How To Play Baidu's Earnings Announcement On Monday

| About: Baidu, Inc. (BIDU)

Baidu (NASDAQ:BIDU) currently owns 73% of the China search engine market share which compares favorably to Google's (NASDAQ:GOOG) 67% of the U.S. market share. While some analysts discount BIDU's future prospects because it is not much of a factor outside of China, there are about four times as many people in that country compared to the good old U.S. of A., and many of them have jobs (presumably making stuff for Walmart), and growing numbers of them are embracing the Internet.

On Monday after the close, BIDU will announce earnings, and this seems like the perfect time to consider the prospects for this company.

BIDU is a reasonable way to play the Chinese market (except that it is a Chinese company that doesn't have the SEC looking over their shoulder). U.S.-based companies with a large and growing interest in the Chinese market include Yum! Brands (NYSE:YUM) where the locals seem to be cutting back on their consumption of KFC chicken and Starbucks (NASDAQ:SBUX) where they seem to be getting hooked on Grande lattes.

There are a lot of things not to like about BIDU. First, there is the possibility that the SEC will come after them as they have other Chinese companies whose accounting procedures seem to be lacking full disclosure by Western standards (or may be guilty of outright fraud). So far, there has been no indication that BIDU is targeted, but the threat remains. However, it is unlikely to erupt in the next few days coming up to and after Monday's earnings announcement.

Second, several commentators have noted that BIDU's Internet model and monetization fall below Google's standards, and that it survives only by copying Google. What's wrong with that? Emulation is usually far cheaper than creation. Let Google spend billions figuring out what works best, and then just copy it. Google doesn't operate in China any more so it can't collect much in court due to lost revenue from a company who it deems to have violated its patents.

On the other hand, there are a lot of things to like about Baidu. While Baidu is contending with competition from Qihoo (OIHU), clearly, Baidu is the search engine of choice in China. (I wonder if Baidu is a verb in the Chinese language like Google is in the U.S. - it surely would help.) Qihoo seems to have captured about 9% of the market, taking most of it from Google when it exited China over its fight with the government on the censorship issue.

Baidu seems to have been granted a perpetual home advantage bestowed on them by the government which believes that censorship is an important national objective, and Baidu is the most likely company to see that it continues. It seems unlikely that any other company will threaten its dominant position in the Chinese search engine space.

Once a search engine has captured a dominant share, it is difficult for anyone else to come along and offer something sufficiently and obviously better to entice most people to switch to a different search engine. In my opinion, it is highly unlikely that Google or Baidu will lose significant market share going forward.

Baidu seems to be fairly valued by fundamental standards. Trailing earnings ($4.42) give it a p/e of 24.5 at yesterday's $108.30 close, and the forward p/e is 18.4.. This compares most favorably to a robust growth rate that has historically been as high as 50% y/y in 2012 and projected to be well above 25% for the next several years as Internet usage expands in China at a much faster rate than it will in most of the rest of the world, including the U.S.

Any time a company's p/e ratio is well below its growth rate, the stock price can be considered to be a fair one (whenever I compare these two numbers, Apple (NASDAQ:AAPL) always stands out as the glaring example of something unfathomable that has taken place over the past three months, but that is another story that remains well outside of anything that makes rational sense).

BIDU has more than $3 billion in cash thanks to a recent low-interest note offering, so cash should not be much of a problem if it wants to expand to mobile or video markets where it does not have much of a current share.

Let's check out the record for the last year:

(Click to enlarge)

In spite of its extremely high earnings growth BIDU is trading about 25% lower than it was earlier in the year. BIDU has been trading below its 200-day moving average for about 140 days but looks very close to moving above it soon. Actually, the 50-day moving average seems to be a far better indicator to follow, and the stock is currently well above that average. On balance, the moving averages suggest a higher stock price may be coming soon.

Although I wouldn't recognize a cup and handle unless it was some sort of ceramic thing that you pour coffee into, comments on Seeking Alpha articles on BIDU seem to universally agree that the chart is saying something important - "It's literally on the edge of a (secondary) cup and handle, with an IBD-rule buy point at $114.98 with the next resistance around $130" one person wrote. I guess something about the shape of the stock price curve is significant for technical indicator followers and the stock should be headed higher. From my standpoint, this is only relevant because there seem to be so many of them out there who believe in this mumbo-jumbo, and they rush in to buy the stock, making them appear to be geniuses when it moves higher.

The analysts who follow BIDU are all over the place, with eight calling it a "strong buy" and four "underperform" or "sell." Come on, now, how can supposedly highly-educated and intelligent people look at the same numbers and come up with such diametrically-opposed conclusions? Do they talk to one another? All I can think of is that the ones who say "sell" believe the possibility of a suit from the SEC is so scary that all the positive statistics are irrelevant.

On balance, I don't expect there will be a big move in the stock once earnings are announced on Monday. Since it has already fallen so far this year, I think a further fall is unlikely. The people who are worried about SEC action have probably already sold their stock if they ever owned it. The Chinese market may have slowed down a bit in the growth department, but it is still growing at a considerably faster rate than our economy (which isn't so difficult to do considering the latest reports from Washington show that we didn't grow at all in the fourth quarter of 2012).

The economic situation in China seems to have cooled off a bit so blow-out earnings and a skyrocketing move upward seems equally unlikely.

Since I believe that there won't be a big move in the stock after Monday's announcement, here is what I have done to take advantage of the fact that the Feb2-13 options expiring on the 8th are trading (as they usually do) at a heightened implied volatility (IV), this time at 66 in advance of Monday's earnings announcement compared to the IV of 40 for the March options, I have bought March - Feb2-13 calendar spreads at the 100, 105, 110, and 115 strikes:

(Click to enlarge)

These spreads cost about $6500 to place after commissions, and here is the potential gain at the close next Friday, February 8th:

(Click to enlarge)

The actual expected gains are probably about half as much as this graph suggests because IV of the March options will fall once the earnings announcement is made. I don't believe the drop will be huge, however, because the average IV for BIDU options is about 35 (compared to 40 for the March series). As long as the stock doesn't fluctuate in either direction more than 5% after the announcement, a nice gain should result. It could be as much as 40% if the stock fluctuation is moderate.

In the last few weeks, I have outlined in Seeking Alpha articles and personally carried out similar pre-announcement trades on eBay (NASDAQ:EBAY), Starbucks , and Herbalife (NYSE:HLF), and each time the stock moved less than 5% after the announcement. My positions gained at least 10% after commissions in each event (and one play gained 44% in a week). Last week, although I did not write about it in advance, I also placed similar spreads on Amazon (NASDAQ:AMZN) and when the post-announcement stock price change was small, I gained 24% after commissions in one week. Of course, there is no guarantee that BIDU will not fluctuate over 5% next week (as it has done in earlier announcement periods), so I hope that you don't invest money that you cannot afford to lose.

Disclosure: I am long BIDU, AAPL, YUM. 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.