BIDU – Examining Baidu’s VIE Structure

We look at Baidu’s VIE corporate structure and attempt to quantify the takeover, bankruptcy and dividend risks to holder’s of BIDU on the NASDAQ. 

In this paper we attempt to quantify a reasonable discount to BIDU-NASDAQ given that, similar to other Chinese internet companies, it is essentially a shell company with much of its revenues being indirect. For some background, PRC laws and regulations restrict foreign investment in the internet, value-added telecommunication-based online advertising, online audio and video services and mobile application distribution businesses. In order to bypass these restrictions, Chinese companies in these industries, including Baidu and Alibaba, have adopted a mechanism called a Variable Interest Entity (VIE). Investors own a shell company, typically in the Cayman Islands. The shell’s corporate structure allows non-Chinese investors to invest in and have a claim on a Chinese operation’s profits and assets through contractual agreements with the VIE rather than through a legal obligation.

Theoretically, the public company through a Cayman Islands shell company will exercise effective control and consolidate financial results with their affiliated entities in China without any equity interest in them.

Do Baidu’s VIEs matter to the operations of the company? In 2014, 2015 and 2016, Baidu derived approximately 27%, 31% and 35% of its total revenues, respectively, from its consolidated affiliated entities through contractual arrangements. Therefore business from VIEs are material. Note a large part of sales, such as those coming from iQiyi, do not come from contractual agreements but rather from direct ownership.

How strong is the VIE contractual agreement? – The contractual agreements are only enforceable in China. The VIE structure has not been seriously tested in the country and the overall business legal system is not very developed. In practical terms, an offshore holding company’s entire viability hinges on the effectiveness of its contracts with its VIE counterpart in China.

Below is the organizational structure of Baidu laid out in their most recent 20-F.

Exhibit 1 – Baidu Corporate Structure

Details on Structure

Baidu Inc. is the Cayman Islands holding company that is listed on the NASDAQ through an ADR listing.

The bottom three companies (Beijing Baidu Netcom Science Technology, Beijing Perusal Technology, and Beijing BaiduPay Science and Technology) are the three main VIEs based in China. These VIEs are controlled by Baidu Inc. through entering contractual agreements between VIEs and subsidiaries of Baidu Inc. Baidu CEO and Chairman Robin Li owns 99.5% of Beijing Baidu Netcom Science Technology. The only division without a majority ownership by Li is Beijing Perusal Technology. The owners here are Xiaodong Wang (50% owned) and Zhixiang Liang (50% owned), both of whom are stated to be employees of Baidu.

The most recent agreement between Baidu and the owners of Beijing Perusal signed in May of 2016 can be seen here:

https://www.sec.gov/Archives/edgar/data/1329099/000119312517105041/d277810dex437.htm

This agreement states that the contractual agreement will remain in place even in the event of a change in equity ownership in Perusal. Therefore it would appear that as long as Robin Li maintains control of both the shell company and VIEs, the conflict of interest risk remains lower than its Chinese internet peers Tencent and Alibaba.

We go into further details below:

How do you value the risk factors of Baidu?

For valuation purposes of the VIE structure, we feel it may be best to incorporate the likelihood, impact, and timing of the impact of Baidu’s structure on the stock price.

Bankruptcy

With the lack of technical majority ownership, there exists a parent-subsidiary relationship between the Company and the VIEs through these contractual agreements. At  the end of 2016, Baidu has made long-term loans in an aggregate principal amount of RMB7.7 billion (US$1.1 billion) to the consolidated affiliated entities. However there are no details as to whether these loans are secured (claim on assets) or unsecured. A 50% discount we believe is a reasonable discount to place on the risk of receiving a claim on the assets in the case of bankruptcy.

Takeover

Baidu itself has the exclusive option to purchase their VIEs. The nominee shareholders of the VIEs have pledged all of their equity interests to Baidu’s 100% owned subsidiaries pursuant to equity pledge agreements under contractual arrangements. Baidu has also registered the equity pledge Baidu Netcom, Beijing Perusal Technology Co., Ltd., or Beijing Perusal, and BaiduPay.

According to PRC Property Rights Law, an equity pledge is not perfected as a security property right unless it is registered with the relevant local administration for industry and commerce.

At the same time, Baidu is in the process of registering the pledge relating to Baidu Netcom, as well as certain other consolidated affiliated entities, relating to recent increases of their registered capital and equity interest transfer.

Having covered their basis with the Chinese government for the large majority of their business, we would put the probability at 90% that ADR shares will need to be taken over in the event of a Baidu takeover by another entity.

Dividends

According to Baidu’s 2016 annual report: “Any and all dividends and other capital distributions from Baidu Netcom to the nominee shareholders shall be paid to Baidu Online in full.”

So, shareholders of Baidu retain the right to collect dividends paid by VIEs, with the caveat that they may be subject to a 10% Enterprise Income Tax and dividends and gains earned by non-resident individuals being subject to a 20% tax.

Exhibit 2-Baidu Valuation Considering the VIE 

This summary shows that the stock is trading at 31x our 2017 EPS of $7.95, or 37x its risk-adjusted 2017 EPS. We continue to believe Baidu is a buy and their corporate structure on a relative basis to other Chinese tech companies is above average.

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