Since July 2013, the share price of Baidu (BIDU) has run up by almost 45% to the current $161 level. Despite the significant price appreciation, I believe there remains a material price upside based on the following reasons:
Even after the run-up, Baidu still trades at a reasonable or inexpensive relative valuation level. The stock's forward EV/EBITDA and P/E multiples are trading at a premium ranging from 23% to 48% over those of Google (GOOG). However, after factoring in Baidu's stronger long-term EPS growth potential (i.e. consensus estimate), the stock's PEG ratio is 6% below that of Google. Given Baidu's superior top-line growth prospects and profitability performance (i.e. higher margins and return on investments), I believe Baidu's discounted PEG ratio relative to Google's would even slightly undervalue the stock (see chart below).
In addition, Baidu trades at discounted valuations relative to its major Chinese peers, which appears to be reasonable provided that market expects higher growth potentials for Tencent (OTCPK:TCEHY) and Qihoo (QIHU). After incorporating the consensus long-term earnings growth estimate, Baidu's PEG is fairly in line with the average of the two peers. Again, given the company's above-average profitability condition, I believe the stock's valuation is completely reasonable and even inexpensive on a relative basis (see chart below).
I believe Baidu's share price will benefit from the following developments, which should mitigate investors' concern on market share competition from Qihoo for the Chinese online search sector:
- The company recently rolled out "Zhixin" search, which provides searchers much more detailed results with enriched information. It is believed that this new feature will enhance user experience with the search engine and effectively lengthen their usage time by allowing more interaction with the website. The new feature will also enable Baidu to collect more detailed user information (e.g. user behavior and preference) and thus to more accurately deliver ads to target groups. In addition, the new feature also enables Baidu to recommend commercial products, which are offered by merchants that partner with the company, to users who have searched specific information that falls in a popular industry vertical (e.g. automobile, health care, financial, travel, and education). Given that "Zhixin" remains in its early user acquisition stage and it is a commercial platform which will improve the quality of Baidu's advertising products, I am of the view that future monetization of this platform would create a solid upside to the company's earnings.
- The company's Baidu Map product, which allows users to search locations and nearby merchants, has reached 140M monthly active users. Management announced that the company will start monetizing the user base over the next few quarters. Given the large user base and popularity of the product in China, I believe the monetization will likely bring in a material earnings upside over a medium term.
- Internet finance has recently gained traction in China and Baidu has been actively developing online finance products for both business and retail customers in recent months (e.g. credit line for merchants to finance marketing spending and investment trust products for retail investing). Owing to the company's dominant advertise base and various distribution channels through its major online platforms (e.g. search engine and various internet communities), it is expected that the internet finance area would likely become one of the company's significant revenue sources over time. In a recent research note, Credit Suisse estimated that Baidu's internet finance business would have a potential to reach a run-rate revenue of approximately $500M over a medium term.
- The spending on development and monetization of new products as mentioned above has been weighing on Baidu's profitability as reflected by a decrease of more than 10% in LTM EBITDA margin from 56.3% as at December 31, 2012 to 45.0% as at September 30, 2013. However, as the company is entering a phase of product monetization and begins tapering the development spending, it is expected that the operating leverage will eventually drive a margin expansion.
In summary, I believe Baidu remains a growth investment given the numerous catalysts ahead and the shares are currently offered at an inexpensive price. Hence, I recommend growth investors to continue loading up shares due to a favorable risk-reward profile.
All charts are created by the author except for the consensus estimate tables, which are sourced from S&P Capital IQ, and all financial data used in the article and the charts is sourced from S&P Capital IQ unless otherwise specified.