INTERNET: Baidu Deals With Perfect World, Acquisition Coming?

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Bottom line: An unexpected mid-sized transaction between Baidu and Perfect World could indicate the former is preparing to buy the latter, with an aim to building up a major new player in the online gaming and literature spaces.

Baidu eyeing Perfect World?
Baidu eyeing Perfect World?

Leading search engine Baidu (Nasdaq: BIDU) has reportedly just sold its online literature unit to the recently privatized Perfect World, in a rare reversal for China’s big Internet companies that have been far more active as buyers over the last 3 years. The deal is relatively small, with a reported sale price of 1.2 billion yuan, or about $190 million.

Media are focusing on the fact that Baidu paid far less when it bought the literature unit for a reported 190 million yuan from the same Perfect World just 2 years ago, meaning Baidu earned quite a nice profit on the investment. But more intriguing is the possibility that this move could presage an acquisition of Perfect World by Baidu, which looks quite logical for a number of reasons I’ll describe shortly.

First let’s start with the latest headlines, which have an unnamed source disclosing the transaction without giving much more detail. (Chinese article) Apart from focusing on the big profits Baidu earned during its 2 year ownership of the unit, the reports try to figure out Perfect World’s reason for buying back the unit, and also why it would pay such a high price for an asset it previously didn’t even want.

Perfect World was one of China’s earliest online game companies to list in New York, and in my view is one of the industry’s better run operators. But like most companies in the space, Perfect World has struggled due to stiff competition that resulted in uninspiring revenue and profits. That caused its shares to languish on Wall Street, and in April this year a management-led group made an offer to privatize the company.

Perfect World’s privatization bid was one of the earlier ones in a flurry of about 3 dozen similar offers that have come this year to de-list Chinese companies from New York. Most of those aimed to re-list back in China where the believe they can get better valuations. But unlike many of the other bids that have stalled due to market volatility in China, Perfect World was one of the few companies to complete its privatization and formally de-listed in July. (previous post)

De-listing in Tough Times

The company’s ability to successfully de-list was quite impressive, since it came at a very difficult time when China’s domestic stock markets were in free-fall in a major correction during the summer. That might imply that Perfect World’s financial backers for the buyout were willing to move ahead because they were confident they could quickly recoup their investment through a sale of the company to a third party.

That’s where Baidu would come in, since it has plenty of cash and could easily afford to buy Perfect World. At the time of its privatization Perfect World was worth about $1 billion, meaning that even with a 50 percent premium it would still only cost Baidu $1.5 billion. Such an acquisition plan would help to explain why Perfect World was willing to pay such a big premium to reacquire its literature unit from Baidu, since the unit would effectively get folded back into Baidu with a future merger of the 2 companies.

Perfect World’s relatively strong management would also make it a good vehicle for Baidu to make a serious play into online games, which has been quite a lucrative area for industry leaders Tencent (HKEx: 700) and NetEase (Nasdaq: NTES). The reality is that online games can be quite a profitable business for companies with big enough scale. That means the combination of Perfect World’s operating base and Baidu’s cash and other resources could position the company to embark on its own buying spree of smaller players in the fragmented market, potentially assembling a major new player to compete with Tencent and NetEase.

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