Search in China: Why Baidu's Growth Isn't Sustainable

Baidu (BIDU) recently released financial results for 3Q 06 and the company is still growing incredibly fast: revenues were up 25% sequentially or 159% year over year and market share increased. Many would immediately argue that this is absolutely a stock to have in the portfolio. Well, unfortunately, growth comes at a price. The stock is trading at a 2007 P/E ratio of approximately 55 for a market cap of $3.2 bn.

There are several reasons why the growth will decelerate in the coming years:

The current base of advertisers is made up of “early adopters”, mid/large cap with a relatively strong knowledge of internet marketing tools. In order to expand the customer base Baidu will start to approach tier two advertisers that are typically smaller, geographically spread-out and less educated vis-a-vis internet advertising. Reaching them through a direct sales force will prove inefficient, while the approach through distributors will cause margins to decline.

Google’s (GOOG) competition will strongly increase over time. The currently small size of the market was probably a good reason for Google to concentrate more on understanding the Chinese web user and to provide a better user experience. After all, user experience has always been a core aspect of Google’s proposition. The rapid growth of the market and the maturity of the business in the US will eventually lead the company to a more aggressive approach to the Chinese paid search market.

Almost 20% of all the searches on Baidu.com are related to mp3 files, often with links to pirated music. The company is trying to address the issue but it seems that it won’t be able to effectively solve the problem without giving up a significant amount of revenues. If you are worried about the copyright issues at Google/Youtube, you’d better be worried for Baidu as well.

Click fraud represents a significant issue for all the companies operating in the paid search market and the problem is particularly relevant in China, where a survey of more than 2,000 advertisers recently found that one-third believed they were victim of click fraud. A lack of confidence from advertisers could severely impact the growth perspectives of Baidu in the medium term. Reputation will play a relevant role in future years and Google is working hard in order to fight click fraud in the most effective way.

Chinese internet users will become more and more familiar with content in the English language over time and – as a result - Google and Yahoo (YHOO) could gradually increase their market share in China at the expense of Baidu.

Currently the market is betting on Baidu’s ability to deliver extraordinary growth in future years and even small disappointments can have a significant impact on the stock: the lowered guidance for 4Q 06 sent the stock down from $99 (market open on Oct 31st) to $84.8 (market close on Nov 1st).

We see the downside potential as higher than the upside and therefore we are shorting the stock.

If implied volatility goes up to 50% (currently it is at 40%) conservative investors might instead find it more appropriate to sell out of the money call options or write covered put (a combination of shorting the stock and selling out of the money put options).

Disclosure: Author is short BIDU

Related: Baidu Q3 2006 Earnings Call Transcript

BIDU 1-yr chart: