Baidu: After the Fall

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

There’s no question that Baidu (NASDAQ: BIDU), often known as the ‘Google of China,' has been a broken stock over the past twelve months. Shares of the Chinese search leader have plunged 40%, hit by bad news on the macro and micro levels at every leg down. But after the fall, Baidu’s fundamentals are looking very attractive, despite the difficult headwinds it faces.

Should investors buy this broken beast, which is slowly slumping towards 52-week lows, or should they consider its higher growth rival, Qihoo 360 (NYSE: QIHU), instead?

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Primary concerns

Baidu is still the undisputed leader of online searches in China, with a 71% market share on laptop and desktop platforms. However, between December 2012 and February 2013, Baidu actually ceded two percentage points to Qihoo. Baidu slipped from 73% to 71%, while Qihoo rose from 10% to 12%.

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Source: Value2020

That decline doesn’t bode well for Baidu, especially when coupled with a projected slowdown in display advertising, which generates approximately 60% of the company’s revenue.

Chinese display advertising, which was once a triple-digit growth industry, has slowed considerably over the past three years. In 2010, the market grew 55%, followed by 67% growth in 2011. However, that growth slumped back to 49% in 2012. Analysts believe that between 2013 and 2016, the market is expected to mature and slow to a CAGR (compounded annual growth rate) of 24.6%. Much of this decline is attributed to the rise of mobile devices, which have opened up a new, hotter market - mobile advertising.

The mobile dilemma

The Chinese mobile market is growing feverishly - China’s mobile Internet users rose from 700,000 users in 2008 to 400 million at the end of 2012.

That means that Baidu must boost its mobile advertising business, where it leads the market with a smaller market share of 35%. Yet less than 10% of Baidu’s revenue last quarter came from mobile ads. The Chinese mobile advertising market is also fragmented, with its primary competitors being Tencent Holdings, which has 23% of the market, and Easou, which has a 22% share.

Tencent, a large diversified Internet company, is a major force thanks to its two flagship applications - Tencent QQ and WeChat. Tencent QQ is the country’s most popular desktop instant messaging application, with more than 670 million users. WeChat, which has over 200 million users, is the most widely used smartphone text and voice chat platform. WeChat’s popularity on mobile devices has given Tencent an ideal platform for rolling out mobile ads.

Meanwhile, Sina’s (NASDAQ: SINA) Weibo service, considered the ‘Twitter of China,’ also has a huge mobile following, with 75% of its 46.2 million users accessing the site through a mobile device. What’s more, Weibo’s user base has grown 82% over the past year, and has shown no signs of slowing down. 30% of Weibo’s total revenue was generated by mobile advertisements.

Sina, with a market cap of $3.2 billion, is often cited as a possible takeover target for Baidu, which needs a viable mobile platform to boost its advertising and market share.

Longer-term mobile solutions

Baidu, on the other hand, has a more scattered approach of approaching the mobile market. CEO Robin Li claims that using a combination of traditional search, mobile cloud services, location based services and international businesses will help drive mobile growth. Last quarter, Baidu spent 25% of its research & development expenses on developing new ways to monetize the mobile market.

The most noteworthy products from this investment are Baidu’s map service, which has roughly 100 million users, and its personal cloud-based service, which is now hosting one billion files for its 30 million users. These services could yield interesting advertising opportunities, but it is still too early to gauge their long-term growth potential.

In addition, Baidu’s WebApp, which was launched last September, allows companies to convert their desktop websites to mobile versions that can be more easily read on smartphones and tablets. WebApp and Baidu’s other mobile initiatives have been a costly affair, forcing the company to sell $1.5 billion in notes to finance its investments and repay debt. That raised some red flags with analysts, and prompted Citigroup to downgrade the stock to “Sell.” Were those concerns justified?

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Although Baidu’s debt and expenses have increased considerably over the past three years, the company’s cash and short term investments are still remarkably robust, at $5.22 billion, with free cash flow at nearly $1.0 billion. I’m highlighting Baidu’s cash position because I believe that Baidu could still afford to make an acquisition - such as Sina’s Weibo - to get out of its mobile rut to win back investors.

Pushing back against Qihoo

Back on the desktop front, Qihoo remains a major obstacle for Baidu moving forward. Qihoo is aiming to double its 10% market share to 20% by the end of the year at Baidu’s expense.

Qihoo, which was already China’s largest antivirus company, used its brand recognition to build a search engine,, and a portal site, It then rolled out its own browser, the 360 Browser. The 360 Browser controls roughly a fourth of the Chinese browser market, which puts it behind Microsoft’s Internet Explorer, which controls half, but far ahead of Google Chrome, Firefox or Apple's Safari. This is a play straight out of Google’s playbook - creating a popular browser that directs search queries through the parent company’s search engine.

Combining these four main products has helped Qihoo steadily chip away at Baidu’s market share. Qihoo’s release of a mobile browser in 2011 prompted Baidu to introduce its own mobile browser a year later. However, neither Qihoo nor Baidu has made a significant impact in mobile browsing, where Tencent’s QQ browser is the clear leader, with 40% of the market, owing to the strength of its WeChat platform. Meanwhile, the UC browser controls 38%.

Baidu has also pushed back against Qihoo in the antivirus business, with the release of its lightweight Baidu Antivirus software, which is designed to complement its aforementioned cloud-based services.

Although Baidu’s mobile browser and antivirus releases are unlikely to have much of an impact on its overall revenue, they indicate that Baidu is readying its defenses to curb Qihoo's growth.

Bottom Line

Baidu is fundamentally cheap at current prices, trading at 12.8 times forward earnings with a 5-year PEG ratio of 0.52, making it a bargain compared to Sina or Qihoo, which trade with respective forward P/E ratios of 30.7 and 18.7.

However, investors are more concerned about Baidu’s growth potential. Baidu has to show that it is able to contain Qihoo’s growth on the desktop front, as well as gain market share on the mobile front to win back investors. These are tough targets considering the increasingly fragmented state of the market, as well as the projected slowdown in display advertising. For now, I think Baidu’s bottomed out, but I don’t think it’s going anywhere until it can show improvement in these areas.

Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Baidu and SINA . 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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