Baidu Is On Sale

| About: Baidu, Inc. (BIDU)

Shares of Baidu (NASDAQ:BIDU) have dropped 34.2% over the past 12 months primarily owing to the concern on China's economic slowdown and the stiff competition from Qihoo (NYSE:QIHU). Given the company's dominating market share in the Chinese online search market and robust financial performance, I believe the plunge presents a tempting risk/reward profile for this growth stock. In this article, I will elaborate on the analysis that supports my bullish view.

BIDU's valuations are very attractive based on the company's strong financial performance relative to its peers' (see comparable analysis table below). Analysts on average predict the company's revenue, EBITDA, and EPS to rise considerably at 2-year CAGRs of 44.9%, 41.1%, and 41.5%, respectively, over the current and next fiscal years. The growth estimates are substantially better than the averages of 27.5%, 25.8%, and 23.4%, respectively, for a peer group consisting of BIDU's comparables. In addition, BIDU has a leading profitability performance. All of the company's profitability and capital return metrics are significantly above the par. It should be noted that BIDU's EBITDA and EBIT margins, ROE, and ROIC are the highest in the group. In terms of leverage and liquidity, BIDU carries a slightly higher level of debt as reflected by the firm's above-average debt to capitalization and debt to EBITDA ratios. BIDU's trailing free cash flow margin of 36.0% also outperforms the peer average of 17.9%. Although both the firm's current and quick ratios are below the par, they are still within a healthy zone.

To summarize the financial comparisons, BIDU's significant market share in China, robust growth prospects, and leading capability in generating profit and cash flow should substantiate a premium valuation for the stock. Nevertheless, the current stock valuations at 11.8x forward EV/EBITDA, 16.3x forward P/E, and 0.49 PEG represent a large average valuation discount of 26%, suggesting that the stock is likely oversold.

Moreover, the stock's forward P/E multiple is currently trading at only 25.3% premium over the same multiple of the S&P 500 Index (see chart below). The valuation premium has plummeted from 167.4% a year ago. I believe BIDU's P/E should command a higher premium over the market level given that 1) BIDU's estimated long-term earnings growth rate of 33.7% is markedly higher than the average estimate of 7.9% for the S&P 500 companies; 2) the firm's profitability is superior to the market average; and 3) BIDU is a cash-generating machine with a robust free cash flow margin above 30%.

BIDU's trailing P/E multiple is at its 5-year low. The last time that the stock was trading close to this level was in 2008, amid the outbreak of the economic crisis (see chart below). The current historically low valuation appears to be very attractive provided that 1) the economic situation in 2008 was much worse than the current condition and most of the firm's financial metrics were at relatively low levels in 2008 (see charts below); 2) the company's capital return metrics including ROA, ROIC, and ROE have experienced a solid improvement over the past 5 years; 3) BIDU has also become more profitable, and the firm's EBITDA margin is expected to be fairly stable; and 4) Despite the relatively low estimated revenue and EPS growth rates, BIDU's EBITDA is expected to grow significantly over the next 2 years.

According to Thomson One data, sell-side analysts are generally bullish on the stock. Of the total 29 ratings, there are 8 strong buys and 14 buys. Their average target price of $141.30 represents a large upside of 52.6% from the current market price. JP Morgan's research analysts, Dick Wei and Evan Zhou, elaborated on their bullish views in their recent research note (Thomson One, Equity Research):

"We maintain our Overweight rating on Baidu based on our view that:

1) It will maintain its position as dominant market leader in China's online search market, which is still in an early high-growth stage. Competitors, like Qihoo, will find it difficult to compete with Baidu, given its years of technological experience;

2) We see search as an attractive business model on both PC and mobile platforms. In addition, we expect the company will continue to see penetration growth among SME customers;

3) Mobile search to generate incremental traffic and revenue to Baidu, and will lead to upside in monetization in the longer term. We believe LBS features and high-frequency of use of mobile devices to help increase monetization down the road; and

4) We see further M&A to help Baidu to expand its market share and solidify its strategic positioning in internet market. Baidu could see good returns in its investment portfolio - like it did in travel, online video."

Assuming that BIDU's forward P/E multiple recover to the peer average level of 20.7x, and supposing that the analysts' estimated FY2014 EPS of $7.63 can be maintained, this base-case scenario would imply a stock value of $157.94, about 70.6% above the current market price. As such, given the tempting valuation and the substantial upside prospect, I recommend acquiring the shares now.

The comparable analysis table is created by the author, all other charts are sourced from Capital IQ, and all financial data is sourced from Capital IQ.

Disclosure: I am long BIDU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.