Big Brother Baidu

| About: Baidu, Inc. (BIDU)

The Internet search engine has completely changed the way that we use the internet and learn new information. The inception of the internet opened up a world of information that could be accessed anywhere with a connection. The new problem that was presented was how to find the information that you were looking for quickly and easily.

The solution to this problem was the internet search engine. This tool allowed people to quickly find information on the internet that was relevant to what they were looking for. After the first engine, Archie, launched in 1990, many competitors came to follow. Each company continued to innovate and contribute to helping the world find information on the internet. Ten years later in the Far East, Robin Li and Eric Xu founded Baidu (NASDAQ:BIDU), the third-largest search engine in the world in terms of traffic, according to the web information company Alexa. Baidu has achieved success similar to Google (NASDAQ:GOOG) in the Chinese market. However, politics in China has greatly shaped how Baidu operates and delivers search results to the people of China.

When Robin Li was hired by IDD Information Services in 1994, he helped develop the online version of the Wall Street Journal. While Robin was working for IDD, he developed RankDex, the first search engine that used hyperlinks to measure the quality of the sites it was indexing. This breakthrough led to a patent and would later be used as a fundamental feature of Baidu. The search engine currently indexes over 740 million web pages, 80 million images, and 10 million multimedia files. Baidu has a wide range of services including search tools for news, mp3s, images, videos, statistics, and also an internet browser. China has an estimated 530 million internet users and Baidu commands an impressive 63% market share among other search engines.

According to the China Internet Network Information Center, over the past 10 years, the amount of internet users in China has continued to rise from 33.7 million in 2002 to 513 million in January of 2012, which averages out to about a 31% increase every year. In the past five years, mobile internet users have grown from 17 million in January 2007 to 356 million in January of 2012. That averages out to an astonishing 83% increase per year over the past five years. To compare that with China's population growth, in 2001 there were 1.27 billion people living in China and by 2011 the number had increased to 1.34 billion averaging a growth rate of about 0.5% over the 10-year period. The internet is rapidly growing in China and Baidu is positioned very well to take advantage of this future growth potential in China.

China is a growing as a country and as a future dominant world power, but some government policies are affecting the way Baidu delivers search results. China has been controlling information that is released to the public for quite some time now. Democracy has been deemed a "dictatorship of the proletariat" and is not a popular idea with government officials. Opposition parties are not allowed and the government is indirectly elected by candidates chosen by the government. It should not come as a surprise that Baidu is limited in terms of what search results it can deliver. Any information that the government does not want the public to know is strictly censored on the internet. This was a major issue when Google entered the Chinese marketplace. Google wanted to have freedom to deliver whatever results it wanted and not to be censored. Google also noticed that thousands of Gmail accounts of human rights activists had been hacked and searched through in 2010. This was the last straw for Google's operations in China. There was a backlash created with the government and the end result was that Google started to forward its search results through Hong Kong. The reason for this is simply that Hong Kong is considered a separate entity from China and is not subject to China's strict censorship laws.

Even though Google China's headquarters is in Beijing, redirecting the internet traffic through Hong Kong allows it to circumvent Mainland China's laws on censorship. In March of 2009, China blocked a YouTube video of Chinese security forces brutalizing Tibetans in Lhasa and claimed that the video was "A lie." In 2009 China also blocked access to the video "Tank Man," the famous martyr in the Tiananmen Square protest who stood in front of a tank that was called in to quell the protest. A common message would appear when searching for these videos, "In accordance with local laws, regulations and policies, part of the search result is not shown." Even with Baidu bogged down with censorship laws in China, it continues to be the highest-ranked search engine in China, with Google coming in at a close second.

The competitive outlook for Baidu seems pretty fierce. Along with Google, Yahoo! China, Microsoft's Bing, Sina, Sohu's Sogou, NetEase's Youdao, Tencent's and PaiPai, Alibaba's Taobao, TOM Online, Xunlei's Sogou and EachNet are all vying gain more traffic. Baidu has distinct competitive advantages in China. The government subsidizes Baidu and protects it from virtually all foreign competition because Baidu strictly adheres to the government regulations regarding censorship of information. Consequently, users seeking unbiased information or information not indexed by Baidu might go elsewhere to find their search results. Another unique feature of Baidu is it allows customers to bid in an auction for advertising spots on Baidu TV. Baidu also hosts a controversial music service that allows users to download music for free while they search. The competitive advantages are apparent through its financial success. Baidu TV brings it about $500 million a year in advertising revenue alone. Overall revenue totaled over $22 billion with a net income of around $10 billion in 2012. The net income of Baidu has soared for the past four years, increasing from $1.49 billion in 2009 to the current $10 billion. This net income results in an astounding 38% return on equity making it a very profitable company.

If China continues to protect Baidu's profits and the growth of Internet users continues to soar, Baidu will have little to stop it in the future.

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

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