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Is It Time to Buy Baidu?

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

The past year has not been kind to investors of Baidu (NASDAQ: BIDU), China’s largest search engine. Once the darling of momentum investors, Baidu surged 1157% from its debut in 2005 to an all-time high of $157 in July 2011. Since then, the stock has stalled out and fallen 35%, due to macro concerns regarding Chinese growth, worries regarding increased regulations (both in China and the United States), and increased domestic competition. Despite this precipitous drop, Baidu has outperformed the Shanghai Composite over the past two years, while underperforming the NASDAQ, the parent index of its ADR shares, by a considerable margin.

Yet with a trailing P/E of 25, the stock is also at its cheapest historical valuation. The company also has revenue and earnings growth that exceed its larger international rival, Google (NASDAQ: GOOG). Should investors consider Baidu now that the stock has fallen out of favor, or is a cheaper price not far down the road?

Signs of a Bottom in China

Although China has struggled with growth and inflation over the past year, the country’s outlook is far rosier than Europe’s endless crisis. Industrial output and retail sales growth rose to an 8-month high in November, rising 10.9% and 14.9%, respectively. The Shanghai Composite has also rallied 10% over the past month on increasing optimism.

Internet usage in China rose from 2% to 38% between 2000 and 2011, compared to an increase from 43% to 78% in the United States. The world on average posted an increase of Internet users from 7% to 33%. This means that if China is to evolve into the next United States, as most economists forecast, then it can still comfortably double its wired population over the next decade. Therefore Baidu, which controls approximately 80.3% of the Chinese search market, still has room to grow.

Earnings and Revenue Growth Declining

In Baidu’s most recent quarterly earnings, it grew earnings per share by 63.1% on revenue growth of 51.9%. Google, by comparison, posted a 7% decline in EPS on a 51% gain in revenue. However, Baidu spooked analysts with its fourth quarter guidance, which forecast EPS to grow 36.8% on revenue growth of 40.6%. This perceived slowdown caused Baidu to slide to $88 per share by early December.

Let’s take a look at Baidu’s EPS and revenue growth over the past year to see if this sell-off was justified.

<table> <tbody> <tr> <td> <p><span><span><span><strong>Quarter</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>EPS</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Y-O-Y EPS Growth</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Revenue</strong></span></span></span></p> </td> <td> <p><span><span><span><strong>Y-O-Y Revenue Growth</strong></span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Q1 2012</strong></span></span></span></p> </td> <td> <p><span><span><span>$0.87</span></span></span></p> </td> <td> <p><span><span><span>85.1%</span></span></span></p> </td> <td> <p><span><span><span>677.1 million</span></span></span></p> </td> <td> <p><span><span><span>82%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Q2 2012</strong></span></span></span></p> </td> <td> <p><span><span><span>$1.24</span></span></span></p> </td> <td> <p><span><span><span>72.2%</span></span></span></p> </td> <td> <p><span><span><span>858.8 million</span></span></span></p> </td> <td> <p><span><span><span>62.5%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Q3 2012</strong></span></span></span></p> </td> <td> <p><span><span><span>$1.37</span></span></span></p> </td> <td> <p><span><span><span>63.1%</span></span></span></p> </td> <td> <p><span><span><span>994.6 million</span></span></span></p> </td> <td> <p><span><span><span>51.9%</span></span></span></p> </td> </tr> <tr> <td> <p><span><span><span><strong>Q4 2012 (estimated)</strong></span></span></span></p> </td> <td> <p><span><span><span>$1.30</span></span></span></p> </td> <td> <p><span><span><span>36.8%</span></span></span></p> </td> <td> <p><span><span><span>999.2 million</span></span></span></p> </td> <td> <p><span><span><span>40.6%</span></span></span></p> </td> </tr> </tbody> </table>

It’s fairly easy to see where this chart is heading if this trend of diminishing returns continues. However, if these declines were caused by macro problems in China, rather than ones stemming from increased competition, then Baidu could reverse course as the Chinese economy improves.

Looking forward, Baidu’s return on equity is at 56%, higher than Google’s 18.7% and Apple’s (NASDAQ: AAPL) 42.8%. The company’s low debt levels and strong cash holdings of $3.4 billion also enhance its attractive fundamental valuations. The stock also trades with a 5-year PEG ratio of 0.37.

Regulatory Threats in the East and West

One threat that Baidu’s investors are well accustomed to is the tightening of Internet regulations in China. The Chinese government is still adding bricks to the Green Dam, also known as “The Great Firewall of China,” to block popular sites such as Facebook, as well as searches for controversial topics such as “Tiananmen Square,” “Taiwanese Independence” or the “Dalai Lama.”

To date, Baidu has cooperated with the Chinese government and given in to all of these regulatory changes, but it has still been censured several times in the past for failing to regulate music and software piracy. Baidu shares also slid last August after CCTV (China Central Television), the dominant state-controlled broadcaster, launched damaging PR attacks against the company, claiming that Baidu was knowingly promoting links to fraudulent businesses.

But recently a new threat has emerged in the west - a crusade in the SEC to weed out and delist fraudulent Chinese companies, especially those that went public through reverse mergers and other methods of creative accounting. Chinese companies on U.S. exchanges are also now expected to be thoroughly audited. Although most analysts believe Baidu’s accounting to be sound, any negative news from other U.S.-listed ADRs is likely to adversely impact the stock, especially if institutional investors turn their backs on all Chinese Internet firms as a result.

The Double Edged Sword of Mobile Growth

Recently, Internet giants Google and Facebook (NASDAQ: FB) have struggled with monetizing mobile advertisements, which are considered less important, and thus cheaper, than their full-size Internet display counterparts. In September, Baidu launched a website conversion application, WebApp, which allows companies to easily convert their websites to a mobile format more easily read by smartphones and tablets. This forward-thinking strategy shows that Baidu is planning ahead, being proactive rather than reactive, in tackling the mobile market. This initiative has been costly, however, and forced Baidu to sell $1.5 billion in notes to finance its investment and repay debt, which caused Citigroup to downgrade the stock to “Sell.”

China’s mobile Internet users have risen from a mere 700,000 users in 2008 to an astonishing 400 million in 2012. If Baidu’s bold efforts with its WebApp platform pay off, monetizing its mobile users to complement its display ad revenue, then 2013 could be the start of a strong turnaround for the company. Baidu’s recent partnership with Apple, which allows it to become the default search engine on iOS devices in the mainland, will also be a positive catalyst as the iPhone 5 goes on sale.

Is it Time to Buy Baidu?

Although Baidu may be threatened in the near term by some younger, hungrier competitors - such as Qihoo 360 (NYSE: QIHU), which captured 10% of the search market in its most recent quarter - its long-term growth potential remains intact. It’s also worth noting that Qihoo’s growth came from the decline of Google - which currently is the second largest Chinese search engine with a 15% market share - rather than from any missteps by Baidu.

Baidu is merely encountering the same growth hurdles that tripped up Google several years ago. The main difference is that whereas Google is dominating mature markets around the world, Baidu has (nearly) exclusive access to the lucrative Chinese market, which is far younger by comparison. If you believe that China’s economy will turn around in the coming year, and that its mobile initiatives will pay off, then Baidu - trading at 11.95 times forward earnings - is definitely a buy.

Leo Sun has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Baidu, Facebook, and Google and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Apple, Baidu, Facebook, 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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