Anyone waiting for Baidu (BIDU) to dominate the fast-growing Chinese search market the way it did a few years ago should invest in some scuba gear and go find a treasure in the sea. Qihoo (QIHU) and Youku Tudou (YOKU) will not permit it to happen. On the flip side, Baidu's quarter two results proved that the Chinese giant still leads the PC-based search industry in China. And if Baidu's spending plans are any indication, skeptics should exercise some patience about its financial commitments to the Chinese mobile computing market.
Baidu's recent report cannot be analyzed without first comprehending the situation the company faces. Baidu is focusing more on the mobile market but underestimating the cost. Qihoo had been eating away at its search engine market share with the new focus.
Ahead of Baidu's report, the market knew the company had been spending heavily on research and development toward diversifying its operations. Essentially, Baidu wanted the mobile sector to invigorate its profits. But the opposite occurred. So shame on people who expected bumper profits from Baidu.
Q2 was in line with expectation
Wall Street was looking for revenues of $1.23 billion in quarter two. Baidu matched the figure, increasing its revenues by 28% compared to the previous quarter. Despite the 4.5% decline in profits, this should qualify as a win, considering the intense competition from rivals and the slowdown of the Chinese economy.
In addition, the revenues from Baidu's mobile services surpassed 10% of its quarterly report for the first time in the April-June period. The revenues were helped by among other things an aggressive research and development spending. Unfortunately, the spending made Baidu's profits to suffer a decline. Despite this, Baidu's EPS is projected to rise to 6.32 next year.
Baidu said the increase in research costs caused the decline in profits. But investors should keep in mind what the expectation was. Baidu still increased revenues at the estimated 28%. In other words, the company achieved results despite the decline in profits.
Bears may say the company should not have spent so much on the mobile computing sector. True, expenses went out of control. But the initiative was for good reasons. The company knew the mobile computing sector would show a growth in 2013 and beyond. China is approaching one billion mobile connections as 3G services gain traction. In fact, that research and development spending jumped should be an indication that Baidu is preparing for the future.
I know a decline in profits combined with increased expenses will not lead to a long-term growth. But Baidu has been reporting big profit increases every quarter. It knew the mobile sector was a growth area. And investors could see this in the company's third quarter guidance. Baidu says it expects revenues to come in the range of $1.4 billion to $1.46 billion. That Baidu's guidance is higher than estimates is a sign of confidence. It was no surprise that Baidu's shares rose 12% on the news. However, the company has to gain back its market share from rivals before it can achieve its revenue target.
Baidu's closest competitors are Qihoo and Youku Tudou. The forward valuations of these two stocks are in the 38 to 45 range; Baidu at a forward P/E of 19.91 is cheaper. With a return on equity of 44.08%, Baidu is more attractive than Qihoo (8.45%) and Youku Tudou (-7.53%). Baidu has a beta of 2.15, compared to 2.3 for Qihoo and 3.16 for Youku Tudou. This means it is less susceptible in a bearish economy.
Of course, Qihoo has been growing its business through the Chinese search sector. Revenues were up 58.6% in the first quarter. Earnings were however down 65% compared to the first quarter in 2012. Analysts are taking Qihoo's growth potentials into account due to the company's initiatives in the Chinese internet space.
Youku Tudou said its first quarter revenue rose 21% to $83.1 million, with its loss narrowing to $37.4 million. The improvement resulted with the combined figure of Youku and Tudou when they were separate entities.
Baidu will grow large profits. The good news is that the Chinese mobile market is expanding, and Baidu is witnessing increased revenues in the sector. That the stock did not suffer after the profit decline shows that analysts have confidence in it. Baidu's profit is a good bet to bounce upwards in the next quarter.