Yahoo! Could Learn Alot From Baidu

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

Baidu (NASDAQ: BIDU) has a dominant, 80% share of the Chinese language internet search market. As such it is tied into, and makes an excellent proxy for the Chinese consumer economy, with one caveat. That is, as a Chinese entity, Baidu serves in a highly censored environment. But life is different when your home market is growing at a double digit % clip, and everyone is worried when, as in the first quarter, growth in the Chinese economy slipped to a “mere” 8.1%. But in many ways, from Baidu's or other consumer companies' perspectives, things are going wonderfully.

In the heady years of double digit growth in China, that growth was being fueled by rising real estate prices and government sponsored capital programs, like bridges and dams. In 2011, about half of all Chinese economic growth came from these public projects. But the pace is slowing down, and in the first quarter such spending accounted for “only” 33% of growth. Instead first quarter growth, which would be an impressive number anywhere but China, was actually fueled by consumer spending, which accounted for 54% of overall growth in the first quarter. And, since consumers are Baidu's customers, growth in that sector is obviously good news for the company.

Baidu has had a spectacular past, but how about its future? Analysts foresee five year growth rates averaging nearly 42%. Certainly, that growth puts Baidu's trailing price to earnings ratio of 35 into perspective. However, where is that future growth going to come from? Baidu is betting on mobile phones. It has the support of Apple (NASDAQ: AAPL), which plans to include Baidu as the default search engine on I Phones for the burgeoning Chinese market. Baidu is also planning to bring to market its own, relatively low cost smart phones to market. There are some real issues about the ability to maintain margins once Baidu starts selling hardware; management has a history of knowing what it is doing. The focus on mobile technology is easy enough to understand where Baidu controls a near monopoly on desktop computer searches, but only about 35% of the market for mobile searches.

One other thing to be aware of is that Baidu historically has had a fairly cozy relationship with the Chinese government. Baidu has contracted with Microsoft (NASDAQ: MSFT) to handle the limited amount of English language searches that are on Baidu's network, which also brings Microsoft into a closer relationship with Beijing. I am aware of censorship and repression issues in China, but I do not believe that should dissuade anyone from looking into the world's second largest economy.

Looking back to valuation basics, Baidu trades now with an estimated 5 year PEG of 0.64, indicating it is undervalued relative to the overall market. It is selling now for a 20% discount to its mid-April price of over $150 per share. Growth like Baidu has experienced surely cannot last forever, yet given China's growth and sheer size, over the three to five year period, I am confident Baidu will readily outperform the S&P 500 average.

While Baidu dominates East Asia, and Google (GOOG) dominates nearly everything else, Yahoo! (NASDAQ: YHOO) is still kicking around. This leading internet search and services provider has fallen in terms of competitive position, and its stocking has been trading in the $15 to $17 for most of the past year. But Yahoo! is now in the midst of reshaping itself into a smaller, and hopefully nimbler and responsive company. Key to that change was the company's recent move to sell one half of its existing stake in Alibaba (ALBCF). The total price agreed to was $7.1 billion, of which $6.3 billion is cash. Yahoo! will use that cash to purchase $5 billion of its own stock, or over 25% of its current capitalization.

The ease of forming a “new” Yahoo! was made easier by its founder and Chairman, Jerry Yang, when he   left the company back in January. At a reduced capitalization, Yahoo! may well prove to be an attractive takeover candidate to many domestic and overseas technology and private equities companies. 

Analysts at Bernstein capital recently rated Yahoo! a buy, citing valuation issues in light of the Alibaba deal. Yahoo!'s stakes in Alibaba and in Yahoo! Japan, along with Yahoo!'s pre Alibaba $2.2 billion in cash on hand are worth the sum of $13.52 per share. Plus the current value of Yahoo!’s earnings is worth an additional $5.36 per share. This makes the company worth nearly $19 per share here and now, or about a 20% premium to today's price.

Yahoo! is also in the midst of a recently announced cost reduction plan, highlighted by the reduction of 2,000 associates from its workforce. I am among the first to remind that headcount reductions do not create new value, or revenue growth. But, in this case, a smaller company needs to have fewer employees.

This is not the first time Yahoo! has threatened to reshape the company. But, with Yang no longer in control, and a firm commitment of returning capital to shareholders, this is indeed a new day for Yahoo!. Patient investors might want to hop on board to see whether this plan works. But the more prudent position is to wait on the sidelines, to see how this all works out for this beleaguered internet giant.

StockCroc1 has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Baidu, and Microsoft. Motley Fool newsletter services recommend Apple, Baidu, Microsoft, and Yahoo!. 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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