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China tech

US probe of China's Netflix puts Baidu in quandary

Tencent waits in wings to take over cash-burning app iQiyi

BEIJING -- Major Chinese tech company Baidu stands at a crossroads over what to do with its video streaming unit iQiyi, a linchpin of its growth plans that is under investigation by U.S. financial authorities over accounting practices.

The probe comes as Baidu endeavors to convert iQiyi from a cash burner into a cash cow as it tries to keep pace with the two other conglomerates that make up China's "Big Three" tech companies. If investors sour on the streaming platform, Baidu could be compelled to give up principle ownership to domestic rival Tencent Holdings.

On the surface, Baidu appears to be doing well. Just-released second quarter results show net profit gained 48% on the year to 3.5 billion yuan ($504 million). The figures show the company has staged a recovery, said Chairman and CEO Robin Li. But cost reductions and the low baseline in the year-earlier period are largely responsible for the rise in black ink.

Revenue in the second quarter dipped 1% to 26 billion yuan, which is alarming since internet-related businesses have been logging rapid growth generally.

The decline in corporate ad submissions amid the coronavirus epidemic hurt Baidu, which is known for its search engine. The online marketing segment, which revolves around search ads, saw revenue decline by 8%.

What offset the slump in search engine ad revenue was the contribution by iQiyi. Membership fees at the online video portal drove the "other revenues" portion of the quarterly report, helping the segment bounce 18% on the year.

Baidu launched iQiyi in 2010 as the Chinese answer to Netflix. The service drew viewers with youth-oriented dramas and other content, and the membership count now exceeds 100 million.

iQiyi operates on the same plane as Tencent Video, as well as Alibaba Group Holding's streaming service, Youku. iQiyi debuted in the U.S. Nasdaq market in 2018.

Although revenue at iQiyi has risen consistently, the unit has struggled to make a profit. Ever since the Nasdaq float, iQiyi has almost always been in the red, generating a 1.4 billion yuan net loss in the second quarter.

Yu Gong, founder and CEO of iQiyi, and Robin Li, CEO of Baidu, ring the opening bell at the Nasdaq to celebrate iQiyi's initial public offering in New York on March 29, 2018.   © Reuters

The performance is the result of fielding high-quality content in the grueling race to capture a wider paying audience. iQiyi burned through 22.2 billion yuan last year on content costs, and those expenses rose 2% in the just-ended quarter.

The biggest challenge facing iQiyi is how to control spending on content.

It was revealed that Tencent approached Baidu with an offer to back iQiyi and take over as the top shareholder. The overture looks promising since it would ease pressure off the video rivalry between the two tech companies.

"If both companies cooperate, the benefits would be huge since they will be able to save on content costs," said an analyst for a Chinese brokerage.

The cash infusion presents a dilemma for Baidu, however. Along with Alibaba and Tencent, Baidu is one of the so-called Big Three companies that have thrived in China since the early days of the internet era.

Yet Baidu's market value is less than a tenth of Tencent's and Alibaba's. While the two rivals have attained growth through social media and e-commerce, Baidu has yet to develop a major business outside of its search engine.

Despite its current hiccups, iQiyi is considered to be Baidu's future gold mine. That designation has made Baidu hesitant to accept Tencent's offer.

At the same time iQiyi released its latest quarterly results on Thursday, it said the U.S. Securities and Exchange Commission has requested records from the company dating back to January 2018.

The probe is in connection to an April report issued by Wolfpack Research, a U.S. short seller company, that alleges iQiyi inflated revenue and user numbers, iQiyi said in a statement. The video streamer has hired advisers to conduct an internal investigation.

"We do believe due to the solid and disciplined internal control process and the corporate governance" that the results of the investigation "will be quite positive to the company," said Wang Xiaodong, chief financial officer of iQiyi.

Chinese companies that list in the U.S. have come under heavier scrutiny following the fraud scandal at Luckin Coffee. That dynamic likely factored into iQiyi's stock dropping by 19% at one point during after-hour trading Thursday. Baidu's shares were off as well.

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