A common theory in the technology world is the concept of investing for the future. Typically, these phases take place prior to a company going public, but lately several large-cap techs have started campaigns to dramatically increase expenses to capture mobile growth. Ironically, the market has chosen to punish one stock while giving the other a big pass. Not to mention, the mobile transition has been a constant profit disruption to most major firms, as the initial traffic flows don't offset the lower monetization levels.
Over the last couple of weeks, both Baidu (BIDU) and Facebook (FB) have reported that margins were greatly impacted by ramped up spending for mobile. The only difference is that Facebook continues heading to recent highs while Baidu languishes at multi-year lows, appearing as if the stock might head much lower.
While investors fret over the increased costs and the transition to mobile search, they are missing the big picture that mobile will eventually lead to much higher traffic for a country with less than 42% Internet penetration. The leading Chinese-language internet search provider, with over 70% market share, will eventually have a much larger market opportunity as the Chinese internet market greatly expands with the potential for a larger mobile proliferation than desktop computers.
Q1 2013 Earnings Highlights
While investors mull over more competition in the search market from Qihoo 360 Technology (QIHU), the real issue clearly isn't occurring as Baidu's revenue expanded by 40% in Q113. The company reported the following highlights for Q1:
- Total revenue in the first quarter of 2013 was RMB5.969 billion ($961.0 million), a 40.0% increase from the corresponding period in 2012.
- Operating profit in the first quarter of 2013 was RMB2.210 billion ($355.9 million), a 5.7% increase from the corresponding period in 2012.
- Net income attributable to Baidu in the first quarter of 2013 was RMB2.043 billion ($328.9 million), an 8.5% increase from the corresponding period in 2012. Diluted earnings attributable to Baidu per ADS for the first quarter of 2013 were RMB5.88 ($0.95); diluted earnings attributable to Baidu per ADS excluding share-based compensation expenses (non-GAAP) for the first quarter of 2013 were RMB6.20 ($1.00).
As mentioned, Baidu reported a 40% increase in revenue for Q1, yet the company only reported an 8.5% increase in net income as substantially higher costs swamped the revenue growth. Principally, the company substantially increased marketing and research and development expenses as it looked to ensure it captures market share in mobile. It also saw higher traffic acquisition, bandwidth, and content costs, partially from the iQiyi consolidation in the quarter.
Updated Earnings Estimates
Based on the guidance from the company, analysts have again greatly reduced the earnings estimates for 2013 and 2014. As shown below, analysts now expect the company to only earn $5.03 for this year,down from $5.42 expected prior to the quarterly report and $6.25 next year, down from $6.82 previously.
* provided by Yahoo! Finance.
While the earnings growth expectations for 2013 have been reined in, analysts still expect the company to report 30% revenue growth during 2014. As can be seen from a Barron's analyst summary, the fears on mobile search appear overblown by the community. It seems a little dubious to assume Baidu would have any more problems than Google (GOOG) at maintaining a lead in the transition to mobile search.
China Internet Growth
Unlike Google in the U.S., Baidu has the tailwinds of a growing domestic internet market. While the majority of U.S. citizens are on the internet, China only had a 42% penetration rate at the end of 2012 according to the China Internet Network Information Center. Of the 1.3B people in the country, only 564M were on the internet and probably over 600M four months into this year.
Even more importantly, 420M people use the internet via mobile phones. Over 74% of the internet users use a mobile phone and that could be a different set of consumers. The major implication is that mobile provides a quicker and better opportunity for Chinese citizens to join the online world. Mobile traffic might have lower profit margins this year, but eventually it will lead to dramatically higher Internet penetration rates
Though Facebook competes in a vastly different market segment of social networking, it still faced similar mobile difficulties that required a high level of spending. Facebook is further along in the mobile transition with a more mature U.S. mobile market.
The stock currently trades at over 34x forward earnings even though it trades at a large market cap of $67B. The earnings level has stayed virtually flat over the last 3 years outside of Q4 bumps higher. With a revenue base of only $6.7B, the stock trades a substantial multiple showing that investors have quickly looked beyond short-term development costs.
On the other hand, Baidu trades at a market cap of only $30B with a revenue multiple of 6x the expectations for 2013. Analysts only expect earnings to grow by 20% long-term yet the stock trades at an incredibly low multiple of 13.5x. Anybody thinking the company has reached a wall only needs to check out the size of Google. As long as Baidu remains the market leader in China, it will eventually reach those revenue levels.
The below chart compares the search engine competitors and social network leader over the last year:
The most notable part of the chart is that as investors become more comfortable with the mobile transition success the stock roars back. It occurred with Google during Q312 and Facebook during Q412. Baidu might be the next stock to rebound.
Baidu continues to provide an incredible value in the market yet it trades at a substantial discount to the short-term reduced earnings growth. The company is in the midst of a transition in the China market to mobile search where it requires a higher level of investment in order secure the market leading position. Just as Google and Facebook before it, the company should no doubt exit the transition as the market leader. The fears are vastly overblown, as the company should dominate the mobile search market. No evidence exists that Qihoo 360 is taking any market share away from Baidu.
The stock is holding support around $84.50 that if broken could push it much lower. If that occurs, investors should look to load up on the stock after it stabilizes at lower levels. The investment for the future should be even more beneficial in a developing market such as China.
Additional disclosure: The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any stock you should do your own research and reach your own conclusion or consult a financial advisor. Investing includes risks, including loss of principal.