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When it comes to analyzing/valuing Chinese companies operating in China, the rules of the game are very different especially in terms of analysts' estimates and expectations. The economy is growing at 7.7% amid a global recovery with the U.S. barely touching 2.5%, and the EU is a lost case as for now. Yet analysts are disappointed and their disappointment is manifested in their expectations of companies operating in the Chinese's ecosystem.

Earnings overview

Baidu (NASDAQ:BIDU) is the Chinese equivalent of Google, leading Chinese Internet search provider. The company announced its first-quarter earnings on April 25. From a quarterly perspective, the results are upbeat; total revenue, operating margins and net income increased by 40%, 5.7% and 8.5%, respectively. The earnings growth rate has disappointed, declining from 39% to 17% sequentially. From year-over-year perspective the gross margin has declined from 71% to 65%, mainly due to an increase in marketing and sales expenditures (77%), research (83%) and Increase in traffic acquisition cost from 7.8% to 10.2%, driven primarily by the aggressive investment in mobile Internet segment. Marketing and sales expenditure is expected to rise in the future given its stake in the mobile Internet market. The company has seen phenomenal CAGR over the seven years increasing revenues and net income by 84% and 115%, respectively.

Industry outlook

The Chinese economy has slowed down over the last few quarters but with major expansionary policy in action, the GDP growth rate is expected to pick in the medium-long term. Chinese online search advertisement market grew at 49% in 2012 but is expected to slow down due to its mature nature, and it would grow at CAGR of 24.6% over the next five years.

Baidu commands 80% of the total online PC search engine market share, handling 82.3% of the total online search queries. It has dominated the industry but with the introduction of Qihoo (NYSE:QIHU), competition is expected to intensify. Qihoo came along last year and has already acquired 12.5% of the market share, collaborating with Google (NASDAQ:GOOG) churning out better monetized products. The PC market is slowing and is expected to grow at much slower rate - paid click revenue growth has been severely hampered by the declining PC traffic, from 64% to 27% year-over-year. Qihoo's management has set 20% market share target for the end of 2013, and 40% market share target for 2014. Given its rate of market share acquisition in the past the possibility of Qihoo matching its targets cannot be ruled out.

But the game is more interesting on mobile Internet search engine front, where Baidu commands 35% of the market with other much more established players, e.g. Tencent and Easuo. In the latest quarterly announcement, the company pointed to its intent to tap into faster growing mobile market, and has proven that by increasing marketing and sales expenditures by 77% in a bet to gain more traction.

Future Outlook

The company's management has made it very clear that it would not aim at maintaining profit margins at this point in time, and would invest aggressively in growing markets in order to sustain the growth rate and expand its presence. The firm's acquisition of iQiyi is evident of its strategy to grow and that is partially via acquiring other companies. According to Reuters, the company is also looking at entering into the online streaming video market by acquiring PSS Net TV, confronting Youku Toduo, the market leader. Although it must be pointed out that its acquisition of iQiyi has not repaid planned benefits and the segment has reported losses. The business segment is not expected to report profits in the short-medium term according to analysts. The market has responded negatively to the recent earnings announcement - this is understandable given lowering growth rates over the last three quarters.

Three Necessary Measures

Baidu has three major objectives up ahead, which would largely determine investors' outlook of the company. The company needs to increase traffic in fast growing and large mobile search services. The management has pointed out that it is focused on providing e-commerce and location based services encouraging the mobile Internet users. Secondly, the company needs to improve its mobile search traffic monetization, which would be an uphill task since mobile screens do not provide enough space for monetizing. Lastly, the company needs to maintain if not increase its market share (dominance) in PC traffic in order to sustain a healthy profit margin growth rates.

Conclusion

Form a Valuation perspective, the company is trading at discount. Its trailing P/E over the last three years has decreased from 99x to 17x, much lower than the industry and sector P/E of 21x and 25x, respectively. But the company's management efficiency ratios have declined in recent quarters especially ROA, ROIC and ROE.

I expect the market participant to be cautious, employing a wait and watch strategy especially before the next quarter's earnings announcement, although the long-term prospects of the company are promising given its investment in research and marketing pays off in the mobile Internet segment.

Source: Where Does Baidu Stand In The Industry?