iQiyi accused of fraud by Wolfpack, Muddy Waters which targeted Luckin

Chinese video streaming site iQiyi has been accused of fraud and inflating its financial numbers by a research firm, just days after coffee chain Luckin Coffee found a senior executive fabricated 2019 sales. 

Wolfpack Research, which describes itself as an “activist research and due-diligence firm”, released a report on Tuesday, alleging that iQiyi “was committing fraud well before its IPO (initial public offering) in 2018 and has continued to do so ever since.”

The company pushed back against the report and said it believes it contains “numerous errors, unsubstantiated statements and misleading conclusions and interpretations.”

In 2018, iQiyi was spun off from Chinese search giant Baidu in a U.S. IPO that raised over $2.2 billion. Baidu holds a more than 56% stake in iQiyi. Often dubbed the “Netflix of China”, iQiyi has become one of the major content streaming platforms in the country. 

Shares of iQiyi briefly plunged 13% to session lows Tuesday after the report, though the stock ended the day up 3% during a volatile session for U.S. stocks, more broadly. Shares fell more than 3% in extended trading.

Wolfpack Research alleged that iQiyi inflated its 2019 revenue by approximately 8 billion yuan ($1.13 billion) to 13 billion yuan ($1.98 billion), or 27% to 44%.

“IQ does this by overstating its user numbers by 42%-60%. Then, IQ inflates its expenses, the prices it pays for content, other assets and acquisitions in order to burn off fake cash to hide the fraud from its auditor and investors,” the research firm said in its report. 

Wolfpack said it used a mixture of publicly available sources, data obtained from private sources like advertising companies as well as surveys the research firm conducted and a former employee of the streaming service. 

Users have to pay for iQiyi’s VIP membership either directly or through partners like e-commerce site JD.com and Xiaomi. Wolfpack alleged that around half of iQiyi’s VIP users got the membership for free or through a cheap deal from these partners. The research firm claims iQiyi accounts for dual memberships on a “gross basis” meaning “it records the full amount of revenue and records its partners’ share as expenses.” 

“This allows IQ to inflate its revenues and burn off fake cash at the same time,” Wolfpack Research claimed. 

Wolfpack also takes issues with a part of iQiyi’s balance sheet known as “deferred revenues,” which typically refers to customers paying for a service in advance of its delivery.

“Because IQ’s subscription customers prepay, most of its revenues are a function of deferred revenue. These pre-IPO overstatements inherently cause IQ’s post-IPO revenues to continue to be overstated,” the report claims. 

The Chinese firm also allegedly inflated its so-called barter transaction revenue. This is revenue that iQiyi earns through barter deals over content copyrights with other companies. Wolfpack alleges, citing an former employee, that prices for these barter transactions are determined internally. The firm asserted that this allows iQiyi’s management to “effectively assign any value they want to these transactions, providing an easy opportunity to inflate its revenues.”

In a statement on Tuesday, iQiyi said it “believes that the report contains numerous errors, unsubstantiated statements and misleading conclusions and interpretations regarding information relating to the Company.”

“The Company emphasizes that it has always been and will remain committed to maintaining high standards of corporate governance and internal control, as well as transparent and timely disclosure in compliance with the applicable rules and regulations of the Securities and Exchange Commission and the Nasdaq Global Select Market.” 

A Baidu spokesperson said it doesn’t have a separate statement when contacted by CNBC. 

Wolfpack Research is backed by Muddy Waters Capital, a high-profile activist firm known for finding alleged fraud within companies and taking short positions against them.

Muddy Waters assisted Wolfpack in the research, and both firms said they took short positions against iQiyi, betting against the stock in light of their findings.

Earlier this year, Muddy Waters said it was shorting Luckin Coffee’s stock which is listed in the U.S. because it received an “unattributed 89-page report” which alleged the Chinese chain is a “fraud.” 

Then just last week, Luckin Coffee disclosed that an internal investigation found that its chief operating officer fabricated 2019 sales by about 2.2 billion yuan ($310 million). Its stock tanked 80% after that statement.