Baidu: The Google Of China

| About: Baidu, Inc. (BIDU)

When your company's nickname is "the Google of China," it leaves the impression of a technological innovator with a bright future. It means you're a giant in a growing industry that controls the market in one of the largest and fastest-growing economies in the world.

Then you release your quarterly earnings report and announce a revenue increase of 42% over the previous year's fourth quarter and 58% growth in fiscal year net income. Certainly, your stock price must be skyrocketing as well.

Well, not if you're Baidu Inc. (NASDAQ:BIDU).

Despite reporting year-over-year growth, Baidu stock fell as much as 10% in value on the day of its earnings release because it committed the sin of failing to meet analyst expectations. That, plus its growth is showing signs of leveling off, with its most recent profit growth being the slowest in the last four years.

Combine that with the overall nervousness investors get when dealing with Chinese companies, stuck between operating as government-owned enterprises and capitalistic ones, and the trepidation of Chinese accounting standards, and it only adds to the pessimism some feel for Baidu.

But are those feelings warranted?

The Google of China

Baidu operates as a Chinese language Internet search engine that provides tailored search results for web pages, audio files, news, images and multimedia, hence the nickname "the Google of China." Even the company's website and format bear a stark resemblance to Google (NASDAQ:GOOG).

Like Google, Baidu makes it money mostly by providing online marketing services that include auction-based payments for performance and tailored solutions.

Baidu is also building a mobile presence. Its web traffic has skyrocketed 1000% in the last three years. The company is investing heavily in mobile products, spending 25% of its research and development budget in that area during the fourth quarter of 2012. Still, like companies before it, finding ways to financially benefit from this traffic has proven problematic.

Stock Price Down

But that seems to be the least of its problems. Baidu is currently trading around $89 a share, down 18% in the past month and 42% from its 52-week high of $154 set just under one year ago. Its most recent plummet was largely because the company released somewhat disappointing earnings in February.

Baidu's quarterly revenue increased by 41.6% to just over $1 billion, while annual revenue rose by 53.8% to $3.58 billion. Quarterly income increased by 36.1% to $448.7 million and by 57.5% annually to $1.68 billion. Online marketing revenues, which make up the backbone of Baidu's business, were $1 billion, up 40.8% from the fourth quarter of 2011. Annual revenue growth was in-line with total top line revenue growth.

Analysts who are down on the stock say the problem isn't that the company won't grow, it's that it won't grow as much as it has in the past and won't grow enough to keep up with rising costs.

In just one year's time, Baidu's revenue growth from its search engine fell from 82% to 42%. Meanwhile, costs are increasing, pressuring its margins. For example, content and bandwidth costs comprised 5% of revenue in the fourth quarter of 2011, but more than 7% in the fourth quarter of 2012.

Baidu also faces growing competition in its main search business from Qihoo and When Google left China in 2010, Baidu took over the Chinese search engine market and possessed as much as 80% share. Now the company's share of the market is down to around 70%.

Several analysts, including Raymond James, have recently downgraded their ratings on Baidu stock.

Potential Growth Areas

Yet many analysts believe the company still has huge potential in China and that fears of competition are overblown.

The company expects growth to continue, at least for the near future. Baidu currently expects to generate total revenues ranging from $945 million to $975 million for the first quarter of 2013, representing a 38.1% to 42.6% year-over-year increase.

There is more than enough room for Baidu to grow, along with its competitors. At home, only 40% of the Chinese population uses the Internet, so there is still a tremendous opportunity for organic, if not market share, growth.

Furthermore, Baidu has operations in 130 countries. It recently released its mobile developer tools in English. In January, the company struck a deal with France Telecom to create a better mobile experience for customers in Asia, the Middle East, and Africa. Finally, the company released an antivirus suite in Thai and English in early January.

As the search market is still in its infancy abroad, especially in Third World countries, Baidu has the chance to remain the "King of Search," with maybe 10 billion, 15 billion, or more searches per day.

Baidu also has plenty of room to expand in the mobile area. Right now, Baidu's mobile business represents only 10% of its overall revenues. The company has worked with smartphone makers and wireless carriers to get its search function into the hands of more Chinese consumers. However, the company says it could be two years before it benefits significantly from mobile revenues.

Growing Assets From Which To Build

Compared to the aforementioned competitors Sohu and Qihoo, Baidu has shown a much greater propensity to earn returns on assets and investments. Most recent returns on assets show Baidu at 20%, with Sohu at 7.62% and 7.15% for Qihoo. Baidu has a whopping 47.73% return on investments, compared with 13.36% for Sohu and 12.14% for Qihoo.

The company greatly increased its cash position in the last year, from $655 million at the end of 2011 to almost $2 billion at the conclusion of last year. It has significantly grown its total asset base from $902 million in 2009 to more than $7 billion last year. Much of that asset base, however, was acquired with debt as Baidu's long-term debt load went from $361 million in 2011 to $1.5 billion last year.

Still, the company remains fairly liquid. It has a quick ratio of 3, meaning that if it had to pay off all of its liabilities at once, it would only have to use one third of its liquid assets to do so.

So it seems fairly certain Baidu will grow, perhaps not as much as it has in the past. It remains to be seen whether its future growth rates will be enough for investors to push up its stock value.

Additional Disclosure: Catalyst Investments is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. This information is not investment advice or a recommendation or solicitation to buy or sell any securities. Catalyst Investments does not purport to tell or suggest which investment securities readers should buy or sell. Readers should conduct their own research and due diligence and obtain professional advice before making investment decision. Catalyst Investments or anyone associated with Catalyst Investments will not be liable for any loss or damage caused by information obtained in our materials. Readers are solely responsible for their own investment decisions. Investing involves risk, including the loss of principal.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was written by an analyst at Catalyst Investments.