Baidu IS a Rule Maker, and Don't You Ever Forget It

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

Being trapped in a Rule Maker state of mind lately, imagine my excitement if I could actually find a company that came close to dominating all these commanding metrics.  While it seemed simple enough in theory, I assumed most of these stocks would be trading at hellacious valuations.  Regardless, I decided to do a little research.

After poking around with a few different stock screeners, I couldn't help but notice one company that was consistently ranked towards the top in most statistical Rule Maker categories.  In fact, it was ranking towards the top in every category:

Huge Revenue growth rates.

Huge EPS growth rates.

Ridiculous margins.  

An ability to raise cash that would make Apple proud...and this was just the start.

With a P/E of only 21 (a number usually reserved for the P&G's or J&J's of the investing world), and a stock price only 2% higher than its 52-week low, I realized that I may have found my first affordable Rule Maker: Chinese internet search provider, (NASDAQ: BIDU).

The Criteria:

Sustainable Competitive Advantage

Much like Google (NASDAQ: GOOG), Baidu has shown that sometimes nothing is more powerful than pure market share dominance.  Just as Google became its own verb thanks to its immense popularity, Baidu has become the go-to site for web searches in China.  This virtual domination in its industry is what gives it such a sustainable competitive advantage.  While companies like Qihoo 360 (NYSE: QIHU) offer more than just search, Baidu keeps its homepage simple, much like Google.

As Baidu goes down the road, one of its major growth runways will lie in its ability to become a leader in the mobile search market, as it looks to leverage this competitive advantage in all phases of its search business. With low penetration rates for the number of Chinese internet users, Baidu has a ton of room to grow, aside from developing its mobile search business segment.

Dominate Its Industry

Holding an 80% share in the Chinese search market, Baidu has this sector well under control.  With Google reporting a 16% share while exiting the Chinese search market, and the remaining few percent being widely distributed, Baidu has no imminent competitor in the space.

Despite holding this dominating position, the market has been unsure of Baidu lately, as software website Qihoo 360 rolled out their new search engine in August.  Initial reports showed Qihoo taking 10% of Baidu's search market share, but things have gone on to balance out, with Baidu regaining roughly 5% since late August.  Furthermore, as Rick Aristotle Munarriz explains, Baidu and Qihoo are not "in a battle to the death over search in China," and may be able to work together.

The 60:10:10:10

Four percentages that make up the Rule Maker criteria are Gross Margin, Profit Margin, Cash King Margin, and Revenue Growth Rate, which we like to see come in at 60%,10%,10%, and 10%, respectively. Currently Baidu comes home with the following numbers (Google and Qihoo are provided as a further comparison): 

<table> <tbody> <tr> <td><strong>Company</strong></td> <td><strong>Gross Margin</strong></td> <td><strong>Profit Margin</strong></td> <td><strong>Cash King Margin</strong></td> <td><strong>Rev. Growth Rate (5 Yr.)</strong></td> </tr> <tr> <td><strong>Baidu</strong></td> <td>84%</td> <td>48%</td> <td>51%</td> <td>63%</td> </tr> <tr> <td><strong>Google</strong></td> <td>65%</td> <td>22%</td> <td>27%</td> <td>22%</td> </tr> <tr> <td><strong>Qihoo</strong></td> <td>89%</td> <td>19%</td> <td>31%</td> <td>Undetermined</td> </tr> </tbody> </table>

Clearly, we can see that Baidu, Google, and Qihoo all blow these Rule Maker metrics out of the water.  What's even more exciting about this is Baidu's relative out-performance versus Google and Qihoo on these same metrics.  

Foolish Flow, ROIC Above 11%, and Cash/Debt < 1.5

<table> <tbody> <tr> <td><strong>Company</strong></td> <td><strong>Foolish Flow</strong></td> <td><strong>ROIC > 11%</strong></td> <td><strong>Cash/Debt < 1.5</strong></td> </tr> <tr> <td><strong>Baidu</strong></td> <td>.39</td> <td>47%</td> <td>3.4B/460M=7.4x</td> </tr> <tr> <td><strong>Google</strong></td> <td>.99</td> <td>16%</td> <td>44.6B/7.9B=5.6x</td> </tr> <tr> <td><strong>Qihoo</strong></td> <td>.65</td> <td>13%</td> <td>348M/0=No Debt</td> </tr> </tbody> </table>

Yet again, all three pass with flying colors, exhibiting some amazing metrics.  Coming in with a Foolish Flow of only .39, Baidu is well below the preferred number of 1.  Holding cash on hand of $3.4 billion and a tremendous ROIC of 47%, things look very strong here for Baidu as well.  Much like the first table, Baidu beats Google and Qihoo in every metric, displaying its financial strength.

With these numbers on hand, it is clear to see that Baidu and Google meet the statistical requirements to be Rule Makers.  Throw in the domination of their respective markets and quality competitive advantages, Baidu and Google are definite Rule Makers.  As for Qihoo, time will tell as it meets most of the Rule Maker metrics, but it has a long way to go before it truly dominates any markets.

However, despite all these great numbers for Baidu, it is only a good investment if it can be bought at a reasonable valuation and price.

The Right Price

Currently trading at $94, a price it hasn't been below since September 2010, Baidu's stock is only 2% higher than its 52-week low. Furthermore, Baidu sports a P/E of 21 and a Price to Cash Flow of 16, both of which are only half of their respective 5 year average. Similarly, with a Forward P/E of 16 and a 5 year PEG of .5, Baidu is trading at a major discount to its future growth.

A Few Foolish Final Thoughts

Regardless, no matter how much of a screaming buy a company may be, there are always risks associated.  Perhaps the biggest risk with Baidu is its homeland, China.  Having been a holder of a few Chinese stocks that quickly fell apart due to fraud over the past 3-4 years, it is understandable that many investors would prefer to stay away from Chinese stocks in general.  

However, at these current valuations I feel that the risk for fraud is already priced in, and the Chinese internet search company represents a buying opportunity.  With its sheer size alone, Baidu will be under intense pressure to produce incredible numbers (ethically), and I believe they will be ready to deliver.  Having bought in at $125 on CAPS, I see their current price as a great entry point and have them at the top of my watchlist for the immediate future.

joryko has no positions in the stocks mentioned above. The Motley Fool owns shares of Baidu and Google. Motley Fool newsletter services recommend 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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