Buy Baidu on a 10% Spineless Sell-Off

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

When a 10% sell-off slaps a market leader in the face, my ears perk up. In this case, Wall Street has overreacted to Baidu's (NASDAQ: BIDU) fourth quarter earnings report. Worries represent a shortsighted view, missing the big picture. At today's price I see the sell-off as an opportunity for patient investors to pick up shares of China's leader in search and online advertising at a great price.

What happened?

On Monday Baidu reported fourth quarter net income, operating income, and revenue up 36%, 24%, and 41%, respectively.

What was the problem? Decelerating growth and margin contraction.

Investors were apparently a bit spooked by Baidu's 8% year over year growth in ad spending, compared to the prior quarter's growth of 17% and 62% growth in the year-ago quarter.

Furthermore, a shrinking net margin of about 170 basis points to 43.9% was a reflection of increased spending on marketing, R&D, and traffic acquisition. Plus, as Baidu's new rival, Qihoo (NYSE: QIHU), makes a strong attempt to enter the search business, investors are worried this spending could reflect a weakness in Baidu's competitive position. The company is a dominant player in the Chinese browser business. But it lacked its own built-in search engine until last August. According to a recent Bloomberg Businessweek article, Qihoo already controls 9.6% of China's search market traffic.

Zooming out . . .

But there is more to the story.

First of all, the deceleration in ad spending growth is no surprise. There are a limited number of large advertisers that can have such a large impact on ad spending growth averages. As these big clients max out their spending, their incrementally smaller increases in ad spending will have smaller effects on the average. The majority of Baidu's clients are small-business owners (on that note, there is 40 million of them in China and Baidu only claims 406,000 clients).

More importantly, the company's number of advertising clients are on the rise, increasing by 30% year over year. The deceleration of advertising client growth will come at a much slower rate than the deceleration in ad spending – especially in light of an increasing willingness of Chinese business owners to turn to trackable and measurable online advertising.

Second, net margin contraction is a result of very important investments with a long-term outlook. These investments should reward patient investors in the future as the company looks to fortify its competitive position in the search market.

Its aggressive investments include a year over year increase of 70% in R&D and a 52% increase in sales and marketing. As Baidu pointed out in the earnings call: mobile internet is a strategic priority for the company. On that front, Baidu is keeping its word; the 70% increase in R&D will help the company roll out a suite of new mobile products, including mobile maps, an updated mobile browser, and a voice-activated search assistant. The 52% increase in sales and marketing will help Baidu protect its growth trajectory in light of Qihoo's elaborate entrance into the search business.

Baidu, of course, isn't the first online search company to witness shrinking margins as costs increase. Over the past ten years Google (NASDAQ: GOOG) has witnessed a similar trend of increasing and then decreasing margins. Now Google investors are witnessing signs of a bottom to the trend and the Street is more confident than ever in the company's competitive position.

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GOOG Operating Margin TTM data by YCharts

The bottom line

With approximately 70% of China's online advertising and an even higher percentage of China's online searches, Baidu has nearly replicated a younger version of Google in China. As online advertising grows with increasing internet use, Baidu is poised to benefit. Despite an enormous market and a positive industry outlook, Baidu trades at just 21.6 times earnings – even cheaper than Google's P/E ratio of 23.5.

To solidify my conviction in the stock's future, I'm making a CAPS Call on Baidu.

Daniel Sparks has no position in any stocks mentioned. The Motley Fool recommends Baidu and Google. The Motley Fool owns shares of Baidu and Google. 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.

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