How China Small-Caps Can Come Clean

Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. He is a contributing writer to TheStreet whose views on these stocks are independent of TheStreet's news coverage.

BEIJING ( TheStreet) -- On Nov. 19, a certain company listed in the U.S. issued the following press release:
(the "Company") today announced that it will restate its previously issued financial statements for fiscal years 2007, 2008 and 2009 and the first three quarters of fiscal year 2010 (including the quarterly data for fiscal years 2009 and 2010 and its selected financial data for the relevant periods), due to errors identified in these financial statements. This decision was made by the Company's board of directors, upon the recommendation of the audit committee and in consultation with management. As a result of this decision, investors should no longer rely upon the Company's previously released financial statements for these periods and any earnings releases or other communications relating to these periods.
If this were a Chinese small-cap, the consequences would be predictable: widespread allegations of fraud, the stock would plummet 30%-50% and the usual five to 10 lawsuits would roll in within one week. But it wasn't a China small-cap. It was Green Mountain Coffee ( GMCR), and instead of falling, the stock price rose 11% on the day because the restatement was somehow perceived to be not all that bad. So almost four full years of finanicals can no longer be relied upon, and it's "not all that bad!?"


2010 was a rough year for Chinese small-caps, with a number of earnings restatements, allegations of fraud and confirmed outright fraud cases. Companies who have been (rightly or wrongly) impacted include Fuqi International ( FUQI), Rino International ( RINO) Northeast Petroleum ( NEP), China Sky One Medical ( CSKI), China Biotics ( CHBT), China Marine Food Group ( CMFO), China Education Alliance ( CEU) and Orient Paper ( ONP).

I provide additional detail below, but the key conclusion is simple. Obviously, there does exist fraud in some portions of U.S.- listed China stocks. However, the real problem for the larger space as a whole is that these companies are immature in the U.S. capital markets and leave themselves very vulnerable to speculation of fraud even when none exists. As a result, valuations for the entire space have been depressed.

In my opinion, this immaturity in the capital markets can be witnessed in numerous areas including: lack of emphasis on submitting correct domestic State Administration for Industry and Commerce ( SAIC) filings, use of unknown auditors, inaccurate and outdated websites, unprofessional reliance on free email services (such as Yahoo! or Gmail), as well as a lack of responsiveness to investors. None of these things are an absolute indication of fraud, but they do weaken general investor confidence and leave companies vulnerable to speculation by short-sellers. The good news is that many companies (the smart ones) are starting to realize these weaknesses and are beginning to change accordingly.

I address each of these points below.

Lack of emphasis on submitting correct domestic filings

By now, anyone who is familiar with the recent spate of short attacks is well aware that the first line of attack by shorts is to cite the fact that a company's SAIC filings do not match its SEC filings. At first, many investors fell for this ruse blindly and viewed it as concrete evidence of fraud causing massive selloffs in a number of small-cap names.

The issue is actually more complicated than that. Much has been recently written about the significance of discrepancies between SAIC and SEC filings. My experience in dealing with many China small-caps leads me to several conclusions.

1. Minor discrepancies in SAIC filings are no cause for concern due to differences in accounting treatment as well as differences in revenue and income recognition for subsidiaries and international sales.

2. Large discrepancies can be (but are not guaranteed to be) a cause for concern. I have spoken with many Chinese CFOs, and many of them have never even paid attention to their SAIC filings. The filings are a perfunctory administrative filing that is often delegated to junior non-financial staff or even outsourced to third-party filing agents. In addition, these statements are not audited by U.S. or Chinese auditors.

Therefore, in many cases they may have no relation to the legitimate profitability of the company. I do, however, view large discrepancies as a red flag and a cause for concern, partly because it reflects sloppiness on the part of management and partly because it opens up the company to short speculation or an outright short attack

3. The real filings that matter are the SAT (Tax) filings of the Chinese company. The Chinese government is focused on collecting tax revenue, and senior management does pay attention to these filings. As a result, if SAT filings do not match, it can be a cause for significant concern. Unfortunately, unlike SAIC filings, these documents are not public and in fact are almost unobtainable. It is possible to get them in some circumstances and can be a very clear indicator of the presence or absence of fraud.

4. The conclusion is a bit complicated, and many investors miss this important nuance. There are two types of corporate structure for Chinese small-caps, variable interest entities (VIEs) and foreign invested enterprises (FIEs). Getting into all of the details is beyond the scope of this particular article, but I hope to do so later. The relevant point to consider here is that for an FIE structured company, the SAIC and SAT financials are reconciled and audited in China and should definitely match. If they do not, then there exists a high probability of either SEC fraud in the U.S. or tax fraud in China. Neither of these things is good. But if the filings do all match up, then much concern can be alleviated.

The good news going forward is that companies are starting to see the havoc that SAIC filings can wreak upon their company. I am increasingly hearing that going forward, companies will make it a priority to file SAIC filings themselves with attention from senior management and that they will make sure that the filings do indeed reflect the profitability of the business which should therefore also match the SEC filings. What we will see going forward is that historical SAIC filings do not match, but 2010 and onward filings will be largely correct. Also, in my dialogue with Chinese companies, I am strongly suggesting that they make an effort to make their own SAIC and SAT filings public (disclosed on their Web sites). Whether or not this actually happens remains to be seen.

Use of unknown auditors

Many Chinese small-caps began their public existence as tiny micro-cap reverse mergers. They therefore engaged small unknown accounting firms who were cheap and willing to do the work. As the firms grow, it is obviously appropriate to switch to a top 10 auditor, or perhaps even a big four auditor. Large companies who use no-name (or even shady) auditors are a major red flag for me and there have been many times where I avoided a company that had great financials simply due to its choice of auditor.

Again, the good news for 2011 is that this is already starting to change and in this area, Chinese small-caps clearly "get it."

Based on recent discussions with China small-cap companies, I expect to see a wave of auditor upgrades during early 2011; hopefully some will be in time to process 2010 10Ks due out in March or early April. This will greatly enhance investor confidence in the space, and I believe it will help separate the good companies from the bad. Companies who are unwilling to upgrade to a reputable auditor will see their share prices suffer.

Recent examples of auditor upgrades that have recently occurred include:

It should be noted that there are more than 500 Chinese companies that trade in the U.S., and it is simply not feasible for all of them to be using big four auditors. For most of the smaller companies, I am perfectly happy with the selection of a top 10 auditor, including auditors such as BDO or Grant Thornton which have a strong and reputable China practice.

Inaccurate and outdated Web sites

It is important to remember that with many of these companies, senior management is not fluent in English and therefore does not focus on their English language website. This is often delegated to an outside firm to design on a one-time basis, and Web sites are not updated. Clearly, this is unacceptable. I have invested in companies that I felt were very solid, and in my discussions with management, I emphasized that their Web sites (which are often downright pathetic) can be a deterrent to other investors and can therefore impact the stock price.

In my experience, many Chinese companies still don't get it, and I still see many terrible Web sites even at companies that are performing very well financially. Typically, companies that use a solid IR firm will have a better-looking Web site, but that is still no guarantee that it will be updated on a regular basis. I am hopeful that this will start to change, and in some instances, I see progress, but in 2011, I still expect to see many pathetic Web sites for Chinese companies.

Also, stating the obvious, even while a great company may have a terrible Web site, a fraudulent company may have a fantastic Web site. The point is that a bad Web site is unacceptable for a company that wants to be shareholder-friendly and, despite being a triviality, it can have an impact on investor demand for the shares, thus affecting the share price.

Unprofessional reliance on free email services

When an investor tries to email the CFO of a NYSE, Nasdaq or Amex-listed company (with a market cap of perhaps several hundred million dollars) and the CFO can only be reached at wang1634@ yahoo.com, it certainly does not inspire confidence. In fact, it immediately conjures up the image of a fraudulent company operating out of someone's basement. With one company, I was so adamant about it changing to professional emails that I even bought a domain name for the company and signed it up for email. The company's excuse was that it had been using the existing Yahoo! email so long that it was reluctant to change. Ultimately, it did acquire a real domain name and now they use professional emails. It took more than a year.

Again, this is very common in China at companies big and small, public and private. It does not raise any eyebrows with investors in China at all, but for companies listed in the U.S., it is not acceptable simply due to the negative image it creates among investors. That said, even a fraudulent company (or perhaps especially a fraudulent company) can have a very professional-looking email address and not be legitimate. My point is that this is just a cosmetic issue that companies need to pay attention to.

Lack of responsiveness to investors

There is a wide gap between Chinese small-caps in terms of their responsiveness to investors. Yesterday, I sent an email to a Chinese small-cap company's internal IR person; he called me within an hour and he was very well informed. In other cases, companies are slow to respond, if they respond at all. Some of this can again be blamed on the language gap, but for larger companies, they either need to be able to respond to investors on a timely basis or cough up some money and hire an external IR firm. The ones who figure this out will trade much better than the ones who don't and as a rule I make it a point to not invest in companies who are not responsive.

The conclusion I reach from all of this is that, while there are frauds in Chinese small caps, the very widespread lack of confidence and depressed valuations for the space as a whole are a crisis of their own making. Some companies will figure this out and make the right changes and will see a benefit to their share price, others will not and will continue to languish.

My goal in 2011 will be to distinguish between the companies that can make these changes on a rapid basis and restore investor confidence. Obviously, the most important changes will be the switch to focusing on filing correct SAIC documents (and hopefully disclosing them) as well as the upgrading of auditors. I am hopeful that we will see significant progress in this area in the first quarter of 2011 and I will be sure to highlight companies that are making the right moves.

Disclosure: The author is long ONP.

The author can be reached at comments @ pearsoninvestment.com.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

Rick Pearson is a Beijing-based private investor focusing on U.S.-listed China small-cap stocks. Until 2005, Pearson was a director at Deutsche Bank, spending nine years in equity capital markets in New York, Hong Kong and London. Previously, he spent time working in venture capital in Beijing. Mr. Pearson graduated magna cum laude with a degree in finance from the University of Southern California and studied Mandarin for six years. He has frequently lived, worked and traveled in China since 1992.

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