When iQiyi Goes IPO, What Do Baidu Shareholders Get?

In this segment of the MarketFoolery podcast, host Chris Hill and Million Dollar Portfolio's Matt Argersinger answer a question several listeners have had about the pending spinoff of Baidu's (BIDU 0.98%) streaming-video unit, iQiyi: How will this work for Baidu shareholders? Do they get shares automatically? Money? A better business? It's not totally clear, but it doesn't look like they'll be adding a new ticker to your portfolio -- unless they buy it on their own. And, as Argersinger says, there's a case for doing just that.

A full transcript follows the video.

This video was recorded on March 7, 2018.

Chris Hill: We've gotten a couple of emails over the last couple of days regarding something you had mentioned on Motley Fool Money last week, and that is in relation to iQiyi. For those who are unfamiliar, iQiyi is the video streaming service that is part of Baidu, which is the search engine giant in China. Baidu is spinning off iQiyi into an IPO, we think in April. The timing is always a little bit fuzzy, but we're expecting sometime this spring. This will be in the U.S. They filed the necessary paperwork with the SEC. They have their ticker symbol, which is going to be IQ.

Devin Smith, Justin Lonchard, just a couple of people who have emailed asking basically the same question, which is, "How is this going to work for Baidu shareholders?" If you're a Baidu shareholder -- and I'm not, but if you are, good for you, because that's been a tremendous performer over the last decade -- but,if you're a Baidu shareholder, are you automatically going to get shares when this gets spun out into an IPO? Or is that not the case?

Matt Argersinger: Good question, and it's actually part of a bunch of questions that I've actually sent Baidu's investor relations department to get more clarity. But, from what I know now, and I've gone through the prospectus, I've gone through Baidu's last conference call, a few other things, I'm 95% sure that, as a Baidu shareholder, you're not going to get shares automatically in iQiyi. This looks to be a cash transaction for Baidu. In other words, they're going to sell off part of their investment in iQiyi for cash. And depending on the size of the offering, that could be a few billion dollars. We'll have to see as the offering approaches.

As a Baidu shareholder, though, I think there's a lot of reasons to be excited about this. iQiyi has always been kind of a subsidiary investment for Baidu. Now that they're spinning off a part of it, Baidu is going to continue to be a majority shareholder, they're still going to be the controlling shareholder, they're going to own all the class B shares, which are the super voting shares, for iQiyi.

At the same time, by deconsolidating iQiyi, they take out all the losses. iQiyi, as a fast-growing subscription Netflix-like (NFLX -3.92%) service, incurring a lot of losses, investing a lot in content. Baidu takes those losses off of its income statement. It also removes itself from having to invest billions in content, that iQiyi is going to have to do over the next several years if they want to compete. So, you're left, in Baidu, as owning the core search advertising artificial intelligence business, which is very profitable and, in my view, undervalued. And, by the way, you have this optionality, I guess, in this iQiyi investment. So, that's Baidu.

For iQiyi, now, I think there's a lot of reasons to be excited. If you want to maintain the 80% ownership stake you had as a Baidu shareholder, you can simply buy iQiyi after it goes public to build that stake up. But, now you have a purely focused video streaming company in China which is the leading company based on several metrics. I talked about it on the radio show, but 120 million daily active users watching almost two hours of content on iQiyi, 50 million subscribers, up from 10 million just a few years ago. I think, if you missed out on Netflix, a lot of us did, this probably looks like a good chance to maybe get another Netflix-type investment in your portfolio.

Hill: It's interesting to hear you talk about Baidu and what this is going to do for shareholders in terms of transparency. It reminds me a little bit of when Google redid its corporate structure as Alphabet, and part of the impetus there was, we want to take the moonshot part of the business and essentially put it off to the side so that people understand, these are the economics for that, and they're essentially going to be off the books of the day-to-day Google budgeting. In terms of iQiyi, it's amazing to think of it as, essentially, a combination of what we think of in terms of Netflix and YouTube. That they have the subscription service, but they also have the free ad-supported model, as well.

Argersinger: Yeah, it's a great hybrid. If you like internet video and the business of internet video, from an advertising perspective and a membership perspective, this is pretty much the best of both worlds right here in iQiyi. Of course, it's also operating in the world's most populous country, and a country that's growing really rapidly in terms of internet adoption and video adoption and things like that. So, you have this great advertising business that still makes up about 40% of the revenue, but then you have this membership business, which is growing by leaps and bounds, that's also now getting closer to that 40%. So, it's going to be, in about a year, an even-even split between advertising revenue and membership revenue. The membership is probably what you really want to be excited about because I think that's what builds in that sort of flywheel of recurring revenue. Members come in, they pay for the content, that enables iQiyi to invest in more content, attract more members. It's just this virtuous cycle that Netflix has had now going on for a bunch of years.

Another thing for iQiyi that's fascinating for me, and this is stuff I'm pulling right from the prospectus, 42 out of the top 50 most popular drama series, variety shows and film titles in China are on iQiyi. 42 of the top 50 most popular shows. In terms of iQiyi's original content, they have six of the top 10 drama series in China in 2017. Six of the top 10 are on iQiyi. As I mentioned, users are spending about two hours daily watching videos. If you think about Netflix, what's made Netflix so successful is the breadth and quality of the content library that they've built out over the last several years. That's exactly the strategy that iQiyi is pursuing. What the IPO is going to enable them to do is get $1.5-2 billion in additional capital that they can invest back into the content library.

Hill: And that's one more thing to like about this move. Whether you're going to be a shareholder of these companies or not, I always like to see this level of transparency. In the case of Baidu, it's being very upfront about, this is what it's going to do, it's going to provide greater transparency to our overall business. In terms of iQiyi, they're very upfront about the fact, this is why we're going public, we're going to take this money and invest it in content. Good for them.

Argersinger: Yeah. Now, there's always caveats to this. It sounds like an amazing story. But you have to keep in mind, this is a company, like Netflix in the early years, burning a lot of cash. They lost $600 million last year alone, and those losses have kept increasing. And that's because they're just plowing so much back into content, which I think they have to do.

The other thing, too, and this is mostly from the advertising perspective, but the daily active users in 2017 were 126 million. That's only slightly more than the 125 million that they had in 2016. So, the growth there has really stalled out, whereas the membership business really soared. Now, I think an optimist would say, that's just a strategic choice that iQiyi is making, emphasizing the membership model much more. But, you do look at those numbers on the daily active users side and say, yeah, the growth is really flattening out. Is that because they're getting competition from Tencent, for example? Or Alibaba, which also owns a popular video platform? You could probably make an argument there.

If the market decides and investors decide to focus on those daily active users number, they might be less excited about iQiyi going forward, because that growth is going to slow down quite a bit. But, if you look at the subscriber numbers, which I think is the right metric to look at, and the amount of activity on the platform, which just keeps going up, and the minutes per day that are being watched, it's very, very exciting.

Hill: Thank you for mentioning both Alibaba and Tencent, because I did want to get around to the fact that they're not in a vacuum. They're not the only show in town. They have great numbers, what they have compiled to this point is very impressive, but they absolutely have competition in terms of two companies with very deep pockets.

Argersinger: Yeah. And it's a double-edged sword in a way. You have these two other very clearly defined competitors. But, at the same time, the overall market now, in terms of internet video, you really have three competitors, which is interesting. It doesn't face the same sort of fragmented entertainment market that we have here in the U.S. with more competitors. You don't really have a cable business. Cable is not really that big in China, so it's not like I have big alternatives. If I want to watch video on my phone or on my PC, I really have three big options. And iQiyi, right now, is in pole position.

Hill: Wow. It's like America in the 1970s. We have three broadcast networks.

Argersinger: That's right. There's three dials, that's it.