Assessing Chinese ADR Financial Statements

by: James Sands

The focus of this article is to provide an understanding of the differences associated with filing requirements between public companies with registered securities in the United States, and Chinese companies with registered securities that trade on US stock exchanges as American Depository Receipts, ADRs. Thoroughly understanding the financial statements filed with the Securities and Exchange Commission (or SEC), as they relate to the requirements for US public companies and Chinese company ADRs (filing as foreign corporations or entities), is crucial for any investor seeking to review and assess Chinese company ADR financial statements.

Any US company with registered securities is required to file quarterly and annual financial statements, among other disclosures. This is a requirement by the SEC and is stated accordingly within the both the Securities Act of 1933 and the Securities Exchange Act of 1934. Both quarterly and annual financial statements are filed based upon a company's fiscal year of operations. Quarterly statements are filed every three months and are designated as 10-Q filings while annual statements are filed at the end of the fiscal year during the final quarter and are designated as 10-K filings. Similarly, Chinese ADRs with registered securities in the US are required to file financial statements, among other disclosures. A significant factor, however, is that Chinese ADRs are only required to file annual reports and other disclosures. Chinese ADRs do file quarterly updates, however, they tend to be more like a disclosure as compared to US 10-Q filings. Instead of a 10-Q, Chinese ADRs file a 6-K disclosure statement for each quarterly period. It is important to know the particular company's fiscal year in order to distinguish financial quarterly related 6-Ks from other informational disclosure 6-Ks. At the end of the fiscal year and last quarter, Chinese ADRs file a 20-F report, which provides the annual statements for the year.

For comparative purposes, I will use Netsuite, Inc. (NYSE:N) as the US company example and I will also use a few Chinese ADRs including Baidu, Inc. (NASDAQ:BIDU), E-Commerce China Dangdang, Inc. (NYSE:DANG),, Inc. (NASDAQ:SOHU), CNinsure, Inc., (CISG), and 51Job, Inc. (NASDAQ:JOBS).

Focusing on N, for those not familiar with financial statement filings, US companies which file 10-Q and 10-K statements typically provide similar information with respect to the Income Statement, Balance Sheet, and Cash Flow Statement. Quarterly statements obviously focus on each 3-month period and usually aggregate the Cash Flow Statement as each quarter progresses (i.e. Q1 changes in cash flows = $100 million, Q2 changes in cash flows = $50 million; Q2 Cash Flow Statement provides cash flow line items aggregately to disclose the changes in cash flow being $150 million). There are a variety of other information disclosed within 10-Q and 10-K statements. 10-K statements typically provide overviews for the business, risk factors, legal proceedings, selected financial data, controls and procedures, management's discussion and analysis, among other items. One other key item that 10-K statements provide is the report of an independent registered public accounting firm, meaning all financial statements have been audited for the annual period. 10-Q statements provide similar other information disclosed including management's discussion and analysis, controls and procedures, legal proceedings, and risk factors, among others. Quarterly financial information, however, is unaudited. From an analysis perspective, the notes to condensed consolidated financial statements is where many items within the financial statements are explained, accounts for cash and cash equivalents, fixed assets and their depreciation, etc. Management's discussion usually includes critical accounting policies too which are very vital informational pieces as to how companies recognize revenue, amortize assets, etc.

So with debates regarding stock based compensation, deferred revenues, billing cycles aside, combining 10-Q statements and 10-K statements together provide very useful inputs for assessing a company's past performance, quarterly and annual growth sequentially and year over year, and information to forecast a company's future growth.

When comparing the information provided within 10-Q and 10-K statements for N to the Chinese ADRs mentioned above, there is a telling tale of some discrepancies and lack of information. While the only requirement for Chinese ADRs is to file an annual report, I have yet to come across a Chinese ADR that I have researched that did not provide a quarterly disclosure.

BIDU files quarterly 6-K disclosures, usually the same day or soon after they announce the quarter's financial performance. BIDU, like many other Chinese ADRs, includes the following information in their 6-K statements; quarterly highlights, quarterly results, outlook for the next quarter/year, etc. This disclosure serves more like an article publication rather than delving into management discussions, policies, or other financial details and notes. BIDU does not provide quarterly information in US dollar currency either, but rather in Chinese Yuan (CNY or RMB) currency. The 20-F annual report on the other hand, does include similar information as its US counterpart 10-K. An audit is also included by the report of an independent registered public accounting firm. The primary difference when comparing BIDU's 6-K financial statements to N's 10-Q is that BIDU does not disclose a cash flow statement. BIDU rather states the most recent quarter's operating cash flow and capital expenditures. As a long term investor, one of my focuses is on a company's free cash flow. I use multiple metrics to assess cash flow related items. This becomes very problematic on a quarterly basis when researching Chinese ADRs. What is interesting to note is that depending upon the Chinese ADR, there are a variety of ways that cash flow statement information is disclosed.

For instance, doing a quick comparison between BIDU, DANG, SOHU, CISG, and JOBS I created a very simple chart to illustrate the discrepancies between 6-K cash flow information.

As we can see only SOHU and CISG disclose cash flow statements within their 6-K/10-Q. CISG has only recently disclosed the cash flow statement beginning in Q1 2011. Prior to this, they did not include any cash flow information. SOHU, while maintaining corporate headquarters in Beijing China, was incorporated in Delaware and therefore does file both 10-Q and 10-K statements. As noted above, BIDU does not disclose a cash flow statement, but includes the operating cash flow and capital expenditures. DANG oddly for the past four quarters has only included capital expenditures with no additional cash flow information. And lastly, JOBS does not provide any cash flow information at all. Most Chinese ADRs and other ADRs from other countries too tend to fall somewhere within these categories.

I have contacted multiple companies inquiring as to why the information is not included and whether or not it is available. Responses have ranged from referring me to the 20-F annual report to directing me to reconcile GAAP net income and make adjustments for changes in operating assets and liabilities from the past two quarters to determine cash flows.

The lack of cash flow information paints an incomplete picture regarding a major component of many Chinese ADR financial developments. What is interesting is that there are more Chinese ADRs that are providing cash flow statements, which seems to suggest that companies are beginning to realize that transparency of information is very important. This is evidenced by companies adding cash flow statements to their 6-K such as CISG, and, Inc., (NASDAQ:NTES) as another example of a Chinese ADR that discloses cash flow statements each quarterly update. There has yet to be the same transformation as it relates to including financial notes and more in depth management discussions and policy information.

In conclusion, it is very important to strongly consider what information is available when performing investment analysis. Depending upon an investor's capabilities, I suggest anyone considering investing in Chinese ADRs fully understand the proper filing requirements and disclosures for these companies. As time goes by, I would anticipate that more and more Chinese ADR companies will provide more information. In addition, most companies are willing to correspond with professionals and members of the public alike and answer questions through their investor relations department. This can be a time consuming process and not necessarily give you all the answers to questions you may have. I am regularly in contact with Chinese ADR companies asking that they provide more disclosure and information for investors.

Disclosure: I am long N, BIDU, CISG, NTES, DANG, SOHU, JOBS.