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1 Green Flag and 1 Red Flag for Baidus Delisting Dilemma

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Will the Chinese tech giant be booted from the Nasdaq Exchange?

Baidu (BIDU 0.91%) has been one of the most well-known Chinese tech stocks on the Nasdaq Exchange ever since its public debut in 2005. It owns the country's largest online search engine, one of its top streaming video platforms, and its fourth-largest cloud infrastructure platform.

A $1,000 investment in Baidu's IPO would be worth about $49,000 today. Its fourth-quarter earnings report last month, which beat analysts' estimates, also allayed some bearish concerns about its maturing advertising business and indicated that brighter days were ahead.

Image source: Getty Images.

Yet Baidu still faces a major risk that is beyond its direct control. Back in 2020, the U.S. Securities and Exchange Commission (SEC) proposed to delist shares of Chinese companies that didn't open their books to the Public Company Accounting Oversight Board (PCAOB) for three straight years.

That proposal, the Holding Foreign Companies Accountable Act (HFCAA), was subsequently passed into law, and the rules were finalized last December. Since then, an increasing number of Chinese companies have been added to a list of delisting candidates, which has caused many investors to shun Baidu and other Chinese tech stocks.

Over the past month, two new developments -- which can be considered a green flag and a red flag for Baidu -- occurred in that ongoing drama.

A green flag: China pledges to work with U.S. regulators

On March 16, China's state-run Xinhua News Agency said the Chinese government would continue to support public listings of Chinese companies on overseas exchanges, and that it would work with the SEC and other U.S. regulators to resolve the auditing dispute.

Those comments suggested that China wouldn't invalidate the variable interest entity (VIE) model that most Chinese tech companies had used to access U.S. markets. VIEs are controversial because they're overseas holding companies that are set up to bypass Chinese laws regarding direct foreign investments in sensitive sectors like technology and education. Foreign investors in VIEs like Baidu don't actually have any voting rights in the underlying companies. But outlawing the entire VIE structure -- as Chinese and U.S. regulators have openly discussed -- would result in the immediate delisting of most U.S.-listed Chinese stocks.

Beijing's comments also indicate it's willing to soften its stance on blocking foreign auditors from fully auditing Chinese companies. China previously cited national security concerns as a major issue in allowing its companies to open their books to foreign auditors, but it's now signaling a willingness to compromise with the SEC to avoid a mass delisting.

A red flag: The U.S. dashes hopes for a quick deal

Beijing's comments initially sent Baidu and other Chinese stocks soaring, but a double whammy of bad news quickly ended that rally.

On March 31, SEC chief Gary Gensler dashed hopes for a quick deal between U.S. and Chinese securities regulators. In an interview, Gensler said there had been 'thoughtful, respectful, productive conversations' so far, but that China would ultimately face a 'hard set of choices' regarding the future of its stocks on U.S. exchanges.

On the same day, the SEC added five more companies -- including Baidu and its streaming video affiliate iQiyi (IQ 3.02%) -- to its 'provisional list' of companies that could be delisted. Baidu subsequently said it was 'exploring options' to deal with a potential delisting.

It's unclear what those options are, but the two most likely outcomes are a voluntary delisting and a full retreat to Hong Kong, where it listed its shares last March, or to simply wait for an agreement between the U.S. and China.

Which development matters more?

I believe the SEC's latest statements and actions matter a lot more to Baidu than Beijing's vague support for Chinese equities. The SEC has clearly started a delisting countdown for Baidu, iQiyi, and other Chinese tech stocks, and that pressure will continue to compress their valuations.

On the bright side, an actual delisting won't occur unless Baidu fails to open its books to the PCAOB for three consecutive years. Even if Baidu is delisted, its investors will likely be able to trade their ADRs for Hong Kong-listed shares for a fee. They'll also be able to keep those shares unless the U.S. government passes broader sanctions against the company, as it did against China's top telecom companies last year.

Therefore, investors shouldn't assume that Baidu is doomed to be delisted. However, those fears will likely hang over the stock until we see some clearer signs of a compromise between American and Chinese regulators.

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