One technology stock that many analysts and market

first_imgOne technology stock that many analysts and market commentators are very high on is the Chinese Internet search company, Baidu (BIDU). According to data provided by Thomson First Call, 22 out of 29 analysts currently rate BIDU either a “buy” or a “strong buy.” The median price target among all the analysts covering the company is $142 per share… an extraordinarily high 46% above its recent share price of $97. One analyst sees BIDU going to $215 per share in the next 12 months. That represents roughly a 125% increase from current levels. Many market commentators at the most popular financial websites are similarly bullish. One of the commentators in a recent article called Baidu “the biggest bargain in big tech.” Another claims that Baidu is “the best stock for 2013.” A quick evaluation of Baidu makes it easy to understand the reason for all the optimism. First of all, Baidu – with roughly an 80% search-engine market share – is well positioned to benefit from the rapid Internet adoption rate in the lucrative Chinese market. Second, BIDU sports an incredibly strong balance sheet, with a current ratio of 3.6, long-term debt to equity of 0.15, and intangibles to total assets of 0.17. From a valuation standpoint, BIDU looks very attractive, with a forward PEG ratio of 0.53. But a closer look reveals a very important – and largely ignored – risk that investors should consider before jumping on the Baidu bandwagon. That is the risk associated with the company’s VIE structure. The VIE Structure When you purchase shares of Baidu, you’re not assuming direct ownership of the company, as you would if you purchased shares in a US company like, let’s say, Google or Apple. Rather, you’re buying shares in what the legal minds at Robins, Kaplan, Miller & Ciresi refer to as “an offshore holding company or shell company whose entire viability hinges on the soundness of its contracts with its Chinese operating company counterpart.” This is what is known as a “variable interest entity” (VIE) structure; it is commonly used by Chinese companies as a way to sidestep China’s ban on foreign investment in certain economic sectors (e.g., the Internet, media, and telecom). Some of the more familiar names that have adopted the VIE structure include: Yoku.com, RenRen, New Oriental Education, Sina, and 21Vianet Group. One major flaw with the VIE structure is that the various contracts and legal agreements between the shell company and the wholly owned Chinese operating company may not be enforceable under Chinese law. And this – as the law firm Robins et al. points out – “exposes foreign investors to the risk that Chinese VIEs may readily breach their contracts with their U.S.-listed counterparts if this serves the VIE’s interests, because Chinese courts will not enforce these contracts against the VIE anyway.” It may happen infrequently, but VIEs do sometimes breach their contracts with the holding company. Once the market becomes aware that a holding company has “lost control of the VIE,” shares go into a tailspin, giving shareholders little time to react. So in a sense, VIE stocks can be a ticking time bomb. Cautionary Tales In early 2008, shares of the PRC seed producer Agria Corporation sank roughly 50% in a matter of days when it was announced that Agria was losing control of its Chinese VIE. The issue was with a Chinese executive at the VIE who became disgruntled at not having received certain compensation for services to the holding company that he believed was owed to him and his management team. The dispute was eventually resolved (and the VIE remained intact) when Agria essentially met the demands of the executive by granting him and other members of management “a significant amount of shares in the offshore parent as well as cash compensation for services rendered to the company.” But shareholders didn’t fare so well; Agria shares never recovered, presumably because investors lost confidence in the company’s corporate structure. Another high-profile example of loss of control over a VIE involved GigaMedia. In early 2010, GigaMedia decided to part ways with a Chinese executive who ran (and largely controlled) its VIE. In an act of defiance, the Chinese executive – emboldened by the fact that he would probably face no legal repercussions – refused to surrender his personal ownership of the Chinese operating licenses for the VIEs… licenses essential to GigaMedia’s business in China. Despite suing the executive in multiple jurisdictions, including in China, GigaMedia wasn’t able to fully regain control of its VIE. GigaMedia shares lost more than half their value as a result. It is important to note that the scenarios above are less likely to happen to Baidu, which has certain safeguards in place to somewhat minimize the risk of losing control of its VIEs. For example, the Chinese executive Yanhong Li, who largely controls Baidu’s VIEs, also has a significant stake in the offshore holding company (BIDU). This serves to align his interests with that of the foreign shareholders, making for a more solid VIE structure. But even with that structure in place, there can be a contagion effect when other companies experience problems with their VIEs. For instance, in May of 2011, Baidu shares fell nearly 30% following the announcement that Alibaba had lost its VIE. The threat of contagion pales in comparison to the threat that Chinese regulators can at any time decide to shut down a VIE. This is what happened to Buddha Steel in March 2011, when it abruptly canceled its proposed public offering in the United States, citing that the company “was advised by local governmental authorities in Hebei Province that [its VIE structure contractual control arrangements] contravene current Chinese management policies related to foreign-invested enterprises and, as a result, are against public policy.” Some have speculated that Buddha Steel was targeted merely because it competed against state-owned steel companies. But others see something more ominous – a potentially broad Chinese government crackdown on the whole VIE structure. Whatever the case may be, one thing is for sure: the Buddha Steel case exposed the vulnerability of the VIE structure whenever it faces regulatory scrutiny in China. Our Final Take on Baidu Ultimately, the Baidu bulls’ claims that shares will surge from current levels may prove to be correct. But because of its VIE structure, Baidu is decidedly not the kind of blue-chip stock many are touting it as. Instead, it’s a far more speculative investment, and it should be treated as such. In Big Tech, we tend to shy away from such speculative and potentially disastrous investments as Baidu. Instead, we focus on the rock-solid stocks that can be counted on to deliver 20%+ annual gains. And sometimes, in our quest to find these stocks, we hit one out of the park, as we did with one company that has returned nearly 150% since we first recommended it. Bits & Bytes Robotic Arm: Mind-Controlled Limb Closer than Ever to Real Human Limb (Huffington Post) This is a fascinating and heartwarming article that found its way into my inbox the other day. It’s about a technology that restores movement for paralysis victims. Will Big Data Get Too Big for the Metric System to Handle? (MIT Technology Review) Andrew McAfee, principal research scientist at MIT’s Center for Digital Business, believes that global IP traffic will surpass the current limit of measures by the end of the decade. Hedge Funds’ Hail Mary: Bet on Tech (BloombergBusinessWeek) Recent SEC filings revealed that the smart money placed some aggressive bets on technology stocks in the most recent quarter. A Devastating Report for Amazon’s Kindle Business (Business Insider) Bad news for Amazon as Pacific Crest analyst Chad Bartley projects sales of the Kindle Fire will come in lower than previously expected for 2013.last_img

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