB might be able to avoid being forced to buy back the kiosk for 90,000 RMB as stated in the brochure.
FAB has not acknowledged that its Beijing media kiosks contained pirated content that my investigators caught FAB subsequently removing. In its response, FAB simply promised to "…examine its content control processes with the assistance of the independent third party and implement any measures deemed necessary to tighten controls."
Without the pirated content, which included recently released movies not yet available on DVD, FAB's media kiosks will have difficulty attracting consumers. If FAB's Board succeeds at banning the pirated content and eliminating the minimum guaranteed returns, FAB's media kiosk business model is unlikely to attract new franchisees.
New Retail Store Prepayments
Shifting its focus going forward toward digital distribution, FAB decided to cut back new store plans and seeks the return of $17.8 million in new store prepayments purportedly made to third parties over the last year. Were these prepayment ever made in the first place?
FAB reports that it received "cash confirmations" from five bank accounts confirming its cash. Do cash confirmations mean anything in China? Definitely not. Professor Paul Gillis of Peking University explains why, here on his China Accounting Blog.
Additionally, FAB received a cash confirmation from the (unnamed) account where Chairman Zhang had secretly deposited the Chinese bond proceeds. After being busted by GeoInvesting, Zhang returned the bond proceeds to a "FAB Universal" operating account. Since Zhang purportedly returned the proceeds, should he avoid getting charged with fraud? Hopefully not.
I have repeatedly offered to meet with Chris Spencer, FAB's independent directors, and auditor to present my evidence. To date, while Chris Spencer initially expressed interest in meeting, neither Chris, the directors, nor the auditor have arranged a meeting. It is imperative that FAB's newly appointed independent investigators contact me to review my evidence. As I have said before, it is critical for FAB's gatekeepers to take swift action to protect shareholders.
Disclosure: I am short FU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.