Is This Fundamental Trend a Silent Stock Killer?

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Baidu (NASDAQ: BIDU) is exploding with gains; the company’s revenue is rising, yet investors ignore areas of caution that are abundantly clear. These areas of caution are affecting the entire space, which you should consider before investing.

3 Metrics of Concern

Baidu is essentially the Google of China, has risen 35% in the last month, and is currently trading higher by 8% after its second quarter earnings beat. For the quarter, Baidu grew its revenue 38.6% year-over-year to $1.23 billion and posted an EPS of $1.26; this was $32 million and $0.05 better than the consensus, respectively.

Baidu’s robust revenue growth is not a problem for investors. However, Baidu is facing a substantial overhang with costs, and the price paid to acquire traffic. In particular, three metrics create a reason for concern: traffic acquisition costs, SG&A, and R&D.

Baidu’s traffic acquisition cost is the price it pays to increase site volume. This metric is the single greatest threat to Baidu’s operating margin, as it’s determined by a percentage of revenue. For example, Baidu spent 8.3% of its revenue in the second quarter of 2012 acquiring website traffic.

This last quarter, the cost rose to 11.6% of revenue, which was up from 10.2% in the first quarter. This continuous rise will cut into the amount of dollars per $100 that Baidu earns as a profit, which affects margins.

In addition, Baidu’s SG&A rose 83.5% to $175.7 million and R&D rose 72.6% to $153.4 million, both year-over-year for the second quarter. The problem is that both costs are growing faster than revenue, and combined with the rise of traffic costs, Baidu faces turmoil in trying to maintain its industry-best margins.

Baidu’s valuation is largely tied to its margins. Baidu has reported operating margins of 46.5% during its last 12 months. With the company trading at 10 times sales, the stock is expensive relative to a technology sector that trades at 3.2 times sales. Therefore, Baidu’s margin woes could be an overhang as the quarters progress.

An Industry Concern

While Baidu’s margin outlook may look dim, it is not just Baidu that faces these issues, but rather many companies that trade in its technology space. Many of these Chinese tech companies mimic successful U.S. companies. These companies have high valuations, rapid growth, and margin pressure.

Qihoo 360 (NYSE: QIHU) is one of the most liked companies on Wall Street. The company sells anti-virus products but also earns revenue through advertising and Internet search. The stock has traded higher by 300% over the last 12 months, and trades at 19.25 times sales.

Investors have flocked to Qihoo because of its growth. During Qihoo’s last quarter, revenue grew almost 60% year-over-year. However, like Baidu, the company’s acquisition of traffic, and its overall operating expenses are growing faster than sales.

For Qihoo’s last quarter, the cost of revenue was $13.9 million, which was an 82.7% increase over the prior year, and a 30.6% rise from three months prior. The company’s total operating expenses were $89.2 million, a near 90% year-over-year rise. Combined, this shows that while Qihoo is a growth company, its expenses are also racking up, and margins are falling lower.

A Rare Exception

Companies such as Baidu and Qihoo continue to show the struggles that Chinese stocks face. While these two companies were used as examples, this trend can be seen in just about every high-profile Chinese tech company.

YY (NASDAQ: YY) is one of the only companies that I’ve identified as operating against this trend, and its stock has been rewarded with gains of 250% since its November 2012 IPO. YY operates like a YouTube but also has a touch of Facebook and Zynga with a social media and gaming platform. They grew revenue 130% year-over-year in their most recent quarter, but also saw a 1,715% gain in net income during the same period.

The primary reason has been a steady increase of operating income that exceeds revenue growth. The company’s ability to manage costs while producing growth might make it a diamond in a rough Chinese tech market.

Conclusion

Chinese tech stocks are on the rise after Baidu’s quarterly report, and rightfully so. The company did beat quarterly expectations, and it’s possible that similar companies could follow its lead this earnings season.

My look at costs is not an overnight stock killer, but long-term; it could affect the returns of these stocks. Therefore, while assessing this space for potential investments, keep in mind the costs that could weigh heavily in the future. 

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Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Baidu. The Motley Fool owns shares of Baidu. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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