Baidu: Why The Current Quarter Will Surprise

| About: Baidu, Inc. (BIDU)

Baidu (NASDAQ:BIDU) reported its slowest profit growth since 2009 last week as transition costs and competition increased for China's largest search engine. The shares fell as much as 11% and saw several analysts downgrade the company even though revenue and earnings beat expectations. While margins could remain under pressure as the company builds out its mobile strategy, the government's plan to ban some advertising of luxury goods on television and radio could mean a significant boost to revenue this quarter.

Banned Advertising and Growth

The Chinese New Year began on Sunday with the official holiday running through the week to the Lantern Festival on Friday. The period represents the nation's biggest gift-giving season and is as important to retailers as Black Friday in the United States.

This year, the State Administration of Radio, Film and Television (SARFT) has placed a ban on ads that encourage lavish spending on luxury goods. The move comes as the government tries to fight corruption and graft at the local administration level but could hurt retailers in the process. The action by regulators could not come at a worse time for retailers. Sales are expected to rise more than 15% this year as a stronger economy and the coincidence of Valentine's Day during the festival week drives purchases.

The ban could be a boon to companies like Baidu as advertisers reallocate their ad spend to the internet where no effort has yet been made to limit marketing. Not only might the increased advertising help the company beat expectations for the current quarter, but it should also help to speed adoption of the medium from traditional forms like TV and radio.

Whether the ban benefits the company or not, the trend in internet usage and penetration should keep sales and earnings growing at double-digits for some time. The e-commerce market is expected to triple over the three years to 2015 as internet penetration increases from just 38% in 2011 to 51% in 2015. GDP growth, which is estimated at 8.4% this year, should help to increase consumption and boost sentiment for stocks as well.

Competition and a Rising Tide

While Chinese security software maker, Qihoo 360 Technology (NYSE:QIHU) has been winning market share in search, it saw its apps removed from the iTunes store recently and has received a warning from the Chinese government for unfair competition. Qihoo has been able to slice off about 10.5% of the search market but could find incremental gains much more difficult.

The appointment of Baidu's founder and Chairman Robin Li to the country's top political advisory board solidifies Baidu's place in the government hierarchy, and it won't make it any easier for Google (NASDAQ:GOOG) to reenter the market after its departure in 2011 over censorship concerns. The search monolith has been in talks with Qihoo for a search partnership but talks may slow when CEO Eric Schmidt's new book hits the shelves. In it, Schmidt accuses the government of sponsoring corporate espionage through widespread hacking and calls into question the values of the world's second largest economy.

Growth in the Chinese internet market will not only lift Baidu but also other firms like (NASDAQ:SOHU) and SINA Corporation (NASDAQ:SINA). The country's internet firewall that blocks out many western sites like Facebook (NASDAQ:FB) and Twitter has created a virtual monopoly for SINA's Weibo service. The microblogging service hired Ken Hong as general manager last year to head up the company's marketing push and monetize over 400 million registered users.

Long-term Investment with a Short-term Strategy

Though slowing marginally, revenue still grew by 57% and earnings grew by 61% in 2012. Analysts expect revenue growth to slow further to just 37% in 2013 with earnings of between $5 and $6 per share. The shares currently trade for 20.3 times trailing earnings and 17.5 times forward earnings. By comparison Google trades at 23.4 times trailing with expectations for earnings growth of just 14%.

I have a long bull spread on the shares meaning I have bought call options at one price and sold call options at a higher price. My own position was opened late last year and uses the January 2014 options, but investors may want to use the 2015 options to take advantage of long-term capital gains rates.

For example, buying the $110 strike call options expiring in 2015 while selling the $120 options means an investment of about $3,230 for every contract. If shares of Baidu close above $120 on expiration, the investor gets $10,000 for every contract. Of course, there is the risk that the shares will close below $110 but the most the investor will lose is the $3,230 paid for the contract. While an investor may hold onto the options until expiration, there is always the option to close the position.

Before the earnings release, I had a fairly significant gain on my position and wanted to protect the gains. To hedge against a drop in the shares, I opened a bear spread with put options expiring that week. Buying the $105 put while selling the $100 put option cost me $1,350 per contract and ended up being worth $5,000 after the plunge below $100 last week. While I believe the current quarter will surprise the market to the upside, investors may want to hedge against future earnings reports in a similar fashion.

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.

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