Are the headaches of Baidu and iQiyi short sellers finally over?

Back in April, a Chinese video streaming company iQiyi (NASDAQ: IQ) has been affected by allegations of fraud. Wolfpack Research and short seller Muddy Waters, who spotted Cafe LuckinThe company’s fraudulent accounting before regulators accused iQiyi of inflating revenues from 27% to 44% in 2019.

Additionally, Wolfpack claimed that iQiyi had inflated its revenue until 2015, well before its split from Baidu (NASDAQ: BIDU) in 2018. That timeline apparently involved Baidu, which owns a controlling stake in iQiyi, and both shares initially sank. These problems worsened in August, when iQiyi disclosed an SEC investigation into its accounting practices.

Image source: Getty Images.

But in early October, iQiyi said it had concluded an internal review and “found no evidence to support the claims.” The review was conducted by an independent audit committee with the assistance of professional advisers, including a leading accounting firm that is not the auditor of iQiyi. He also said he “would continue to cooperate with the SEC.”

iQiyi and Baidu are yet to come out of the woods, but the announcement lifted both stocks. Should investors assume the worst is over?

Have Short Sellers Follow Muddy Waters’ Lead?

If we follow the short interest in iQiyi and Baidu this year, we will notice that the Wolfpack report in April did not attract a rush of short sellers to either stock, and the percentage of short equities remained fairly stable:

IQ Percentage of shares outstanding Short chart

Source: YCharts

Shares of iQiyi and Baidu also rose around 9% and 3%, respectively, this year. iQiyi likely repelled the attack on short sellers for four reasons.

First, several senior analysts have defended iQiyi against the Wolfpack report. Mizuho analyst James Lee claimed that iQiyi’s revenue recognition practices meet industry standards and the likelihood of fraud is low. Oppenheimer analyst Bo Pei also launched a bullish hedge on iQiyi with an “outperform” rating.

Second, Tencent (OTC: TCEHY) reportedly approached Baidu with a takeover bid for iQiyi in June. The proposed takeover would have merged Tencent Video with iQiyi to create China’s largest video streaming platform with more than 200 million paying subscribers. Tencent, one of China’s biggest tech companies, probably wouldn’t have considered the deal if it believed iQiyi was generating bogus revenue with bogus users.

Third, iQiyi’s core business improved in the second quarter. Its revenue grew 4% year-on-year to 7.4 billion yuan ($ 1.0 billion), its subscriber count also increased 4% to 104.9 million and its net loss fell from 2.3 billion yuan to 1.4 billion yuan ($ 204 million). These growth rates were not exceptional, but they allayed some concerns about the slow growth of iQiyi users and its increasing net losses.

Finally, iQiyi’s lukewarm growth rates are a far cry from the triple-digit revenue growth rates that Luckin Coffee reported before going off the rails. In short, Luckin’s numbers sounded too good to be true, but iQiyi’s numbers were not.

What does this mean for Baidu?

Baidu generates most of its revenue from online advertising, but revenue from this core business has been declining year on year for five consecutive quarters. He attributed the contraction to the slowdown in the Chinese economy, the ongoing trade war between the United States and China, competition from rival platforms, COVID-19 and other macro factors. economic.

As its advertising business dried up, Baidu relied more on its iQiyi revenue, which accounted for 28% of its revenue in the last quarter. IQiyi’s growth offset Baidu’s decline in advertising revenue, but its losses weighed on Baidu’s margins.

Therefore, Baidu needs iQiyi to support its revenue growth until its higher margin advertising business finally recovers. So if iQiyi’s revenue has been inflated, or if Baidu is involved in covering up or turning a blind eye to iQiyi’s accounting practices, the tech giant could have serious problems.

The conclusion of iQiyi’s internal audit relieves some of that pressure, but neither company will be fully exempt until the SEC concludes its investigation.

The key to take away

Baidu and iQiyi’s troubles are not over yet, but the conclusion of iQiyi’s internal review should prevent short sellers from launching another attack. For now, investors should focus on Baidu and iQiyi other challenges in online advertising and streaming video instead of worrying about the potential outcome of the SEC investigation.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.

About Ian Crawford

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