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Last month, Baidu (BIDU) agreed to buy the remaining stake of Nuomi, a group-buying website, from RenRen (RENN). The acquisition is expected to close in the first quarter of 2014, after which Nuomi will become a wholly owned subsidiary of Baidu. Although Nuomi never achieved profits, its performance in the third quarter has been commendable. Nuomi's revenue grew 36% year over year to $6.5 million and total active users stood at 3.8 million in the third quarter. Baidu is acquiring Nuomi to combat the competitive pressure from both Tencent (OTCPK:TCEHY) and Alibaba (ABABA), which have a significant presence in the Chinese e-commerce market. Alibaba's backed group-buying service, Meituan.com, had 50% market share in 2013 with total transactions reaching $2.4 billion by the year's end. Meanwhile, Nuomi is the fourth largest player with a market share of 11.6% in the group-buying market. Therefore, acquisition of Nuomi was one of the options for Baidu to gain an entry into group-buying and remain competitive in the e-commerce industry.

Another reason why Baidu went ahead with this move is the importance of group-buying business to its location-based services (LBS), as Baidu has integrated many group-buying deals with its mobile applications. Baidu has added group-buying features on its map, giving unique deals to the users based on their locations. These features include integrated services, such as hotel and car bookings, movie tickets, and booking tables at restaurants. Baidu received an online payment license last year, and these service offerings will be essential to ramp up its mobile payment system. Baidu is yet to monetize its maps, and therefore Nuomi is an important catalyst for map monetization in the coming quarters. Nuomi's strong LBS capability will strengthen Baidu's LBS.

On the other hand, rise of Chinese online companies Tencent, SINA (SINA), and Qihoo 360 (QIHU) has made RenRen's survival in the industry very difficult. RenRen, which was once considered the Chinese Facebook, has lost its sheen due to competitive pressure and rising popularity of instant messaging services like WeChat. The company has struggled to achieve profits in the last two years from its Social Networking service (SNS), and has been moving away from its gaming business due to its negative growth. RenRen is focusing on transitioning to mobile but I don't think this will be easy for the company, especially amidst such competition.

Chinese online companies dive into financial Sector

Financial sector seems to be the preferred destination of Chinese technology companies. Companies like Baidu, Alibaba, and Tencent have ventured into the financial market with their finance platforms and payment gateways. Tencent is the latest one to launch a financial product and has partnered with Huaxia Bank to offer the product through WeChat in January 2014. The company boasts of giving a 6.435% interest rate, which is 16 times more than the central bank's benchmark one-year deposit rate.

Baidu also launched a wealth management platform in collaboration with China Asset management bank last year and was able to garner $164 million with more than 120,000 clients in just five hours of its launch. The real competition to Baidu is from Alibaba and its finance platform, Yuebao, which achieved $41 billion in deposits by January this year.

The huge demand for online financial products is due to the high interest rate offered by these technology companies compared to Chinese commercial banks. These banks offer 0.35% interest rate and 3.25% for one-year deposits. Banking services have been tightly regulated and interest rates aren't liberated. Thus, deposit rates remain low and loan rates are high. This has given technology companies an opportunity to reach out to individuals as well as small and medium enterprises by offering higher interest rates. They also have the advantage of reaching the masses without setting up retail outlets, saving them any incremental costs. However, safety of data and last mile Internet connectivity still poses a challenge for online financial services.

With an annual interest rate up to 8%, Baidu offers the highest rate compared to Alibaba and Tencent. However, an interest rate of 8% was too aggressive and Baidu later withdrew this claim. Looking at the early traction of the first financial product, Baidu launched its second investment product in December last year. The new product, bank deposit agreement, offers more yield than normal fixed term rates. The success of Baifa, Alibaba's Yuebao, depicts the growing demand of wealth management products in China and the potential for Baidu to attract investments from users.

Are these high returns by Chinese online players sustainable?

Alipay.com's (Alibaba's third-party payment arm) "Yu E Bao" online fund which was started in June 2013 brought an opportunity for customers to invest as little as $0.16 (1 yuan). They can also withdraw money and return it to their Alipay accounts at any time. Because of these benefits, this fund has grown rapidly since its inception and its user base reached to 49 million with deposits of $41 billion (250 billion yuan), as of Jan 15, 2014.

"Yu E Bao" mainly invests in bank deposits, with more than 90% of money into agreement deposits with bank, which generates high yields. As a result, it generated returns of around $661 million (4 billion yuan) in last eight months. It reduced its holding of corporate bills from 3.18% as of Sept, 2013 to 1.27% as of Dec 31, 2013 and increased its holding in bank deposits from 85% to 92%, as the bank deposits were offering higher yield.

Talking about interest and bank liquidity environment in China, interchange liquidity has been tight in the recent times, and banks needed cash to meet the year end regulatory requirement. Because of this reason they are currently offering higher interest rates in order to gain funds from the internet finance products like Yu E Bao.

One of the reasons, Chinese banks are facing liquidity issue is that the retail customers reduced their demand deposit from banks and kept in internet finance products like "Yu E Bao". This happened because of the ceiling on deposits. Demand deposits are one of the highest earning deposits, as banks provide around 0.35% interest to accountholders and then lend this at more than 6% interest rate. As "Yu E Bao" provides the same benefit of demand deposits while providing higher interest rate, customers are increasingly investing their money in this fund.

The fixed-day repurchase rate, which is the barometer of Chinese banking system's liquidity, was at its record high of 10.77% in June 2013, and averaged to 4.09% in 2013, which is higher than 2012's average of 3.50% average. In December it reached a level of 8.84%, which shows that interbank liquidity remained high during this period. However, I think these liquidity issues will not continue because of the recent China's interest rates liberation.

Impact of interest rates liberation:

In December, 2013 People's Bank of China announced the inter-bank negotiable certificate of deposits (CDs), and interest rates will be determined by the market.

According to Societe Generale, these certificates of deposit "can help banks secure a more stable funding source and offer liquid and safer underlying securities for investment products targeting individual investors".

In January, banks like China Construction Bank, the Agricultural Bank of China and the Bank of Communications, increased the deposit rate by 10% on the upper limit for some clients. Although, China has not yet removed ceiling on deposit rates, but it is expected to remove the ceiling in the near future, and these steps shows that the country is moving in that direction.

This will attract investors to invest their money in banks deposits, which will help banks to reduce their liquidity issues. Although, it won't bring back the money, which has gone to internet finance products, but in future Chinese banks won't face liquidity issues similar to what they have been facing. This consequently will reduce the interest rates on agreement deposits. Once the Lunar New Year holidays are over, banks' liquidity position will improve and interest rates on agreement deposits will fall.

Bottom-line

Baidu is following the same path as Tencent and Alibaba, diversifying its business from online services to financial services as well, and it witnessed strong signs in the financial services. Going forward, I believe Baidu will realize synergies with its improved LBS offering through map and Nuomi integration as well as from its native app and light app strategies. This along with focus on its mobile search offering should strengthen the company's monetization efforts and contribute towards top-line growth.

In the third quarter of 2013, Baidu achieved 42.3% year-over-year revenue growth, and the company has indicated a strong revenue growth in the range of 45.5% to 49.6% for the fourth quarter. Coupled with the above fundamentals and continuous efforts to build a strong dominance in mobile, I believe the company has strong growth potential in the coming years.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: Fusion Research is a team of equity analysts. This article was written by Rohit Gupta, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article

Source: Baidu: What's Going On In The Group Buying And Financial Services Segment