Baidu (NASDAQ:BIDU) announced on November 2nd, that it is increasing its stake in iQiyi to a controlling interest. The company expects the deal with Providence Equity Partners to close by the end of the fourth quarter and will start consolidating iQiyi’s financial statements going forward.  We think that this was a logical step for Baidu since online video will help the firm diversify its product lines, and drive revenues from display advertisements. We agree with management’s decision to buy control of iQiyi since the company can leverage user growth on this product to drive revenues on other platforms.
Why Online Video?
Baidu’s management considers online video a key vertical for Baidu’s business. This is especially true since the company generates most of its revenues from advertising, and the data that it has on users from its search platform can be leveraged with video based ads on iQiyi.
Additionally, as Internet penetration, which was only around 50% as of December 2011, increases on the Chinese mainland, we expect users to access more and more of their media via online video sites such as iQiyi. We think that Baidu is will likely go the route that Google (NASDAQ:GOOG) has gone with Youtube, leveraging the platform to not only drive user growth but also provide a more diversified advertising product suite for its clients.
iQiyi A Leader in Online Video
iQiyi, since its inception on 2010, has consistently gained market share becoming a leader in the Chinese online video market, which includes competitors such as Youku (NYSE:YOKU). iQiyi is the leader in the Chinese online video industry in terms of time spent per user per day and second in total time a user spends per month. According to management, monthly unique visitors grew 62% quarter-over-quarter to 407 million during the third quarter.
A high growth avenue through with for the company with iQiyi is mobile advertising. At present, approximately 20% of iQiyi’s traffic comes from mobile devices, and we expect this number to increase going forward as Chinese 3G penetration and mobile web views increase over the coming years. Increasing usage, combined with the 7x increase by in mobile advertising spending forecasted by eMarketer, gives Baidu an opportunity to use iQiyi to drive revenues on the mobile front. 
Chinese Online Video Ad Spending to Rise
Total Chinese advertising spending increased approximately 13% in 2012, according to research firm GroupM. What is important to note is that this growth was primarily driven by growth in Internet ad spending which is expected to grow 55% this year and 35% in 2013.  Chinese advertisers spend a majority of their revenues on video advertisements with approximately 53% of ad spending occurring on television. As more individuals move to watch videos online, we expect some of the ad spending on television to shift to online video sites such as iQiyi.
Display Ads to Diversify Revenues
We think that Baidu’s move to buy a controlling stake in iQiyi will help Baidu’s management diversify its revenue streams. We think that iQiyi will be a good complement to Baidu’s music service Ting, which is likely to see growth in its user base due to Google’s exit from the Chinese online music market. We think that the success of these two products can drive display ad revenues and make the division a much bigger contributor to Baidu’s overall value.
We currently have a $125 price estimate for Baidu, which is approximately 20% above the current market price.Notes: