FEATURE: Qihoo-Coolpad Spat Provides Entertainment, Lessons for Doing Business in China

A brewing spat between security software giant Qihoo 360 (NYSE: QIHU) and struggling smartphone maker Coolpad (HKEx: 2369) has provided some good entertainment for followers of China’s vibrant Internet sector over the last few weeks. The tale has all the elements of a good trashy romance novel, including a love triangle and vengeful scheming by China’s most famous Internet bad-boy.

But more fundamentally, the tale is also filled with valuable lessons for anyone doing business in China’s high-tech sector, or really in any of the country’s emerging industries where private entrepreneurs are driving the growth. The story’s biggest moral is to be careful when choosing your business partners – a lesson that many private investors have learned over the last 3 decades as China transforms from a socialist system to a market-oriented economy.
At the heart of the Qihoo-Coolpad tale are two of China’s most successful and colorful high-tech entrepreneurs.

Leading the cast is Qihoo’s controversial CEO Zhou Hongyi, playing the role of jilted lover. Zhou shot to fame as founder of one of China’s earliest and most successful online search companies, which he later sold to Yahoo (Nasdaq: YHOO) for $120 million more than a decade ago. Since then Zhou has earned a name as China’s Internet bad-boy, frequently bad-mouthing opponents and drawing lawsuits for his aggressive business practices.

The other leading entrepreneur is Jia Yueting, whose smooth talk has thrust his online video company LeTV (Shenzhen: 300104) to the center of China’s high-tech stage. Jia has only recently emerged as a master salesman for LeTV, launching a flurry of initiatives over the last year that helped his company’s stock soar five-fold this year before giving back much of those gains in the current market correction.

Somewhat ironically, Coolpad, playing the role of prized lass in this high-tech love triangle, doesn’t have any high-profile figures at the head of the company. Instead, Coolpad’s fame is based mostly on its name, after it was among the first to recognize the important role that smartphones would play in the mobile industry.

Overtaken by Competition

Unfortunately for Coolpad, many other bigger names like Huawei and Lenovo (HKEx: 992) later entered the field, often with better resources to innovate and withstand the stiff competition that quickly developed. As a result, Coolpad found its early profits and success rapidly evaporating last year, and was in need of a cash-rich patron to help revive its fortunes.

That’s where our tale begins, with the faded but still relatively attractive Coolpad looking for suitors in 2014 to fend of a growing field of competitors fighting for share in China’s smartphone market. After several years of breakneck growth, the market would finally top out in 2014 and begin to contract this year, adding further pressure to the dozens of domestic newcomers in the market.

Against that backdrop, it’s not difficult to understand why Coolpad was initially charmed by Qihoo, despite the latter’s bad-boy reputation. Superficially at least, Qihoo had many qualities that Coolpad wanted. Most importantly Qihoo had lots of cash, nearly $1.7 billion to be precise, after raising $900 million through a bond offering earlier in the year. At the same time, Qihoo wanted to enter the smartphone business to better promote its core security software and newer search engine to a growing number of Chinese who did most of their web surfing over their smartphones.

Last but perhaps most importantly, Coolpad made an educated guess that Qihoo was relatively ignorant about smartphones and would let Coolpad handle most of the product design and manufacturing for their planned new venture. That assumption turned out to be Coolpad’s fatal mistake, as it probably would have learned from doing some better homework on Qihoo and Zhou Hongyi.

Internet Wunderkind

Despite his aggressive business tactics, Zhou is also generally regarded as one of China’s leading Internet innovators. His accomplishments are quite wide-ranging, producing an enviable stable of products that include China’s first major search engine, its leading security software, and a newer search engine that is posing one of the first serious challenges in years to the dominant Baidu. Zhou’s record for innovation, combined with his aggressive tactics, should have tipped off Coolpad that Qihoo would hardly be a silent partner in any joint venture.

But Coolpad, more interested in Qihoo’s cash, went ahead with the tie-up, which the pair announced last December as a joint venture to produce a new brand of smartphones known as Qiku. Coolpad contributed its smartphone-making assets to the venture and received a majority stake, while Qihoo forked over $410 million for a minority 45 percent that it later boosted to 49.5 percent.

But if Coolpad thought its controlling stake would give it total control over the venture, it quickly learned otherwise. Instead, Qihoo turned out to be a control freak, seeking to micromanage many aspects of the venture’s product development and other operations, an unnamed high-level Coolpad executive would say in an early September interview, after soured relations between the pair burst into the public.

Another report at that time cited Zhou saying “Whoever helps me, I will treat well. Whoever stands in my way should beware,” commenting on Qihoo’s demand for divorce from the venture. But that part of the story is still to come.

White Knight Arrives

As relations between the joint venture partners were souring, LeTV’s smooth-talking Jia was also searching for a partner for his own new move into smartphones. Such a move was consistent with an earlier successful strategy that saw LeTV sell its online video products by bundling them with low-priced smart TVs that included service contracts.

As its unhappiness with Qihoo grew, Coolpad turned to Jia and LeTV and began to discuss their own new tie-up. The pair then surprised everyone when they announced a deal in June, just a half year after the original Qihoo-Coolpad joint venture. That newer deal saw LeTV become Coolpad’s second largest shareholder by buying 18 percent of its stock from the company’s largest shareholder for 2.18 billion yuan ($340 million).

The new tie-up left many observers puzzled since it appeared to compete with the earlier Qihoo joint venture. But a stream of angry statements that quickly followed from Zhou made it clear that Qihoo was also blind-sided by the move. Qihoo didn’t waste much time reacting, announcing in September that it planned to exercise an option that would force Coolpad to buy out the joint venture for violating a non-compete clause in the original agreement.

The buyout would be particularly painful for Coolpad, which would be forced to pay twice the value of Qihoo’s 49.5 percent stake in the venture under the “put option” that Qihoo intended to exercise. By Qihoo’s own reckoning, that stake had grown in value to $742.5 million, meaning Coolpad would have to pay twice that amount – or nearly $1.5 billion – to buy out the venture. Qihoo made the announcement knowing full well that Coolpad could hardly afford such an amount, after Coolpad reported having just HK$4 billion ($512 million) in cash at the end of June.

Final Chapters to be Written

This story of crossed lovers undoubtedly still has some chapters left, as Qihoo decides whether to really move forward with the plan to exercise its put option. Even if it moves ahead, Coolpad could easily dispute whether the LeTV tie-up violates the non-compete clause in its earlier Qihoo joint venture agreement. It could also dispute Qihoo’s valuation of their joint venture, moving the process into the court system for a prolonged period.

Coolpad and Qihoo will probably reach some kind of settlement in the end, even though such a deal could easily move Coolpad closer to the brink of insolvency. It’s always possible that LeTV could play the role of white knight by providing cash to Coolpad for a Qihoo settlement. But LeTV could also easily decide to walk away after determining Coolpad isn’t quite so attractive anymore.

At the end of the day, Coolpad may end up just one of many victims of China’s smartphone price wars, after failing to innovate despite its early-arriver status to the sector. The company certainly could have boosted its chances for survival by choosing a better financial backer. And at the very least, it could have yielded more control and acknowledged that perhaps Qihoo could provide the innovation it needed to survive, rather than believing it could simply