Baidu: Raising Questions on Valuation and Search Ads

| About: Baidu, Inc. (BIDU)

I addressed in a recent post the operational risks that Baidu (NASDAQ:BIDU) may be facing in the future; today I want to focus more on the market valuation of the company, now standing at almost $4 bn.

I’ve been looking with interest at the recent rally and I’ve been reading a lot of news.. In particular I found the recent research report on Baidu published by WRHambrecht on Seeking Alpha very detailed and insightful. Here’s my view.

Baidu will definitely grow a lot in the future years, though I believe that the pace will slow down more that the Street’s expectations. While not agreeing on many numeric assumptions of the report, let’s assume for a moment that WRHambrecht EPS estimates (approximately 15% higher than consensus) are accurate. According to these estimates, EPS in 2010 will reach $5.58, which already implies a P/E of 20 on 2010 results.

Now, would you buy in 2006 a stock that is already trading at 20 times the earnings of four years later?

Another question: what are our return expectations for a risky technology stock? Should we assume a 15% annual return? In that case we would expect Baidu shares to reach $167 in 2009, but at that point the stock would trade at 30 times 2010 earnings. And this, to me, appears totally unsustainable.

There is also another reason that makes me quite skeptical about the current evaluation. The research report by WRHambrecht says: “As noted before, we believe a major reason that Baidu produces better metrics is due to its website layout, where users cannot distinguish sponsored and natural search results. In contrast, Google’s site clearly distinguished the two, therefore discouraging users to click on them”.

Now this is really worrisome. Google has always made it clear: since switching costs for internet users are zero, they want to provide the best user experience and the most relevant results for a search. Otherwise, a user would go to another search provider. Baidu is not distinguishing sponsored and natural search results. This can only have one consequence: a worse user experience. Maybe in this first phase of internet development in China, people are still not so worried about the relevance of the results returned from a web search, but eventually they will. And at that point Baidu will either see its market share decline in favour of search engines providing higher quality results or will start distinguishing sponsored and natural search results, thus affecting its current click-through ratio and the revenue growth potential.

Disclosure: Author is short BIDU