These 3 Charts Explain Why This Giant Is in Trouble

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

The only thing more certain than death and taxes is change. This seems to be particularly true when it comes to Chinese companies. Baidu (NASDAQ: BIDU) stock has been absolutely crushed on concerns about new competition from companies like Qihoo 360 (NYSE: QIHU), and slowing growth. I've owned Baidu in the past, and my initial reaction to these threats was to dismiss them out of hand. Baidu is the leading search engine in China, and the country's Internet population is relatively small compared to the total population. Unfortunately, my initial assumption that these threats were no big deal falls wide of the mark. Baidu is a company in transition, and investors need to adjust their expectations accordingly.

A scary decline
One of the hallmarks of Baidu's story was the company's almost ridiculously high revenue growth rate. Just one year ago the company's revenue was increasing by more than 80%. In the most recent quarter, the company reported revenue growth of 41.6%, which is still very impressive. However, there is a clear pattern of decline between the two points, and the story the following chart tells is scary:

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As you can see, Baidu's revenue deceleration has followed a nearly perfect 10% drop on a quarter to quarter basis. If a statistician were using this chart for forecast, they might suggest 30% revenue growth is next. Baidu's management is suggesting revenue growth of at least 38.1% next quarter. Even if the company meets this expectation, it would only suggest a slower rate of decline in the future, but would not break the downtrend.

What is really interesting is, if Baidu's revenue growth continues to decelerate, they may find themselves growing at a pace similar to their competitor Sohu (NASDAQ: SOHU), which is expected to grow revenue by 21.70% this year. Ironically, their biggest new competitor Qihoo 360 is expected to grow revenue by 42.57%, and Google (NASDAQ: GOOG) is also expected to grow revenue north of 40% this year. If Baidu slows, and these two companies meet estimates, they may both outpace Baidu.

An even scarier decline
While revenue growth has been dropping by about 10% per quarter, Baidu's operating profit is moving south at an even faster rate. In the last five quarters, Baidu's operating profit growth has dropped from over 80% to less than 30%. What's worse is the pattern of this decline. Look at the chart and see if you notice the same pattern I do:

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What I notice is the decline is less than 10% in two of the quarters, but nearly 30% in two of the quarters. If this trend continues, Baidu may see a small decline next quarter, but by the second quarter of 2013, the company's operating profit growth may decline to near zero.

The reason for it all
There are two numbers behind all of these issues. Baidu is growing the number of its online marketing customers, but revenue per marketing customer has dropped precipitously. Take a look at the chart, and you'll see that as the number of marketing customers is growing, the revenue per customer is going down just as fast.

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This is similar to something Google was going through in their business last year. Google was seeing significant growth in paid clicks, but a decline in cost per click. Google has managed through this transition, but Baidu is in a different place. The difference is, while Google had to deal with competitors like Microsoft and Yahoo, the U.S. search market is much more mature. Baidu faces numerous competitors looking to stake their claim in the ever changing Chinese market.

Cheap for a reason
Some would argue that even with these challenges, Baidu is extremely cheap. The stock trades at just over 16 times 2013 earnings, and under 13 times 2014 earnings. Analysts are calling for EPS growth of over 31% in the next few years. However, Baidu is also losing to its competition in another way, the company is spending relatively less on research and development.

In the last year, Baidu has spent between 9% and 11% of revenue on R&D. By comparison, the peer that spent the least on R&D was Google at 13.30%. When it comes to Baidu's Chinese competitors, Qihoo 360 spent 15.86% of revenue on R&D, and Sohu actually spent 17.51%.

The bottom line is, Baidu has fallen far, but could fall even further. Analysts are calling for 25.5% EPS growth between 2013 and 2014, and given the above charts, this may be too much to expect. I would suggest investors wait until Baidu shows these declines are abating before investing. Trying to catch this falling knife seems like a bad idea.

Chad Henage has no position in any stocks mentioned. The Motley Fool recommends Baidu, Google, and 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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