(Bloomberg Gadfly) -- Baidu Inc.'s equity investors have been mighty patient in awaiting a turnaround at the Chinese search engine. Debt holders not so much.
That makes now a particularly unfortunate time to tap credit markets, as Baidu is doing this week, but a good chance for bond investors to reassess how they view its prospects.
With quite a few peaks and troughs along the way, Baidu's shares have eked out a 14 percent return over the past year. That's probably more than the company deserved given three declines in net income out of four quarters.
Its debt, on the other hand, has continued to suffer. While Baidu's 10-year bonds due June 2025 have moved sideways over the past 12 months, more telling is the spread against peer Alibaba Group Holding Ltd. For a long time, notes of Baidu and Alibaba tracked each other, but that's changed sharply.
From trading 8.5 basis points below Alibaba's debt due 2024, Baidu's bonds were at 30.2 basis points above on Tuesday. And it's not just Alibaba: A similar spread can be seen against fellow BAT trio member Tencent Holdings Ltd.
The gap was already starting to widen by the time Moody's Investors Service and Fitch Ratings put Baidu's debt on negative watch in May. Both cited concerns over Baidu's fully owned Financial Services Group, which has joined the fray in operating wealth-management and micro-lending businesses. In an interview almost two years ago, president Zhang Ya-qin told me that Baidu has an advantage because it collates reams of user data to map creditworthiness. A similar story is being told by Alibaba and other competitors.
But big data can't hide the fact that Baidu's secured borrowing tripled in the past year, pushing short-term liabilities up 46 percent. That's because, as the company stated, "the transactions of Baidu Wealth Management do not constitute a sale of the underlying securities for accounting purposes. We account for these transactions as secured borrowings."
There is an offset to this in trading securities under short-term investments, but the fact that 12 percent of total assets, as Moody's calculates, sit in Baidu's new financial services business has raised concern at the ratings company. And presumably among debt traders, too.
Yet if we're generous to Baidu and view worries about the financial services business as noise, the company's core business of search and future prospects in artificial intelligence make it possible to be a little more positive.
Bloomberg's credit risk model puts Baidu at IG6, in the middle of the investment grade category. By adjusting parameters in that model -- which include debt, interest expenses, adjusted cash flow from operations, and share price -- we see that Baidu's default risk is currently quite robust.
It's important to note that China's declining currency has had an outsized impact on Baidu's cashflow, given that the company generates revenue in yuan and services most of its debt in dollars. In yuan terms, cashflow from operations looks more solid while revenue has stabilized.
As Baidu's bankers hit the phones to sell this new debt offering, it's likely they will paint a picture of the coming boom in AI and driverless cars, tell investors that last year's advertising woes are behind it, and explain that 2017 is a transformational year for the company.
So far, shareholders have believed the story. The pricing of these new notes will tell us if debt investors do, too.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Tim Culpan is a technology columnist for Bloomberg Gadfly. He previously covered technology for Bloomberg News.