Yes, that's right. The "Chinese Google", who on the heels of reporting yet another strong fiscal quarter in Q2 FY2013, is undervalued at close to $140. Despite Baidu (BIDU) currently trading at its highest price since April 2012, significant catalysts in the company's platform, including strong search engine adoption and improved monetization in the mobile arena, as well as continuing growth in advertising revenue leads me to believe that the company still has quite a bit of upside in the intermediate to long term. In addition, the acquisition of 91 Wireless, China's third largest app maker and distribution platform, could help advance Baidu's mobile market share at a significantly faster rate. Combined with solid fundamentals and stellar financials, Baidu is a steal even though it is flirting with $140.
Baidu is the largest search engine in China, providing a plethora of online services such as Baidu Audio and Image searching, Baidu Map, and Baidu Space. During the Q2 FY2013 earnings call, it was announced that Baidu had grown its revenues 39% YoY to $1.23B, which was in line with street estimates. This was mainly attributed to the company's 33% YoY increase in online marketing customers (468,000) and a 4% YoY increase in revenue generation per online marketing customer (~$2,580). On the flip side, increased TAC expenditures, additional investments in network capacity and R&D, as well as ramped up promotional expenses for the company's mobile platform caused costs to rise as well. This caused a contraction in Baidu's margins, but allowed for the company to intensify its growth prospects and expand its mobile platform to become an increasingly significant contributor of revenue. This was confirmed when CEO Robin Li announced that Baidu's mobile platform accounted for over 10% of revenues for the first time in the company's history.
Going forward, I believe that R&D costs and promotional activities will increase in the intermediate term before leveling off. While this will likely cause margins to contract more in 2013 and 2014, investors should look at these expenditures as a plus, since adding additional services to the company's platform and the expansion into the mobile space will only add to the company's long term value. A few more things to note:
- Baidu has garnered significant share in several different online markets through acquisitions. The most recent of these has been China's top online video streaming platform iQiyi and one of China's largest app developers 91 Wireless.
- Baidu updated its vertical advertisement platform, allowing user searches to create an increasingly accurate display of advertisements. For example, if a woman searches for designer purses, advertisements for Versace and Gucci are more likely to be displayed rather than advertisements for Wal-Mart off-brand products.
- Baidu added over 58,000 new online customers in Q2 2013 - representing the largest single quarter growth in this category in the company's history.
- Baidu developed a new proprietary software platform allowing users to create mobile versions of their websites - resulting in over 50% of mobile revenues coming from mobile optimized web pages.
- The company's adoption of new mobile advertising channels and its updated integrated PC and mobile bidding system has been strong, with a majority of the feedback being positive. The company expects further improvements such as geolocation to be available in the near future.
- Why is Baidu's mobile growth so important? Because China is currently undergoing a massive shift to mobile technology. The charts below detail the shift, and for more information, take a look at my article on Apple, which contains even more data on mobile and smartphone penetration in emerging markets.
And now we are on my favorite section - breaking down the financials of a company. Baidu has a truly pristine balance sheet, and revenue and cash flow generation has been stellar. Let's take a look at a few of my favorite financial ratios:
- Current Ratio of 4.21x.
- Quick Ratio of 4.21x (Baidu does not have physical inventory).
- Cash Ratio of 1.44x.
- Estimated FY2013 Operating Cash Flow to Liabilities Ratio is 2.53x.
You can see a snapshot of my Baidu model's statistical information below:
One thing of note here is the PEG ratio. While I forecast that the company has a terminal P/E ratio of 23.3x (more on that in the following section), the average growth rate over the next five years is 40.9%. This results in a PEG of 0.57, telling me that on the basis of a P/E valuation, Baidu is significantly undervalued at its current levels. For me, this presents a large amount of potential upside, as the company would be justified in having a higher P/E multiple - and thus higher valuations.
Like in all of my articles, I am going to start off by displaying my model's projected income statement, lead into a refresher on my two primary valuation methods, then give an analysis. For the sake of consistency, this section will read almost identical to those in my previous articles.
1) Intrinsic Value (IV) refers to how much the stock is worth by projecting future EPS and/or DPS growth. The IV is theoretically what the company's price would be in a fully rational market where stocks trade at exactly the amount they are worth and multiples, such as the P/E, moved at a relatively stable rate. Therefore, stocks do not necessarily have to trade at the IV. The IV is calculated by forecasting 4 to 5 years into the future, then discounted back at the present value. Thus, the IV places a higher emphasis on companies that are estimated to have sustainable earnings and/or dividend growth.
2) Target Price (TP) refers to what we believe a stock will sell at given a particularly time frame - such as a 12-month TP. The TP may differ from the IV as it could be higher or lower due to investor perception and/or less than efficient markets. Theoretically, at some point within the long term (4-5 years), the long-term Target Price will equal the long-term Intrinsic Value. The TP does not take into account a company's long-term growth potential, but is likely a more accurate depiction of a company's stock price in the more immediate term. Theoretically, a TP multiple, such as P/E, will be higher than an IV multiple, as company's growth tend to slow over time.
Now, let's take a look at the valuation from the perspective of the P/E Multiple:
The two lines to focus on in the above exhibit are the two "My Estimate" rows. The first of these rows forecasts the Intrinsic Value, while the second forecasts the Target Price. Without going deep into the specific technical aspects of the model, here is how I calculate both the IV and TP P/E multiples. The TP multiple comes first, and is comprised from several factors of information: 5-year historical high and lows (taking out abnormally high and low values), and consensus estimates. Then I assign several ratings to the company, including financial standing, growth prospects, industry outlook, management grades, and profitability.
These factors all combine into what I call the "Modified P/E ratio" which in this case is 33.0x. This is what I believe the stock should trade at, not necessarily where it will trade. The next step is to take into account a company's historical P/E trend and use this to forecast a P/E multiple, which comes out to 18.9x. In addition, I take into account the average of the P/E multiples of a company's peers (which I calculate to be 24.0x). Finally, I combine the "Modified P/E", historical trend P/E, and the peer P/E, which leaves me with a P/E ratio of 25.3x. This becomes my TP's P/E multiple. You can see a visual of the proceas below.
The final step in the process is to calculate the IV P/E multiple. Rather simply the IV P/E is the TP P/E discounted at the company's Weighted Average Cost of Capital, or the WACC, which you can see outlined below. This process results in an IV P/E multiple of 23.3x. Think of this as what the mean P/E multiple would theoretically be (based on an initial P/E multiple of 25.3) for Baidu over the next 5 years. Remember, like I discussed earlier, as company's growth typically declines over the years, so should its P/E multiple (which is often viewed as a reflection of growth).
Therefore, my Target Price is calculated by using the P/E multiple of 25.3x my 2014E EPS of $5.95 - giving me a valuation of $150.
The Intrinsic Value calculation is a little bit more complex, but it comes down to applying the P/E multiple of 23.3x to forecasted EPS and DPS that run through 2017 - which results in a valuation of $185. In a very similar manner to a Free Cash Flow Analysis, this is what I believe Baidu's per share value is when taking into consideration future earnings and dividend growth.
Now let's take at the valuation from a free cash flow point of view:
As you can see, my free cash flow analysis calculates the stock's fair value at $153. I use a long term growth rate 2.5%, which is in line with economic growth in the U.S. over the past 5 years, and my WACC of 8.7%. The FCF analysis complies with the analysis from both of my P/E valuations. This consistency makes me feel more comfortable that the valuations are strongly supported.
Baidu is a stellar example of an industry giant with stellar financials and plenty of additional room to grow. By factoring in the company's recent push into mobile with China's mobile explosion, I view the stock as having significant long term potential, perhaps even more so than my valuation suggests.
Additional disclosure: Many of the financial models presented in this report were first developed by the Louis Wilson Fund of Millsaps College, where I served as Lead Analyst and Portfolio Manager from 2011 - 2013. All data, estimates, exhibits, and opinions are my own.