Baidu’s Mobile Blues not News to Google

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

China’s leading search engine Baidu (NASDAQ: BIDU) witnessed a 60% jump in quarterly profits year-on-year to $478 million due to an increase in advertising revenues. Total revenues grew by 49.7% to $994.6 million. However, the revenue growth in this quarter was ~10 percentage points lower as compared to the previous quarter. The company now enjoys 79% dominance over the large Chinese Internet search engine market following the exit of Google (NASDAQ: GOOG) two years ago whose local market share has shrunk to just 15.4%.

Meanwhile Baidu is now facing new competition from the local firm Qihoo 360 Technology (NYSE: QIHU), which specializes in security and antivirus software but has recently launched its own Chinese search engine about three months ago. Despite Qihoo’s rapid growth, it is still a small player and is unlikely to have any impact on Baidu’s market share now – August saw them take between 7% and 10% of search volume-- but other smaller firms operating in the Chinese search engine market, such as Google or Microsoft’s (NASDAQ: MSFT) Bing will have to contend with them. Microsoft’s stated goal of just 5% Bing market share in China, so there is room for Qihoo to slip in and keep that 7%-10% they pulled at the end of August.

Baidu’s performance has been in stark contrast to Google’s; the latter of which is witnessing falling advertising margins due to lower CPCs as more consumers switch to smartphones and tablets. Over the year, Google’s profit margin dropped from 28% in September 2011 to 22.8% in September 2012, while Baidu has been able to increase its margin from 45% to 48.2% in the same period.

Baidu’s executives have stated that they wish to move deeper into mobile and the tablet market, an area that has witnessed explosive growth over the past year. The recent statistics suggest that until July this year, China’s Internet population grew by 11% to 538 million, out of which 72% is the mobile internet population.  After successfully releasing the Android based smartphone OS in May, Yi, Baidu has now launched its mobile-Internet web browser that offers better download speeds and access to all Baidu services and applications. However, the company is a late entrant, as this market is currently ruled by UCWeb and Tencent Holdings (NASDAQOTH: TCEHY.PK), which have a 28.9% and 16.5% market share for Chinese mobile web browsers. Baidu is now working with handset manufacturers to have its browser pre-installed on up to 80% handsets sold in China in 2012, and it is already installed on all new iPhones sold by Apple, which has ~10% of the smartphone market.  As well, Baidu is also aiming to establish a $1.6 billion cloud computing center, which would offer remote data storage and app development services.

For the final quarter of 2012, the business is expecting to earn between $987 million and $1.01 billion in revenues, which means that it could see a sequential decline if Baidu manages to hit the lower end of the estimate. An alarming aspect for Baidu has been the fact that Chinese advertisers are not willing to spend as much online as they did before, but this slowdown was offset by Baidu’s ability to attract new customers, whose numbers have reached a record 390,000.

Interestingly, Baidu is now directly competing with UCWeb, an organization that has been supporting Baidu for a long time by offering Baidu’s services on its mobile browser. UCWeb is a small company whose bread and butter comes from the niche market of Chinese mobile browsers. The business will now have a tough time in maintaining its leadership. So far, UCWeb continues to support Baidu’s services while Baidu insists that its entry into UCWeb’s arena will not harm their working relationship; but it is difficult to envision a future where UCWeb is not pushed to the back of the market.

<table> <tbody> <tr> <td> </td> <td> <p><strong>Baidu</strong></p> </td> <td> <p><strong>Google</strong></p> </td> <td> <p><strong>Microsoft</strong></p> </td> </tr> <tr> <td> <p><strong>YTD Stock</strong></p> </td> <td> <p>-2.26%</p> </td> <td> <p>4.53%</p> </td> <td> <p>8.67%</p> </td> </tr> <tr> <td> <p><strong>P/E</strong></p> </td> <td> <p>25.76</p> </td> <td> <p>21.16</p> </td> <td> <p>15.25</p> </td> </tr> <tr> <td> <p><strong>EPS</strong></p> </td> <td> <p>4.42</p> </td> <td> <p>31.91</p> </td> <td> <p>1.85</p> </td> </tr> <tr> <td> <p><strong>Yield</strong></p> </td> <td> <p>N/A</p> </td> <td> <p>N/A</p> </td> <td> <p>3.30%</p> </td> </tr> <tr> <td> <p><strong>ROA</strong></p> </td> <td> <p>24.51%</p> </td> <td> <p>10.10%</p> </td> <td> <p>14.21%</p> </td> </tr> <tr> <td> <p><strong>ROE</strong></p> </td> <td> <p>50.39%</p> </td> <td> <p>17.18%</p> </td> <td> <p>24.50%</p> </td> </tr> </tbody> </table>


Despite the surge in profits, the fact remains that the growth in revenue has been lower than in previous quarters, and Baidu has been priced like a growth stock in the past.  But that premium has dissipated in 2012 along with their revenue/earnings growth rate.  This slowdown can be attributed to the general sluggishness in the Chinese economy, where growth fell from 7.6% in the previous quarter to 7.4% in Q3 2012, or to Baidu's difficulty finding a new revenue stream beyond normal search.  One of its hallmarks, however, has been to quickly identify when a project is not working, excise it quickly and move on to the next thing.

Baidu’s current strategy is to move into mobile and cloud computing, and it is the right one albeit long overdue. Without giving the exact numbers, its chief executive Robin Li said that their mobile search growth was in “triple digit” numbers. However, as the company transitions towards mobile, its profit growth is expected to take a dip, as this area is not effectively monetized yet. Li believes that “it would take some time to fill the gap.”  

In short, the weakening Chinese economy coupled with the shift towards mobile means that Baidu’s growth will decrease in the coming quarters and in this sense Baidu is not unlike Google in finding it difficult to maintain margins in the smaller real estate environment of a mobile device.  But, that said, China’s is a mobile and home market that is far less saturated than the U.S. and Europe, which hints at plenty of raw numbers to grow into.

But, at a P/E of 27, it may still be too rich for value investors.  The bloom has come off the rose of Google’s retreat from China; to make the case for Baidu at these levels means believing they can monetize mobile without much degradation of their gross margins (~72%). 

PeterPham8 has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Baidu, Google, and Microsoft. Motley Fool newsletter services recommend Apple, Baidu, Google, and Microsoft. 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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