Should You Worry About Baidu's Fintech Move?

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Many discussions about Baidu (NASDAQ: BIDU) focus on its slowing ad revenue growth and its rising investments in online-to-offline (O2O) services. The bulls think that the lull is temporary, and that the expansion of its ecosystem will pay off. The bears think tech giant Tencent (NASDAQOTH: TCEHY) could overtake Baidu with its growing ecosystem of apps, services, and games.

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Over the past few years, that battle has spilled over to the fintech industry, with Baidu, Tencent, and several other tech giants offering short-term loans and wealth-management products through digital channels. Credit rating agencies -- which call these products part of the "shadow banking" system in China -- claim that these moves could hurt their credit ratings.

In May, Moody's placed Baidu's A3 issuer and senior unsecured bonds rating on review for a downgrade, citing the "higher financial and execution risks when compared to its core business." Fitch followed suit earlier this month, placing Baidu's bonds on "negative watch" due to the "significantly higher" risks of the fintech industry. Should investors be concerned about these changes?

Understanding the Chinese fintech market

About 160 million people in China took out 1.2 trillion yuan ($180 billion) in online loans last year, according to iResearch. The firm sees that figure growing at an annual rate of 50% over the next three years. But the rapidly growing market is also a loosely regulated one plagued by fraud and defaults.

iResearch reports that the average overdue rate ranges from 10% to 20%, and is the "main factor that prevents online lending from becoming a mainstream channel in China's financial industry." Fintech bulls believe that improvements in artificial intelligence -- which Baidu, Tencent, and Alibaba (NYSE: BABA) are all investing heavily in -- will weed out the deadbeats by analyzing their smartphone behavior and pulling more data from their credit histories.

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Yet that can be tough due to the limited credit history of many Chinese consumers. Many businesses in China are still cash-based, mortgages were barely issued before 2000, and the average Chinese consumer uses a third of a credit card -- compared to an average of 2.6 cards per American consumer.

But China's tech giants rush ahead...

Despite these challenges, the biggest Chinese tech companies are aggressively expanding their ecosystems into this market. Baidu's Financial Services Group (FSG), which was officially formed a year ago, had 25 billion yuan ($3.7 billion) in assets at the end of its last quarter, which accounted for 12% of its total assets.

That unit sells wealth management products and loans, and offers an online-only bank for customers. Those services are tied to its mobile payment platform Baidu Wallet, which had 100 million activated accounts at the end of 2016 -- representing 88% growth from 2015. Baidu also invested in ZestFinance, a U.S. fintech company that uses big data for credit scoring purposes, in two separate funding rounds.

Tencent, which expanded its popular WeChat messaging app into an ecosystem of O2O services over the past few years, pulled in users with its own online bank (which offers loans) and its mobile payments platform WePay. It also joined China Rapid Finance, a consumer-lending marketplace, to offer other investment products.

Alibaba's fintech affiliate Ant Financial claims that over 100 million users have taken out loans. Alibaba spun off Ant last year, enabling it to maintain a large stake in the company but removing its volatile cash flows and debt from its balance sheet.

Alibaba's rival JD.com (NASDAQ: JD) also plans to spin off its similar fintech arm, JD Finance, but that plan hit a wall in February when regulators started probing the unit over allegations that it violated security laws.

Should investors be worried?

Fitch believes that Baidu's credit risk is higher than Alibaba and Tencent's, since those two companies are more profitable and have stronger cash flows. Simply put, Baidu's heavy investments in O2O growth and next-gen initiatives could throttle its ability to contain overdue payments or defaults at its fintech arm.

But even if Moody's downgrades Baidu's debt from A3 to Baa1, or Fitch cuts its current rating from A to A-, the bonds would still be well within "investment grade" parameters. Therefore, there's no need for investors to panic over the negative comments.

However, Baidu is still entering a riskier market, and a wide range of challenges -- including fraud, defaults, and new regulations -- could throttle the unit's growth. But with Tencent, Alibaba, JD.com, and others already deep in the market, Baidu must keep expanding its fintech business to avoid being left behind a major tech curve.

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Leo Sun owns shares of Baidu and Tencent. The Motley Fool owns shares of and recommends Baidu and Moody's. The Motley Fool has a disclosure policy.