It’s been 10 days since reports surfaced that Tencent (OTCMKTS:TCEHY) was interested in buying part or all of Baidu’s (NASDAQ:BIDU) controlling, 56.2% stake in iQiyi (NASDAQ:IQ), the Chinese version of Netflix (NASDAQ:NFLX). Since the day before the June 16 report, IQ stock is up almost 19%.
There are so many questions surrounding Tencent’s interest. The biggest is whether jumping out of bed with Baidu and into bed with Tencent is a good or bad idea.
Here are my thoughts on the subject.
Baidu Is Smart to Dump IQ Stock
Year-to-date, Baidu, Tencent, and iQiyi have total returns of -2.1%, 31.0%, and 6.9%, respectively, through June 25. Of the three, Tencent’s performance stands out like a sore thumb. Indeed, it has both the financial means with $26.4 billion in cash, an enterprise value of $86.3 billion, and a stock price that’s at or near an all-time high.
Tencent could pay for its stake in iQiyi with cash, stock, or a combination of both. Baidu, meanwhile, has a good balance sheet, but it doesn’t generate nearly as much profit or free cash flow as Tencent.
Baidu owns 56.2% of iQiyi’s outstanding shares and 92.7% of the total votes. According to the video streaming platform’s April 2018 initial public offering prospectus, the existing shareholders paid 70 cents per ordinary share for the stock before the public offering. Based on 2.89 billion ordinary shares, Baidu’s investment in iQiyi cost it $2.02 billion [2.89 billion times 70 cents].
How much are those shares worth today?
Based on one American Depositary Share being equal to seven ordinary shares, Baidu holds 410.9 million ADS shares, worth $9.2 billion as of June 26.
iQiyi Is Losing Lots of Money
In 2019, iQiyi had sales of $4.2 billion and an operating loss of $1.3 billion. Since 2015, its sales have grown by 445% while its operating loss has increased by a more modest 281%.
In the first quarter ended March 31, sales rose 9.4% while its operating loss increased by 10.7%. Paid memberships were up significantly offset by lower advertising.
Each day, iQiyi is becoming more like Netflix and less like Roku (NASDAQ:ROKU). This means investors can expect losses and content costs to keep rising.
Meanwhile, Baidu’s core business of search is doing reasonably well. Although revenues in the first quarter ended March 31, fell 13% over last year, its operating income increased by 69% to $261 million.
It’s tempting to look at Netflix and think the same payday awaits Baidu and iQiyi shareholders. Alas, investing doesn’t work that way. While the two companies have significant synergies, in the long run, a tie-up with Tencent could be better for all three companies’ shareholders.
Of course, that all comes down to the price Tencent is willing to pay for Baidu’s stake and whether or not iQiyi would even entertain such a tie-up.
The Bottom Line
InvestorPlace contributor Matt McCall believes iQiyi has several catalysts that will push its stock higher at some point. This, despite the fact IQ stock had languished for most of 2020 until the rumors started circulating in mid-June that Tencent was eager to buy a majority of the video streaming platform through Baidu’s controlling stake.
Add to this continued growth in new subscribers for its paid service and it’s hard not to like its future trajectory.
Earlier this year in mid-January, I suggested that IQ stock could fall back to $15 from $24 where it was trading at the time. Little did I know that the novel coronavirus would hit China shortly after that, sending its stock spiraling lower. From the middle of March to the middle of June, IQ was stuck around $17, until the Tencent rumors hit. It’s been above $20 ever since.
In my January article, I wondered if it were a $15 or $30 stock. I argued it was the former unless it delivered a strong fourth quarter in February, which it did, boosting subscriber revenues by 76%.
Unfortunately, Covid-19 kicked in, putting its momentum into neutral. Where it goes from here really depends on what Tencent and Baidu do next.
From where I sit, iQiyi is better off in the hands of Tencent rather than Baidu, despite the synergies between the two.
Is IQ stock a buy? I’d say it is but save some cash because the coronavirus isn’t done with the world just yet.
Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia. At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.
