Fear Creates a Buying Opportunity

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

Investors in Baidu (NASDAQ: BIDU) must feel like they're always waiting for the next shoe to drop. The company is clearly the dominant search engine in the Chinese market. Just as it seems their dominance will go unquestioned, a new competitor arrives on the scene. The most recent threat is a company called Qihoo 360 Technology (NYSE: QIHU), which recently decided to oust Google as its browser's default search engine. The worry is that Qihoo will steal market share from Baidu by offering their own search engine results. Fortunately for Baidu investors, this most recent fear appears founded more on worry than real data.

The Chinese Market

To understand the seriousness of this new threat, we first have to understand the search market in China. Baidu is the leader with 78.6% of the market. While it's true that Qihoo is implementing their own search in their 360 browser, investors need to understand that this browser has always offered search, but previously through Google. Additional players vying for time that the Chinese spend online are companies like Sina (NASDAQ: SINA), which operates the Twitter/Facebook hybrid site Weibo.com, and Sohu (NASDAQ: SOHU) and their Sogou.com search engine. Each of these companies represents a different opportunity, but the risk to Baidu doesn't appear to have changed much. In fact, the largest risk for Baidu investors is still the same issue that the company has dealt with for the last several years.

Say The Country China And Investors Get Nervous

Any company based out of China is generally seen as a riskier investment because of the multiple failures and accounting issues in this part of the world. This was highlighted recently by fellow Fool Sean Williams in his article “The Idea That Burned Me: Buy Anything Related To China.”. Sean said that he basically fell for the same thing multiple times with Chinese companies. Many Chinese companies had plenty of cash on hand, and their earnings growth look terrific, but most had little to no history or analyst coverage. With stories of Chinese companies committing outright fraud in their financial statements, and the subsequent fallout, it's understandable that investors would be gun shy of any company from this region. Sean did go on to say that there were a few companies that had better coverage and were more verifiable than others. The companies he mentioned are the ones I've already detailed, and the bottom line is that Baidu still looks like one of the best values on the market.

How Is Baidu Doing?

Baidu's value was apparent enough that The Motley Fool's own Brian Stoffel recently said, “I'm Buying This Stock Now.” He acknowledged the recent threat of Qihoo 360, but also pointed out that Baidu appears to be doing just fine with its revenue per customer up 34.8%. In the company's most recent quarter, revenues were up almost 60%, and the company's active online marketing customers increased over 18%. Baidu's online advertisers are both growing in number and in revenue per advertiser. Where the threat of Qihoo 360 is concerned, I think the piece that everyone is missing is that this company already offered search results from Google and is just supplanting their own search engine. It's not as though the company is a brand-new entrant, and a far more established company in Sohu already knows that Chinese search is owned by Baidu. If you need further proof that Baidu is a solid value, let's compare the company to its competition on a couple financial measures.

The Valuation Comparison

One comparison that I find useful for companies operating in the same market is that of their P/E ratio versus their growth rates. Let's see how each of these companies compares looking at their projected earnings per share and projected growth rates:

Name

P/E on '12

P/E on '13

Growth Expected

PEG on '12

PEG on '13

Baidu

24.71

18.44

39.48%

0.63

0.47

Qihoo 360

35.06

22.83

50.14%

0.7

0.46

Sina

520

60.92

28.03%

18.55

2.17

Sohu

22.31

14.47

15.36%

1.45

0.94 

There are several numbers that jump out at me from this table. First, investors in Sina need to be very careful about their assumptions for growth. Over the next two years, Sina sells for a significant premium to any of the companies that we are looking at. Baidu's most direct competitor is Sohu. It doesn't seem reasonable that Sohu should sell for a PEG that is roughly double that of Baidu using both the 2012 and 2013 expected results. This leaves us with Baidu or Qihoo 360 as our remaining choices. The fact that both companies are expected to see tremendous growth, and both sell for similar valuations, in my eyes means that we could have two potential buys.

The Free Cash Flow Comparison

Another useful measure I've come across in comparing companies is free cash flow per $1 of sales. This allows investors to see how effective companies are in turning $1 of sales into free cash flow. Since the measure is done per $1 of sales, it allows us to look at different size companies in an apples to apples comparison. It shouldn't be a surprise that based on its strong growth and leading position, Baidu produces the most free cash flow for each $1 of sales. In the most recent quarter, Baidu generated about $.44 of free cash flow for each $1 of sales. Their closest competition using the same measure was Qihoo 360, which generated $.39; Sohu produced about $.23, and Sina fell far behind, generating just $.02 of free cash flow for each $1 of sales. In short, Baidu has more free cash flow at the end of the day from the same $1 of sales than any of these major competitors.

Conclusion

At the end of the day, Baidu still holds the dominant position in China's search market. Much like Google, once customers are conditioned to use a particular search engine, it becomes very difficult to change this pattern. While other entrants may arrive on the scene, as long as the average Chinese customer thinks of Baidu for their search needs nearly 80% of the time, other companies will struggle to compete. This most recent worry gives investors one more chance to buy Baidu at a discounted price. Baidu sells for a fraction of its 2012 and 2013 P/E ratios and the company consistently beats earnings estimates. As one of the few well researched companies in the Chinese market, Baidu looks like a great investment at current prices.

Dig Deeper

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MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Baidu. Motley Fool newsletter services recommend Baidu, SINA , and Sohu.com. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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