Baidu is set to benefit from a buyout of its iQiyi position or reduced cost pressures in the sector.
The company already has an $11 billion net cash position, so the ultimate goal is an improved investment in the video streaming market.
Both the stocks of Baidu and iQiyi are cheap, with Baidu having a core EV of down to only $15 billion on a premium cash deal for iQiyi.
Baidu (BIDU) spiked to recent highs on headline-grabbing news that Tencent (OTCPK:TCEHY) was interested in supplying the Chinese Internet search giant with some cash to part with an asset. Like a lot of Chinese stocks, Baidu has been under extreme pressure this year due to the coronavirus outbreak and fears of U.S. legislation restricting Chinese companies from listing on U.S. stock exchanges without reform. My investment thesis remains locked in on owning Baidu, as the company has several ways to reward shareholders.
Image Source: Variety
Making A Deal
Baidu is heavily invested a large variety of businesses, usually to the detriment of the stock. The large Chinese company spends heavily on developing businesses that hurt profits, while the core Internet search business has struggled the last few years.
Baidu has traded down the last two years, while most industry stocks such as Alibaba (BABA), Tencent and Pinduoduo (PDD) are trading near the multi-year highs. Baidu got some interest on Tuesday after Tencent was reported as interested in acquiring the 56.2% position Baidu holds in iQiyi (IQ).
Considering Baidu is only worth $42.1 billion, the surge in iQiyi to a market value of $18.1 billion places its position value at $10.2 billion. The news reports provided absolutely no details on what price Tencent was willing to pay in order to acquire part or all of iQiyi.
The acquisition has an apparent goal of reducing competition in the sector for Tencent Video and the associated costs for acquiring subscribers and paying for content. Along with Alibaba’s Youku, the three companies control the long-form video segment, with somewhere around 100 million paying members for each service.
When a video streaming company like Netflix (NFLX) in the U.S. has a market valuation approaching $200 billion, any move to sell iQiyi appears short-sighted. My view agrees with that of Tim Culpan, a Bloomberg Opinion columnist covering technology. Any consolidation in the industry would just lead to additional entrants to compete in the less crowded space. Baidu needs to exit the sector, or the company needs to be careful to not sell a small stake and be left holding a less valuable asset in a suddenly more crowded space in the future.
In addition, Baidu has long had a large net cash balance, so selling iQiyi for cash isn’t necessarily appealing to shareholders. The company has over $20 billion in total cash and ~$11 billion in net cash. A deal with Tencent for $12-15 billion based on an additional premium for iQiyi would push the net cash position towards $23-26 billion prior to any tax implications for a sales transaction.
iQiyi ended the last quarter with 118.9 million paying subscribers, up 23% YoY. The market appears large enough for a few top competitors, so Baidu shouldn’t feel any pressure to exit the sector.
The company had Q1 revenues of $1.08 billion. The quarterly revenues were only up 9% YoY, but the key membership revenues surged 35%.
Even with the Tencent-related boost in iQiyi from $19 to nearly $25, the stock still trades at half the forward P/S ratio of Netflix. Netflix has seen an advantage during the virus outbreak from not relying on online advertising revenues, but the market shouldn’t overly focus on short-term hiccups in what are otherwise sustainable business models.
The market has rewarded Netflix with double the P/S ratio of iQiyi. This is another reason that Tencent is likely looking at buying up its shares.
The desire for Tencent Video to focus on restraining costs could help Baidu either way. Its core business has 30% net profit margins, while the whole business is down at only 14%, due in a large part to the excessive costs and losses at iQiyi. Less-aggressive competition in the sector would help improve the overall margins at Baidu.
Ultimately, Baidu shouldn’t look at dumping iQiyi for such a low valuation when the company doesn’t lack for cash. It can clearly look to invest more in AI, Cloud and AV technology, but the company doesn’t need over $20 billion in cash to make these investments.
Remember, the stock is constantly compared to Alphabet (GOOGL) with its Internet search leadership position in the U.S. Google regularly invests in video via YouTube, Cloud and AV technology as well.
The key investor takeaway is that an easy argument can be made that both Baidu and iQiyi are cheap. Baidu doesn’t need a deal, but a premium deal for iQiyi would highlight how cheap the Chinese search leader’s stock is trading for an EV in only the $15 billion range. Either way, Tencent digging around should spark further interest in the Chinese stock nearly left behind in the recent market rally.
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Disclosure: I am/we are long BIDU. 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: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.
Originally published on Seeking Alpha