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Over the year, Google (GOOG) share price has been raging up by over 40% from the low of $560. On the contrary, Baidu (BIDU) share price has declined over 40% from the peak of $150. Here I'll compare Google versus Baidu and explain the reasons why I'd switch out from Google to Baidu for the internet search engine space.

1. Google is stronger than Baidu but each is the monopoly in its respective turf.

It is a well-known fact that Google is the largest search engine in the world, commanding 65% market share in global searches. In comparison, Baidu holds a very small 8% market share globally; however, Baidu is the monopoly in its own turf, owning 70% market share in China. Yes, Google is technologically more innovative than Baidu and Baidu's monopoly in China is partly a result of Google's retreat from the country. The sustainability of Baidu's monopoly position in China depends on when Google will re-enter China. Given the slow reform of freedom of speech in China, as long as Google conforms to its "Don't be evil" motto, China will remain a stronghold for Baidu for the visible future.

2. Both are facing the headwind of declining margin.

The rise of mobile search queries is more of a headwind than a tailwind. Due to the small screen nature of mobile devices, mobile search queries are more difficult to monetize and therefore carry lower margin. As mobile search queries gain more revenue share of the two companies, the margin is inevitably declining. Even if we argue that the incremental revenue growth will lead to incremental earnings growth, margin decline is always a bad development to the market because the nature of market is to extrapolate margin in a straight line.

Coupled with their heavy investment in other new products especially video portal, mobile hardware and cloud computing, the decline in margin will continue in the near term. Google even states, "we anticipate downward pressure on our operating margin in the future" in its 10-K. Nevertheless, the trend margin decline has already started and has been well absorbed by the market by now.

Table: Declining advertising gross margin.

Year

4Q2012

3Q2012

2Q2012

1Q2012

Google

61.5%

61.5%

63.7%

64.4%

percentage point change y-o-y

-3.5

-3.8

-1.2

-1.4

Baidu

68.5%

72.9%

72.4%

70.7%

percentage point change y-o-y

-3.7

-0.6

-1.9

-1.8

3. Google offers more potential upsides from its untapped assets.

Undoubtedly, Google have developed or acquired a number of valuable assets that are providing the vast opportunities for monetization. YouTube, Google Maps and Gmail are the positive examples but Mobile segment is a drag to the earnings.

On the other hand, Baidu does not have the equivalent of Gmail. Baidu is also just starting to invest in its video portal, iQiyi but is facing serious competition from the incumbent Youku Tudou (YOKU). One bright spot is Baidu Map ranks top two in mobile maps with another mapping leader, Autonavi (AMAP).

In short, Google owns more assets that have yet to be fully monetized.

4. Baidu's revenue growth prospect is still stronger than Google in the immediate term.

Both Google and Baidu are experiencing slowing revenue growth primarily due to increasing revenue base and increasing market share. At the same time, both are entering another phase of investment, leading to declining margin. A double hits of slowing topline growth and declining margin has hurt their earnings growth. Baidu saw a 6 percentage point decline in operating margin in 4Q2012 due to the aforementioned reasons and not to dismissed, partly due to competition. However, the difference is Baidu's revenue growth is still running at a rate of 40-50%, about 10-20 percentage points higher than Google's revenue growth. As a result, even with a 7.5 percentage point decline in margin, 35% revenue growth will still result in a healthy 12% earnings growth for Baidu.

Table: Growth is slowing for both but Baidu is still growing faster.

Google

Year

2012

2011

2010

Revenue growth

32.4%

29.3%

24.0%

Advertising revenue growth

21.5%

29.3%

24.0%

Earnings growth

8.9%

17.9%

24.9%

Baidu

Year

2012

2011

2010

Revenue growth

53.8%

83.2%

78.0%

Earnings growth

45.9%

91.4%

146.7%

5. Baidu's valuation is much lower.

Along with its share price increase, Google's PE has risen from the low of 17x PE to currently 25x trailing PE. The reverse has happened to Baidu of which PE has declined from the high of 32x PE to currently 19x trailing PE. The valuation gap between Google and Baidu implies a very bullish earnings expectation for Google. On the other hand, given the strong topline growth, any positive surprise with margin will immediately translate into a strong boost to earnings growth for Baidu. The current valuation of 19x trailing PE is more than reasonable for Baidu for its strong position in China albeit slowing growth in the near term.

Table: Historical PE.

Google

Year

2012

2011

2010

52-week high PE

23.2

20.6

23.9

52-week low PE

17.2

16.8

18.2

Baidu

Year

2012

2011

2010

52-week high PE

31.8

51.8

73.5

52-week low PE

19.2

33.4

29.4

6. Baidu is oversold.

A string of negative news flow has hit Baidu. Earnings disappointment is the key reason of the sharp share price drop for Baidu. However, the combination of the numerous accounting scandals of the US-listed Chinese ADRs and the overhyped competition from Qihoo (QIHU) has exacerbated the negative sentiment against Baidu. Yes, competition will arise from time to time but Baidu's resources are simply much stronger than Qihoo and surveys show Qihoo's market share has stabilized at about 10%.

Most importantly, both the current valuation and recent share price movement of Baidu have priced in these negative developments. Baidu share price has recently stabilized around $87, suggesting weak shareholders might have been shaken out.

Conclusion

This is a classic situation to buy a stock when the margin is depressed due to heavy investment and temporary competition from peers. Baidu, though not as superior as Google, is still the leading player in China. Evidently, switch out from the crowded trade of Google to Baidu, which is undervalued, over bearish, oversold.

Disclaimer: Third Mile is not a registered investment advisor or broker/dealer. All information contained herein is for general information purposes only and does not constitute any investment advice. Third Mile does not guarantee the accuracy or completeness of the information contained herein. Readers are solely responsible for their own investment decisions.

Source: Baidu: A Better Alternative To Google