Baidu (BIDU) is the leading search engine in China and has grown at an eye popping pace since inception. The company has benefited greatly from the implicit barriers that the Chinese government puts up against foreign companies. Google (GOOG) was forced to abandon one of the richest Internet markets because of Chinese censorship policies. Companies like GE (GE) and Siemens (SI) have also complained in the past about the unequal playing field for foreign companies in China. Baidu has grown to be the second most valuable search engine company after Google. This is mainly due to their Chinese home advantage. Google is the dominant search engine in almost every country except Russia and China. Baidu has managed to successfully navigate through the Chinese bureaucracy (and its attendant information secrecy) to become a $35 billion behemoth.
Why you cannot buy Baidu
Technology not as good as Google
Baidu's core search product is not as good as Google's search engine. Its success in the past has been more due to local factors than technological superiority. The way it displays its ads in the search pages is also not as user friendly as Google. This makes the company susceptible to change in China's policies in the future. If the Chinese government opens up and allows more foreign competition, then Baidu could be in trouble. Currently trade wars are flaring up between China and US on a number of issues like steel, solar and wind turbine imports. Europe is also seeking to impose duties on imports of Chinese solar panels. China could be forced to give concessions like providing better access to Western companies.
Competition is Growing after Google exit
Baidu has been losing marketshare to local home grown competition like Qihoo 360 (QIHU), Sohu (SOHU) and Tencent Holdings (TCEHY). It's almost monopolistic marketshare in the Chinese market implies that Baidu marketshare has only one way to go - down. Baidu's marketshare has come down from 80% in 2011 to 58% in 2012. Google has got only a miniscule 6% marketshare due to its exit in 2010. However, if Google is allowed to return, then Baidu could face a huge headache in its core search segment.
One Country Pony
Baidu earns most of its revenues from China and does not have a material presence elsewhere. Its efforts to diversify to other neighboring countries like Korea and Japan have not borne fruit. While we concede that China is a huge market, the concentration risk cannot be ignored lightly. The slowing of the Chinese economy and the fall in the Shanghai stock market has affected Baidu. A future hard landing in China would be bad for Baidu. Google earns almost 50% of its revenues from outside its home market. Lots of companies are dependent on their home market for most of their revenues. However, the contrast to big Internet companies like Amazon (AMZN), Google and Microsoft (MSFT) remains stark in this case
Mobile Search Marketshare is not even half that of PC
Baidu's marketshare in the mobile phone search segment is not even half that of the PC share. This has been the biggest cause of the stock price decline as analysts have repeatedly emphasized this point. Search queries are rapidly moving towards mobile phones and tablets. This means that Baidu is at risk of losing its top dog position in China's Internet search sector.
Late Investment in Cloud Computing
Baidu has been late to the cloud computing space though it is now investing a massive 10 billion yuan to build a cloud computing centre. It is copying Google and Amazon who have been the first movers in the market. Baidu is introducing a copycat Google Drive with a 100 GB space.
Chinese ADR Risks
Chinese companies listed in the US have come under sharp attack for accounting problems if not outright fraud. Baidu has not shown any such problem yet, however this risk has to be kept in mind while investing. The SEC is taking action against Chinese subsidiaries of big audit firms for not providing adequate disclosure. This has the potential of turning into a nasty fight between US and China in which the Chinese ADRs will get hit.
Risks to the Upside
Online Video Leadership in China
Baidu has managed to enter new business streams such as online video in which it has become the No.2 player just behind the market leader Youku (YOKU). The company has managed to successfully copy Google's entry into online video (Youtube). Google is managing to increase its online ad revenues through monetizing Youtube videos. Baidu is set to follow Google's example in this revenue stream as well.
Growth Still Strong but Tapering Off
Baidu's revenue and operating profit growth is still quite strong, increasing by 50% y/y in Q312. Baidu's customers increased by 29% y/y and have reached 400,000. In less developed markets like China and India, customer relationships with SMEs are more important than places like USA. Customers are still mainly acquired through offline means as they don't have a good knowledge about online advertising. Revenues per customer growth decreased sharply to 16.8% y/y. Overall, the trend line for most metrics shows a declining growth trend.
Valuation is not Cheap though not as Expensive either
Baidu's valuation has come down substantially from the heady P/E multiples it used to command earlier. However, it is not cheap either as it trades at roughly 8.5x P/S based on current quarter revenues of ~$1 bb. The P/E at ~20x based on current quarter earnings is not expensive given that the company is expected to grow by 25-30% next year. But in technology, we know that the earnings can evaporate suddenly based on an abrupt technology change. We think that Baidu, despite its recent fall, is still not cheap.
Baidu's stock has fallen by ~40% from its peak in 2011 to ~$100 now due to concerns about mobile monetization, slowing growth, Chinese ADR issues and a 3Q12 revenue miss.
Baidu remains a formidable Internet force in China due to its dominant search engine. However, the company has been late in entering segments like cloud computing, mobile etc. The company has also lost marketshare in the PC and desktop segments to local competitors. There is always the danger of Google returning after a deal with the Chinese government. The company's valuation is still not cheap despite the price fall seen in the last couple of years. Baidu is undertaking a painful transition of moving into the mobile market from PCs. It has not been proactive in recognizing the new Internet trends. Its strategy has always been to copy the western Internet companies. This is the reason that they have not been successful in their international operations. The Chinese government implicitly protects them in the massive domestic market. I think the days of sharp stock price growth are over for Baidu. It may not make sense to buy Baidu.