Why Should You Buy This Chinese Search Giant

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

Baidu.com (NASDAQ: BIDU) leads the Chinese internet market with more than 80% in both search revenue and traffic. The leading search quality, heavy R&D investments in mobile space, and strong backing of the Phoenix Nest system keeps Baidu solidly profitable against rising competition from start-ups.

A substantial three year ROA of ~30% vouches for prudent management efficiency towards resources utilization and profit maximization. While investors have some concern about rising Qihoo (NYSE: QIHU) search traffic, the way I see it, it’s not going to create a big impact on Baidu’s revenues. The search’s business model creates a monopolistic market and it becomes very difficult for small players as well as new entrants to steal from market leader. It would take years for Qihoo to achieve the scalability necessary to compete against Baidu.

From a longer term perspective, I see many profitable market drivers that will help boost Baidu's stock price.

Mobile & Cloud Computing – Baidu is the first free cloud provider in China. With hopes of capturing Chinese smartphone users with cloud based interfaces and services, it is investing $1.6 billion in cloud computing. Also, in order to cut down competition in the area of coupons apps, daily deals, and navigation from competitors like DDmaps, Soso maps & Dianping,  Baidu recently launched location based service (LBS). This new division will be focused on local listings and online maps services (PC and mobile). With a huge user base of 77 million, Baidu is expanding its service portfolio to consumer interests for shopping, hotels, pubs, and entertainment activities. Baidu is aggressively pursuing the monetization of mobile search, which is still in an infant stage in China. This would bring an upside in revenue streams in time to come.

Advertising – Baidu estimated advertising revenue of $3.20 billion (up more than 40% from the 2011). The company’s revenue growth is further fueled by new advertisers, contextual ads, and a new advertising platform launch in Q4. Side by side, the company has recently formed special sales team to acquire new SME advertisers in lower tier cities. I see a strong Q4, even after considering economic slowdown and Qihoo’s impact, as these are offset by monetization improvement of Phoenix Nest, higher video/social traffic, and lower quality of traffic lost.

Another key factor that gives Baidu an upper hand is its ROI generation capacity for advertisers. The advertisers are more focused on ROI instead of search pricing.  If advertisers only wanted lower pricing, Sogou and Soso would have been the market leaders. ROI is high on Baidu, given its large traffic and sophisticated keyword bidding platform.

Search Share – The Golden week in China is a recent proof of Baidu’s strong market share position, which has remained consistent at about 81%. Baidu rates higher than its competitor Easou in terms of quality/number of search results. On the other hand, Tencent’s activity into mobile integration and market share acquisition were a negative for Baidu. But I will not assign it a lot of weight, given the fact that Baidu’s five year revenue growth has been higher than Tencent.

Baidu bags 78.6% of the online search market in China, as compared to Google’s (NASDAQ: GOOG) share of 15.7% in terms of revenue. The new search industry entrant Qihoo, though it has captured 10% of the search query market share, has failed to monetize this market. As a result, the supply of monetizable search terms declined against stable demand of keywords. This should increase the price of keywords sold and click through rates at remaining search providers. Having such a huge piece of the market pie, Baidu is all set to be the beneficiary from this situation, which may bring the company around $10 million.

Discussing the growth opportunities, Baidu has a strong position in emerging online businesses such as iQiyi (online video) and Qunar (online travel). Qunar (the Expedia of China) has reported double digit growth in H1, 2012, led by higher ad revenues. Baidu owns a 2/3 stake of Qunar, and saw the growth begin after its mid-year purchase in 2011. It is an emerging vertical search engine and possesses competitive advantages in the form of low cost channel for hotels and quicker services for transportation. I foresee the possibility of a complete acquisition of Qunar down the line, increasing shareholder value.

Also, with Google shutting down its services (music search) in China, Baidu is expanding its music search service with “Music.” I feel that at current valuations Baidu’s stock is cheap at 17x P/E against 28% 3-year EPS CAGR. If the Chinese economy can stabilize in Q4, Baidu can still achieve ~35% year over year growth in 2013. I rate this stock a buy.

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

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