IQ – Baidu = 24% upside

Shares in iQIYI (IQ), a Chinese Netflix-style video streaming service controlled by search giant Baidu Inc. (BIDU), fell during its trading debut on March 29. The Beijing-based iQIYI sold 125 million U.S. depositary shares at $18 per share, which was in the middle of its range. The company raised $2.25 billion in its IPO, which was the largest of the year. The shares closed down 14% on the first day of trading, valuing iQIYI at about $11 billion. Baidu offered about 17% of its ownership in IQ and remains a controlling shareholder post-IPO (see “BIDU/IQ split,” below). 

IQ is an online video platform with a content library that includes copyrighted movies, television series, cartoons, variety shows and other programs. The company derives a majority of its revenues from online advertising services. IQ offers commissions to third-party advertising agencies and recognizes revenue net of these commissions. IQ also derives an increasing portion of its revenue from other sources, such as subscription services and sub-licensing of licensed content to other video websites. The company intends to use 50% of the funds (a little more than $1 billion) raised to produce new content. 

Baidu, which means a “100 times,” is a leading Chinese-language Internet search engine (Baidu.com) with about 80% of the search market in China (Google is Baidu’s main competitor, with about 20% of the Chinese market.) Baidu offers news, MP3, video and image searches. It earns nearly all of its revenue through online advertising services. To reap the rewards of a market that consists of a whopping 470 million Internet users, the company has had to accept a massive government bureaucracy and its censorship rules. 


Deal Rationale

China, with its rich demographics, has proven to be one of the most lucrative markets for e-commerce and content streaming. IQ is an early player to capitalize on this trend. Over the years, the rivalry between IQ and its close competitor, Youku Tudou (now part of BABA), has intensified. The separation is primarily about positioning IQ as a leading player in the Chinese online video streaming market and developing an acquisitive currency, which will enable IQ to grow in a consolidating market.  

With $2.67 billion in fiscal year 2017 revenues (a 55% growth rate) IQ trades at a backwards-looking valuation of 3.25X estimated valuation/fiscal year 2017 revenues. If one extrapolates IQ’s growth forward you see about 40% revenue growth in fiscal year 2018 ($3.74 billion). This suggests that IQ currently trades at 2.3x estimated valuation/fiscal year 2018 revenue multiple. Netflix (NFLX), by comparison, trades at a robust 8x forward revenue. IQ trades at a deep discount to Netflix. 


Valuation

As the largest streaming player in China, IQ is well-positioned to flourish from the growth in entertainment and Internet spending that has been accelerating in China during the past decade. The current modest valuation does not reflect this potential. Based on a price/forward sales multiple implied by Alibaba’s (BABA) acquisition of Youku, we estimate IQ’s valuation at $14.5 billion or $20 per American Depository Share (ADS). Each iQIYI ADS is currently trading at $16.10 as of April 3. This suggests 24% upside to our estimated value of $20 per ADS.